Investing For Your Future

Unit 6: Mutual Fund Investing

Patricia Q. Brennan, M.A., CFP, Rutgers Cooperative Extension

An individual's investment portfolio should be more than just a collection of mutual funds. Before you select funds to invest in, you will want to determine your investment goals, your time-frame for needing the money, and the amount of risk you are willing to take. This unit will help you learn how to invest in one of the best investment vehicles ever created in the context of your own overall financial plan. One of the top reasons for learning about mutual funds is that you can save money if you choose the funds and maintain your portfolio yourself.

What is a Mutual Fund?

A mutual fund is a portfolio of stocks, bonds, or other securities that is collectively owned by hundreds or thousands of investors and managed by a professional investment company. The shareholders are people who have similar investment goals. Each fund has specific investment criteria, which are spelled out in its prospectus, the official booklet that describes the mutual fund. Investors then know what they are getting and can match their objective to that of a fund. The pooled money has more buying power than one investor alone, so that a fund can own hundreds of different securities. Thus, its success is not dependent on how just one or two companies perform.

A mutual fund makes money in several ways: by earning dividends or interest on the investments it owns and by selling securities that have appreciated in value. You, in turn, make money in the form of dividends and interest that are passed on to you and the increase (or decrease) in the fund's value. The mutual fund manager keeps constant watch on financial markets and adjusts the portfolio to achieve the strongest returns. By owning part of a fund, the hard work of selecting and monitoring stocks and bonds is done for you.

The majority of mutual funds available are open-end funds, which are the focus of this unit. Open-end funds can have an unlimited number of investors or money in the fund. Managers of closed-end funds, on the other hand, decide upfront how many shares they will issue and when they will sell them. The only way to purchase shares in a closed-end fund, once the original shares have been sold, is to buy them from a current investor. Occasionally, open-end funds can and do close to new investors, often because of high cash inflows that cannot be invested in a timely manner. They do not become closed-end funds, however, because current shareholders can still buy additional shares from the fund company.

When investors purchase a mutual fund, they own a piece of an investment portfolio. They share in the gains, losses, and expenses in proportion to the amount they have invested in the fund. At the close of every trading day, a mutual fund company tallies the value of all the securities in its portfolio and deducts its expenses (e.g., management fees, administrative expenses, advertising costs). The balance is divided by the number of shares owned by shareholders to arrive at the dollar value of one share of the mutual fund. This value, the net asset value or NAV, is the price your fund pays you per share when you sell.

At this point, you may want to review Units 4 and 5 to understand the underlying instruments in most mutual funds.

Why Mutual Funds Versus Individual Securities?

For a majority of people, mutual funds should be a major part of their investment portfolio--unless they have a lot of money and ample time to devote to investing in individual securities. While there are arguments for buying stocks and bonds directly, consider buying mutual funds first, or at least use them as a core holding, because of the following drawbacks to individual stock and bond picking and trading:

Nevertheless, there are several circumstances when you do not need mutual funds:

In the last case, you would do better purchasing them directly through the Federal Reserve's Treasury Direct program (http://www.treasurydirect.gov/indiv/products.htm).

Mutual Funds: 10 Advantages

1. You get full-time, professional money management. Most people do not have the time or skill to select and monitor individual stocks and bonds.

2. You get reduced risk through diversification because a mutual fund owns many stocks or bonds. You can also pick your level of market risk by choosing particular types of funds (e.g., money market funds to insure your principal will not drop in value, bond funds if you want current income and some stability in your portfolio, stock funds if you want your money to grow over the long term.)

3. You will earn competitive returns on your investment. Mutual funds can furnish the kinds of returns you need to reach your goals. In fact, by choosing an index fund, (a fund that invests in securities of one of the broadly based market indexes such as Standard and Poor’s 500), you can expect to match the market’s performance, minus the expenses of running the fund. This is an assurance that no other investment can provide.

4. You don’t need a lot of money to get started. Many funds require only $1,000 to open an account, and some funds require minimum initial investments as low as $250 to $500. Subsequent deposits can be as small as $25 to $100 if an automatic investment plan (AIP) is adopted. An AIP is an arrangement where you agree to have money automatically withdrawn from your bank account on a regular basis, (e.g., once a month or every quarter) and used to purchase fund shares.

5. You retain ready access to your money. A mutual fund is required to buy back your shares, which makes withdrawals easy. It will mail your check within seven days of the request at the closing price (NAV) on the day it is received. (An exception to receiving NAV at sale time is back-end load funds that charge a redemption fee).

6. Mutual funds are a cheaper way to get the investing job done. Research and operating costs are shared by the thousands of shareholders. The most efficiently run funds have an expense ratio (the percentage of fund assets deducted for management and operating expenses) of less than 1% a year. Some well-established funds charge annual fees as low as 0.2% to 0.5%. Also, many funds are sold directly through their sponsors with no sales charge-known as "no-load" funds. Funds that charge a sales commission are called "load" funds.

