Mutual Funds for Wise Bloggers

by Nora Dunn on 8 September 2007 13 comments
Photo: Joshua Davis

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

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.

 

Index Funds

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.

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Guest's picture
Justin

"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."

What can I say to that? First of all, no one should be watching the stock ticker every day unless they're a day trader which should eliminate 99.99% of us. Watching the market on a daily basis will only result in the investor making irrational decisions due to the potential volatility the market can experience in a short period of time.

Next, no one here should need a financial planner. People that are reading these personal finance blogs are already ahead of the game. They should be smart enough to thoroughly research any financial moves before they make them. It's really sad that you keep writing about this considering YOU are a financial adviser. Have some dignity and stop using this site to try and recruit business.

Oh, and saying that index funds aren't diversified is just plain wrong. All the popular funds are very well diversified and produce excellent returns over the long haul. Plus, like you said, they won't eat you alive with fees like an actively managed fund will do. Even Warren Buffett agrees that index funds are the way to go for the common investor.

Julie Rains's picture

Thanks for the discussion and I'll know we'll learn even more from you about mutual funds and other investment strategies and tactics in the future.

I'll add some to the conversation by saying that if you hold the mutual funds (or other types of investments) in a U.S. tax-deferred account (IRA, 401-k, etc.) then you don't have to pay taxes on the pass-through capital gains and/or dividends. Also, the scenario can occur in a taxable account that the mutual fund declines in value but the shareholders still have to pay taxes on capital gains (the manager may have sold one of many stocks at a profit but experienced an overall decline in value for the basket of stocks).

Nora Dunn's picture

@Julie: Thanks for the added tax info! It's muchly appreciated.

@Justin: You're a smart guy, and I'm not going to try to pick a fight with you. Wise Bread readers value the commentary, and you have a lot to add. However, please refrain from the personal attacks. I've said it before, and I'll say it again: I am no longer in the business of financial planning. I am not trying to recruit business. I have no agenda. I am retired. And I have lots of dignity to go with it.

 

Will Chen's picture

I think your problem, Nora, is that you look too young to be retired.  =) 

Next, no one here should need a financial planner. People that are reading these personal finance blogs are already ahead of the game.

On behalf of our readers, I'd like to thank you for thinking so highly of us!  Of course many of our readers are financially savvy enough to handle their own investments.  But a lot of our readers are also beginners who may be well served by going to a financial planner.

I was going to add that I can get a good look at a T-bone by sticking my head up a bull's ass, but I'd rather take a butcher's word for it.  Then I remembered Chris Farley is dead, and that made me kind of sad. 

Guest's picture
zack

http://finance.google.com/finance?client=ob&q=VTSMX

"The investment seeks to track the performance of a benchmark index that measures the investment return of the overall stock market. The fund employs a passive management strategy designed to track the performance of the MSCI US Broad Market index, which consists of all the U.S. common stocks traded regularly on the NYSE, AMEX, or OTC markets. It typically invests substantially all of assets in the 1,300 largest stocks in its target index, thus covering nearly 95% of the Index's total market capitalization."

Awesome.

http://finance.google.com/finance?client=ob&q=VGTSX

"The investment seeks to track the performance of a benchmark index that measures the investment return of stocks issued by companies located in Europe, the Pacific region, and emerging markets countries. The fund invests in three Vanguard funds- the European Stock Index Fund, the Pacific Stock Index, and the Emerging Markets Stock Index Fund. It allocates most of the assets based on the market capitalization of European, Pacific, and emerging markets stocks in the Total International Composite index. "

Also awesome.

Check out the ER's on those two. Not bad at all!

Nora Dunn's picture

Awesome info Zack!

Vanguard is a pioneer in index investing. They have a variety of mutual funds available, and if I'm not mistaken, the ones you linked to are a hybrid of an actively managed mutual fund and passively managed index fund. It appears that the managers track the general performance of certain indices, but also retain the right to change up the mix and percentages of indices, as well as the specific holdings. It appears to me to be the best of both worlds.

Vanguard also is a no-load company, and caters to investors looking for low fees - and they ended up changing the mutual fund industry because of it. I know many advisors that use Vanguard as part of their portfolio recommendations.

I'll also note that if somebody is determined not to work with a financial advisor, there are a few things you might want to take a look at in picking your funds:

1 - Long track record of steady performance. If the fund did gangbusters for one year three years ago, it's average annual returns for the last three years will be great. But what about the 5 year and 10 year returns? Don't look only at these numbers, but also look at the calendar returns for each of the last 10 years if you can. It can be very revealing.

2 - Long history with the same manager. If fund managers are being traded out like dirty laundry, it might be a sign of mis-management or a tough fund mandate to satisfy.

Morningstar is also a great benchmark for how funds are managed and performing, although not entirely foolproof.

