Mutual Funds: A Practical Guide to Investing for Beginners

9 minutes

Courtesy of dnaidia.com
Courtesy of dnaidia.com

Mutual Funds are currently the backbone of our retirement system. Just about everyone one of us a mutual fund in our 401k or invest in them directly as a means of making more money.

Did you know that currently as of 2015 there is $15.7 Trillion in assets invested in the US in mutual funds. Also there are 54.9 million households that are invested in mutual funds. Additionally, there are 93.1 million individuals investing in mutual funds. Needless to say mutual funds are a incredibly important vehicle of our retirement system.

In this post we are going to discuss what a mutual fund is, how they are organized and whether or not we should be so heavily invested in them. I think with such a reliance on this vehicle that it is paramount to understand them.

So what is a mutual fund?

According to our old friend Investopedia a mutual fund is an “investment vehicle made up of a pool of fund collected from many investors for the purpose of investing in securtities¬†such as stocks, bonds, money market instruments and similiar assets.”

Mutual funds are managed by money managers, whose job it is to invest the funds in creating capital gains and income for the funds investors. This is all guided by the objectives and principals that are stated in a funds prospectus. A prospectus being a legal document that will state everything about security offereing such as a mutual fund. In it will be the objectives of the fund, what kinds of securities it will invest in and what kinds of fees it will charge. More on this later.

One of the big draws of a mutual fund is they give us small investors the access to professional money managers and an extremely wide range of securities, bonds and other investments. All this helps us diversify our portfolio.

So each shareholder that invests in the fund will track either wins or losses with the increase or decrease of the fund. The price per share of a mutual fund known as a Net Asset Value or NAV is determined by dividing the total assets under management by the total shares available.

Mutual funds are different from stocks in that they track by the market capitalization of the fund itself as opposed to each individual stock that is held by the fund. So, for example lets us the number one rated value mutual fund according to Morningstar.com. They are considered the best resource for information about mutual funds.

The Vanguard Equity Income Fund (VEIPX) is trading for $31.12 per share. It currently has an asset under management(AUM) total of $23.6 billion. As the share of the fund rises or falls the AUM match the rise or fall. This is how the fund is measured by the amount of money being managed.

So different from stocks in how they are tracked. Stocks are evaluated by the individual price and the fund will be evaluated by the market capitalization. One big reason for the difference is the share of Amazon is one share in that particular company, whereas the share of VEIPX is a holding of many, many stocks.

Let’s dive into the Vanguard Equity Income Fund to learn more about it and how it works to illustrate some of the features of a mutual fund.

Firstly, Vanguard is arguably one of the leaders in the mutual fund world. They have currently have $1.657 Trillion of assets under management. Impressive. This particular fund is a large-cap value fund. What that means is that they include large companies that have a value of over $5 billion. These companies typically will be of the blue-chip variety and pay a dividend.

The breakdown of the asset allocation of this fund is:

  • 87.3% US stocks
  • 9.3% Foreign stocks
  • 1.8% Others
  • 1.6% Cash

The top holdings of stocks for fund are:

  • Microsoft
  • Johnson and Johnson
  • General Electric
  • Jp Morgan Chase
  • Wells Fargo
  • Exxon Mobil
  • Verizon
  • Pfizer

As you can see all very large, well known companies that all pay a dividend. One of the perks of investing in a mutual fund would be if you wanted to buy some Johnson and Johnson but couldn’t afford the share price you could invest in the mutual fund instead. If you tried to buy all of these stocks individually it would add up to quite the investment.

Each fund will have a desired asset allocation and sector weighting base on the parameters setup in their prospectus. This is where the goals and objectives of the fund will be stated.

There an incredible amount of mutual funds to choose from. As of 2014, there were over 9000 funds in the US alone. Needless to say, there are plenty to pick from.

There are also as many different flavors of funds to choose from as you have imagination for. The can range from a technology focus, financial focus, industrial focus or a bond focus. There are really so many out there it is a little overwhelming.

Because there are so many funds. One of the ways to screen for them is use a well-known firm such as Vanguard to help you decide which one would be best for you. Another resource would be a trusted financial advisor as well. Keep in mind that the two largest mutual fund firms are Fidelity and Vanguard. These would be the best resource for you to find a fund you would want to invest in.

One of the most popular ways to screen for funds is to look for the hottest performer lately. Individual investors will look for the fund that has had the best return last year or the last three to five years. For example, our fund VEIPX last year had a return of 17.21%. Which is pretty darn good. The returns for the last 3 years has been 10.19% and for the last ten years it has been 7.63%.

Let’s talk about fees

Fees in the mutual funds are where the rubber meets the road. By this I mean this is where all the feel good, fuzzies come to a screeching halt about investing with mutual funds.

This is in my opinion where the wheels come off. And I am not the only one who feels this way.

Let’s take a closer look at this so you understand what I mean by this.

When you invest in a mutual fund you are assessed a fee known as an expense ratio. A fund’s expense ratio can be either it’s management fee or it’s advisory fee plus administrative costs.

These fees can be assessed either in the front-end or the back-end. These are known as front-loaded or back-loaded fees.

Front-loaded fees are assessed at the purchase of shares in the mutual fund. Likewise, back-loaded fees will be assessed with the sale of the shares.