7. Mutual funds are convenient. They can be purchased (and sold) directly from a mutual fund company by mail and by telephone and from full-service brokers, financial planners, banks or insurance companies. (Important note: when mutual funds are purchased from banks, they are not insured by the FDIC like other bank products.) In addition, some discount brokers have established mutual fund "supermarkets" where investors can own funds from many different fund families in one consolidated account without any sales charges or transaction fees. Earnings from mutual funds can also be automatically reinvested in additional shares. Reinvesting and compounding are keys to building wealth.

8. Automatic withdrawal plans are available, making it possible to have a steady stream of income for retirement (e.g., withdrawals of $250 per month).

9. Mutual funds have less risk of bankruptcy or fraud than many other securities because they are highly regulated by the federal government through the SEC, which is charged with assuring that mutual funds and investment advisors follow specific rules of disclosure.

10. Monitoring mutual funds is simple. Prices are reported daily in the financial section of many newspapers and more in-depth information is available in the Sunday business sections (See Unit 9 for details).

Mutual Fund Disadvantages

1. If there is a broad market drop, your fund’s value will dip with it. The diversification of most mutual funds protects you when one or several securities fall, but not when the whole market takes a downturn. The fact that funds can fluctuate up and down, sometimes wildly, is par for the course and should not deter you from investing or scare you out of the market.

2. There is no guaranteed rate of return with mutual funds as there is with CDs and Treasury securities. Since risk is higher, the liklihood of greater earnings is increased. You must also expect investment performance to fluctuate.

3. Unwanted taxable distributions can also be a disadvantage. Funds are required to pay out 98% of their dividends, interest, and capital gains annually. Taxes must be paid on these distributions, even if you never received them but instead reinvested them in additional shares. Unfortunately, sometimes you can also owe taxes even if your fund lost money for the year. For the time being, however, this is a non-issue, if funds are held in a tax-deferred account such as a 401(k) or IRA.

4. Record-keeping for tax purposes can be hard work. Investors who are not meticulous about keeping track of fund purchases and sales may end up paying higher taxes than are actually owed at the time of sale because of a miscalculation of their cost basis. This is the amount of your original deposit, plus additional contributions and reinvested dividends and capital gains. The amount of taxes you pay will vary depending on the method you use to calculate your gain or loss (e.g., average price, first-in, first-out, or specific identification). Thus, it is important to keep every annual statement for as long as you own the fund.

 

The Mutual Fund Marketplace

A mutual fund's stated objective might read something like "this fund seeks capital appreciation," meaning it is appropriate for investors who want to grow their money over the long term. Or it could state, "this fund seeks current income,"   indicating that the fund should be considered by investors who need a regular stream of income from their investments. The way these objectives are to be accomplished is outlined in the fund's prospectus and is the responsibility of the professional money manager hired by the mutual fund company.

To be a successful investor, you must match your objectives to that of the fund (e.g., long-term growth for retirement in 15 years). Equally important is matching the fund's risk level to your own risk tolerance. Study the fund's objective and understand the strategies it uses to achieve its goal in light of what you want to accomplish. Refer to Figure 1 to put various categories of mutual funds into perspective according to their level of risk and return:

Figure 1. Adapted from AAII Mutual Funds Video Course Workbook (1990)

The worksheets which follow break down mutual fund types by their basic investment objectives. Use them to help you match your goals with the appropriate funds. Examples for each category are provided. Any of the sample objectives could be met by any of the mutual fund types in each category. Write in your goals in the space provided on the left under Your Objective in each chart.

Worksheet 1

Worksheet 2

What Mutual Funds Cost and Where to Buy Them

What you pay to purchase or sell a mutual fund, as well as the ongoing fund operating expenses, can have a great impact on the rate of return on your investments. So, keeping fees to a minimum is in your best interest. Generally, there are four categories of expenses—direct sales commissions, management fees, marketing costs, and overhead expenses.

Mutual funds come in two types: load and no-load. Load funds carry an up-front sales charge of 4% to 8.5% of the amount invested for "Class A" shares and are bought from a stockbroker, commission-based financial planner, and others who earn their living on sales commissions. A mutual fund is considered low-load if it carries a smaller up-front sales charge of 1% to 3%. Some funds charge a back-end load, also known as a contingent deferred sales charge (CDSC). You don’t pay a sales fee to get into the fund, but you will incur a sales charge on the way out if you sell early. These funds, commonly called "Class B" shares, were created to combat the negative image of up-front loads. Typically, the charge declines 1% each year until it disappears after the fifth or sixth year. However, management and marketing fees are usually higher on this version of a load fund. Try to avoid this arrangement if you don’t know how long you will hold the fund.

No-load funds, on the other hand, require no upfront fees to purchase shares and usually have no marketing fees. Investors deal directly with the fund company, a mutual fund supermarket (e.g., Charles Schwab, Waterhouse), or a fee-only financial planner, rather than with a broker. Some load and no-load funds also impose redemption fees to discourage investors from moving in and out of certain funds too frequently.