Guest's picture

Hi Nora, I think your post is a great primer on Mutual Funds. Yes, there are many more discussions to be had with mutual funds - one in particular is the open versus closed debate (I made the link from my name go to the specific post on my blog regarding this if anyone wants my take on it).

There are many closed-end funds with managers out there, I think your article is vague on that concept. While most index funds (Vanguard, iShares, etc) are "manager-less" they exist as mostly open-end vehicles. Closed-end funds can be more prevalently found with small-cap mandates. If your small cap universe is $10 billion on your market and there is $10 billion in a small cap mandated fund, then you can see the problem: having a manager manage $10 billion will cause the fund to BE the index - no value add. (not to mention the fact a fund manager can't hold more than a certain amount of the securities in any one company...)

Also, another point of clarification is currency effects. You stated that the performance of a fund is entirely dependent on two factors - but you forgot currency effects which if un-hedged, introduce a third factor in the total performance.

Also, it is important to note that for someone using an advisor, back-end loaded funds (even with the sliding schedule of fees) are IMHO mostly mis-used. You can purchase front end loaded funds and the advisor has the option of charging you 0-2%. The MER is basically the same as the DSC (back end with sliding scale) but you retain the flexibility given up with DSC funds.

Also, almost 40% of MER's go towards paying the distributor and advisor - it might be worth noting that in your line that deals with the expenses covered by the MER.

But these points are nit-picky - your post is well written and I will probably refer people to it for a great primer on mutual funds - it's much better than the one I wrote - I'm just glad my (considerably smaller audience) isn't so harsh on me!

Well done.

Nora Dunn's picture

Great comment, and thanks for your input.

Your article is a great intro to open vs closed end funds - something I felt was a little beyond the scope of my article, but very valuable information nonetheless. For our readers and yours, can you provide any examples of closed ended funds that trade on exchanges that are currently on your radar?

Also, great observation on currency risk. (Hmmm......I feel an article on asset allocation and investment risk coming on)!

As a quick primer for those who may not know, currency fluctuations occur when you invest in a foreign fund, and your currency changes in relation to that of the fund holdings you are invested in. For example, if you buy a foreign fund for $10/share, those ten dollars will be used to purchase shares in a Japanese investment, for example. But, if the Yen goes down in value against the US dollar, the value of your fund will go down since if you sold it that day you wouldn't get as much back in US dollars, even if the company itself doesn't change in value. On the flip side, if the Yen does gangbusters (or the US dollar declines), your investment will have gone up in value since you'll get more US dollars back when converted.

Guest's picture

http://www.amex.com/?href=/closedEnd/ClosedMain.htm

The above link is an excellent starting point into finding closed end funds on the AMEX - it even explores some more advanced concepts such as the concept of a fund trading at a discount/premium to it's NAV. I've seen instances where the market price trades at more than 10% of a discount to the funds NAV - which represents an extreme potential arbitrage opportunity.

That page also links to a list of 150 closed end funds complete with ticker symbols...

On a side note - for Canadians (like me) currency effects of ETF's bought on the AMEX or NYSE that have non-US exposure have no currency effect between CAD/USD even though the investments show up in USD's on client statements. The currency effect is strictly between the native currency and the currency of the markets in which the underlying securities lie. i.e. IF there was a hypothetical ETF that traded in US$ and invested in Australia only, as a Canadian I would take my Canadian dollars and buy US$ so I could buy shares of the ETF which immediately is converted to AUD$ by the intermediary. On the way out (redemption) it goes from AUD->USD->CAD (again all but instantaneously). So while there is instantaneous currency exposure to US for me on the way in and way out, DURING the investment it is only the effect of CAD/AUD that I'm exposed to. It took me a few minutes to figure out how that worked - but eventually the guys at Barclay's explained it.

Guest's picture

Thanks for the info, it is quite confusing decifering how to invest these days.

Mark P. Cussen's picture

Good article, Nora! Keep up the good work.

Mark P. Cussen, CFP, CMFC

Guest's picture

"The competence of the fund manager"
Yes if you are going to invest in a managed fund you really want the best manager. It really pays off.

Guest's picture

There are various tips while investing in mutual fund.
Stay invested: Unless we fear a total meltdown and expect the Sensex to move back down to 8,000 levels, we should stay invested.
Use opportunities to add to your portfolio: Market corrections provide patient investors with a great opportunity to add to their holdings, because funds become cheaper.
Cut out the noise, think long-term: The long-term future for our economy is safe, in fact quite bullish. The biggest favour we could do ourself is to invest in high-quality mutual funds that are invested in companies that will benefit from India’s long-term growth. http://www.guidetoinvest.net/
Don’t try stock picking at home: Stock picking is not for everyone – one needs time, expertise, and research capabilities, all of the things that give professional investors an edge over the retail investor.