Mutual Funds for Wise Bloggers
I know that Wise Bloggers are smart readers, so you might already know everything there is to know about mutual funds. However I have come across many very smart people who don't always have the full scoop on the mechanics of mutual funds. Hence: this refresher article.
Mutual Funds: The Basics
A mutual fund is a "basket" of investments, managed by a fund manager (usually with the help of a team of analysts). This basket of investments can be made up of stocks, bonds, short term securities, or even real estate among other vehicles.
As a mutual fund investor, your money is pooled with that of other people who are investing in the same fund. The fund manager, now with lots of buying power since the money is all pooled together, then buys and sells the securities and actively manages the holdings.
As a mutual fund investor, you buy shares (also known as units) of the fund, based on the amount of money you are investing. You are also able to buy fractions of shares if the money you invest doesn't divide exactly into the share value or if you are investing small amounts of money. Mutual funds are open-ended, so when you invest you buy shares directly from the fund itself, and when you wish to sell you sell directly back to the fund. This makes for a fairly liquid investment, as you don't have to find a buyer in order to sell (or vice versa).
Mutual funds are valued daily (and in some rare cases semi-monthly or monthly, for example with real estate). The daily value (known as the Net Asset Value) is calculated as a function of the current market value of the holdings divided by the number of shares outstanding.
Performance of a mutual fund depends entirely on two factors:
1) What the fund invests in.
2) The competence of the fund manager.
A fund that invests in small cap stocks will perform quite differently from one that invests in bonds, and differently again from a short-term money market fund. Likewise the competency of the fund manager comes into play and can drastically affect the returns. The fund managers do however have many incentives to perform, as they can lose their job if they under-perform compared to other funds of similar mandates.
Making Money with Mutual Funds
Assuming your mutual fund is a winner and is making money, the fund manager passes the capital gains/dividends/interest earned by the holdings on to us, the shareholders. Thus at the end of the year, you must report the income when you file your taxes.
I will also note that in most cases, people re-invest the income in the fund, which is a great case for compound growth and passive money management. You are still required to report the income on your taxes each year though, even if it is re-invested.
The Ever-Present Fees
One of the biggest criticisms that the mutual fund industry battles is that of their fees. It is often expressed as a percentage of the assets of the fund and goes towards managing the fund; covering expenses such as trade fees, admin, custodian, legal/audit, accounting, and even salaries of the managers and analysts. These fees are often referred to as Management Expense Ratios (MERs). Not all funds carry the same fees either.
Please note that all reported or advertised performance figures of a mutual fund are always net of fees. What you see reported is what you get. So even if a fund carries a higher fee, if it outperforms other funds in its peer group, it still warrants consideration.
Load vs No Load
In addition to the MERs which are ever-present and unavoidable, you may find yourself weighing load and no-load options.
A Loaded fund is one which carries an additional charge to invest in the fund, usually because you are receiving advice from a salesperson or financial planner. A Front-End Load entails an up-front fee for investing in the fund, and a Back-End Load (also known as a Deferred Sales Charge) would charge the fee upon redemption; both fees are often expressed as a percentage of the money invested. Some Back-End fees operate on sliding scales, such that if you leave the money in the same fund or family of funds for a certain period of time (usually five to seven years), the fees decline to nothing. Thus if you plan to invest for the long haul, these back-end loads are often the most appealing.
And although the term No Load obviously means there is no additional charge, they can sometimes charge a higher MER than their Loaded sister funds, thereby reducing your effective returns.
An Index fund operates very similar to a mutual fund, except is it not actively managed. The performance of the fund is linked to the performance of a market index, such as the S&P500. Thus, the fees are often considerably lower than other mutual funds, since you as the shareholder aren't relying on the fund manager's expertise to pick the right investments.
Historically it has been a toss-up as to which option is better. Because of the lower fees, index funds can be harder to beat. However, indexes weren't created to be investments unto themselves; they are more of a barometer as to how certain markets are performing. They can also be heavily weighted in certain holdings, thereby reducing the diversification you might get with other funds. (A mutual fund is not allowed to invest more than 10% of its assets in any given investment, thus providing an amazing amount of diversification; if one specific investment tanks, you still have a number of others to save the day and reduce your losses). Fund managers can also make certain investment decisions and change up the holdings of a fund if there is trouble brewing, something index funds can't as easily do. If an index is sinking and you're not watching it actively, you're going down with the ship.
There is much more to mutual funds than the simple overview given here: We could talk about classes of shares, equity funds, bond funds, money market instruments, disclosure scandals, exchange traded funds, and the list goes on and on from there.
What I can say in favour of mutual funds is that they are a great way to invest for the long haul in a passive manner. You can create a "bomb-proof" portfolio of funds that are well balanced and diversified, and then technically forget about it. Given enough time, good fund managers, and a good financial planner keeping an eye out for you, you can reach your financial goals without having to watch the stock ticker every day. Go have dinner with your family or friends instead: they'll likely appreciate your company more than the numbers in your bank account.