Let’s talk some numbers about how the fees effect your returns and why they are not good for you.

Using our fund VEIPX as an example. In their prospectus they list their management fees as 0.27%. This means that for every $10,000 you have invested you will pay them $27 a year. That may or may not sound like a lot but to put it into perspective.

If you extend that out to 10 years that fee would equal $331! Now we are talking about some real money here. Keep in mind this is a fee you will pay every single year, regardless of the performance of the fund. This is not the fee you pay to get into the fund or out of the fund. This is strictly the management or administration costs.

So let’s say that the fund for last year had a performance of 5%. The real return you would have would actually be 4.73% because the fee would be paid to the fund manager out of your profits. What if they had a bad year and the return was -5%? Well, guess what your return would be even lower at -5.27%.

This is where fees start to make a difference for you. And to add more fuel to the fire would be to pile on by talking about inflation. This comes into play in the respect of inflation eats into how much your money is actually worth.

Therefore, if your return for the years was 5% and they take their fee out bringing us down to 4.73%. We then tack on the inflation rate, which currently is 1.46%. Now our actual real return is 3.27%!!

Talk about taking a bite out. Ouch.

This is one of the biggest topics going on in the world of investing right now. Everyone is super concerned with fees and rightly so. They eat into your returns drastically and can end up costing you thousands of dollars. Money that could have been earning so much more with the power of compounding.

A few articles that I read recently, one by Jason Zweig. If you are not familiar with him he is a contributor to the Wall Street Journal and is a fabulous writer. He submitted a talk he gave 21 years ago talking about the damage fees can do to investors. His speech can be found here.

The other great article I read was by Stephen Mihm of Bloomberg. He talks about the revolution that is going on in the investing world. One of the points he talks about is the stampede of money heading out of expensive funds and into cheaper, more passive investments. You can find the article here.

As of 2016, the average cost is .90% per year. This doesn’t include another cost that isn’t discussed that much but defnitely is another added fee that is hidden by fund managers. This is called the transaction fees.

To break this down a little bit. A transaction fee occurs whenever there are buying or selling of the stocks in a mutual fund. These fees are passed onto the consumer of the mutual fund from the manager. These fees average 1.44%

Another fee that is not discussed is the impact of taxes on a mutual fund. Let’s say you are invested in a fund that is not in a tax-advantaged fund, like a 401k for example. If you purchase shares of a mutual fund that has increased in value prior to your investment runs the risk of paying capital gains on those increases. In other words, you would pay a 1% tax on those gains even though they happened before you bought into the fund.

So now we have this scenario:

  • Expense ratio .90%
  • Transaction costs 1.44%
  • Taxes 1%
  • Total cost of fees 3.27%

3.27% in fees just to have your money managed for you. That is insane. This means that you will have to have a 3.27% return per year just to break even! Crazy.

An additional cost that could incurred would be a financial advisor fee on top of all of this. A typical 1% fee for their guidance or advice might not be a bad investment in and of itself, particularly if you trust and value their opinion. But when you top that with the fees from the mutual fund, you start to get why a mutual fund might not be the best investment for you.

The last cost I will talk about is one that can’t have an exact number attached to it. This would be the market impact cost. This is a combination of a factors that can impact the price of a particular stock or the market as a whole.

Typically when a mutual fund moves in and out of a stock, it will affect the price even before or after it is done with the transaction. Keep in mind when these managers trade these stocks we are talking about millions of shares in some cases which can drastically alter the price.

This can affect you by giving you a less favourable stock price when the transaction occurs. Also the fund manager may alter his investment strategy to avoid impacting the price of the market excessively. In addition he may take a longer horizon to move a stock to avoid the sudden sharp movement in prices that can happen in the short term.

Lastly, he may be forced to include lesser stocks in the portfolio to lessen the load on the more popular stocks in the portfolio. This can drive down the value of the fund by having lesser valued stocks, all to keep the value of a more valued stock higher.

All in all, this is a bad situation for the investor because the fund may get less value from the stocks in a buy or sell situation as well as the over all value of the fund decreasing in an attempt to lessen excessive costs.

Frankly, it is all a delicate balancing game.

Final Thoughts

Mutual funds are a investing vehicle that has served it’s purpose. At one time they were the instrument used for investing when you didn’t want to spend the time valuing common stocks. If you were a passive investor or you didn’t have the time to study stocks this was the instrument of choice.

The time for mutual funds has passed, in my opinion. One of the many reasons is the huge fees that are charged. We spent quite a bit of time talking about how much fees can affect your returns. This is money that you have worked hard to earn and to give it up to excessive fees is such a waste.

With the arrival of ETFs and Index funds the mutual fund as it sits now is becoming a thing of the past. Keep in mind that most mutual fund managers have not kept pace with the S&P 500, which in most cases is their benchmark for comparison. So why in the world would you pay extra money for fees when they can’t even beat a benchmark that you could invest in for considerably lower fees and could make you more money. This can all be accomplished with an index fund that matches a particular index like the S&P 500.

I have enjoyed diving into mutual funds with this post and I have learned a thing or too myself. I hope this has been of benefit to you and please take a moment to share it with some who you think could benefit from this info.

As always, thank you for taking the time to read this post.

Take care,

Dave

 

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