Both no-load and load funds charge annual money management and administrative fees. These costs are a percentage of the assets in the portfolio. These costs, in addition to the marketing/advertising fees, called a 12b-1 fee, make up a fund’s expense ratio. The 12b-1 fee pays for advertising and distribution costs, as well as broker compensation. Deducted from shareholder assets, 12b-1 fees can range from 0.1 to 1.00%, and every shareholder pays a pro rated share. Typical expense ratios, which can include a 12b-1 fee, range from 0.5% to 2% of fund portfolio assets. Beware of funds with expense ratios greater than 1.4% for stock funds, 1% for bond funds, and 0.5% for money market funds.

Generally, no-load funds have lower fees than load funds, resulting in lower expense ratios. However, there is an exception—"Class C" shares—another version sold by a broker that has no sales charge but has a higher 12b-1 and management fee than either Class A or B shares. All things being equal, low cost funds will net you higher returns than high cost funds. Costs matter!

Putting it all Together:
How to Find the Right Mutual Fund

Now that you are familiar with the various types of mutual funds, here are some specific guidelines for picking them.

Step 1. Identify the types of funds you need (e.g., growth) to reach your goals.

Getting started will be easier if you first focus your search on a specific type of fund with a specific investing objective. Eventually, your goal should be to build a portfolio that includes both stock and bond funds with various investment objectives and investment styles for maximum diversity. This portfolio allocation process involves assigning appropriate percentages of your total investment portfolio, no matter the size, to interest-earning (income) and stock (growth) investments. You can purchase them gradually, perhaps starting out with a balanced fund, an asset allocation fund, a lifestyle fund, or a broad-based index fund such as a "total stock market" fund. The latter tracks 7,000+ large, medium, and small U.S. companies and is offered by fund families like T. Rowe Price, Vanguard, Fidelity, Charles Schwab, and others.

Step 2. Do more reading.

Visit the library or buy some specialized books on mutual fund investing that will build on what you have learned from this unit. In addition, visit the Web sites of investment companies and the Investment Company Institute to learn more about mutual funds and available fund products.

Once you spot several funds that have consistently performed well and are aligned with your goals, go to your library’s reference section to complete your research. Rating services such as Morningstar and Value Line Mutual Fund Survey provide current data on mutual funds with a one-page report on each. This makes it easy to review and compare funds you are considering. Look at 3-, 5-, and 10-year periods. Last year’s high flyer could be this year’s dud.

You can whittle down the 12,000+ fund universe to a manageable list in short order by using a few criteria to help with the elimination process. For example, suppose you are looking for a stock fund to invest for retirement. Right there, you have cut the number to a little over 5,000 funds by eliminating all the bond and money market funds. Perhaps you will toss out all funds that have a sales commission, all stock funds with an expense ratio over 1.4%, funds that have an investment minimum over $3,000, any fund where the manager’s tenure is less than 5 years, and all funds that have not outperformed 60% of comparable funds over the last 3 and 5 five years, etc. Applying these criteria as you research your favorites, pay most attention to performance, cost to invest, and risk.

Step 5. Call or write for a prospectus.

A prospectus for a mutual fund is the selling document legally required to be distributed to mutual fund investors. It describes the fund’s investment strategy as well as the risks and costs of an investment.

Step 6. Make your purchase.

While you can always do business by mail, and in some cases, at a local investment center, most mutual fund groups offer a toll-free number for telephone assistance. Of course, if you are buying a fund with a sales commission, the broker or financial planner executes your order.

Step 7. Continually buy more shares.

One of the best ways to grow your investments is to use a dollar-cost averaging strategy—investing a fixed number of dollars (e.g., $50) in a mutual fund(s) at periodic intervals, usually monthly or quarterly. (See Unit 8.) When the price of the fund is low, your dollars buy more shares. When the fund’s NAV moves higher, you will buy fewer shares. Although dollar-cost averaging does not guarantee you a profit, in most cases your average cost per share will be less than the current price.

Summary

Successful mutual fund investing requires a plan and the discipline to stick to your plan. Mutual funds are a proven winner and one of the best ways for the small investor to build wealth while managing risk. This unit has reviewed what mutual funds are and how they work, their advantages and disadvantages, fund categories and investing objectives, and, finally, the mutual fund selection process. You have what you need to get going. As the NIKE advertising slogan says, "Just do it." Start with the action steps listed below.

Action Steps - Check off the steps after you have completed them

References

American Association of Individual Investors (1990). Mutual funds video course workbook.

Bogle, J. (1994). Bogle on mutual funds. New York: Irwin Professional Publishing.

Clements, J. (1998, April 4). Your starting point for mutual funds? Here are 65 of them in the annual List. The Wall Street Journal, C1.

Clements, J. (1994, December 10). If you’re still hiding in mutual funds, maybe it’s time for mutual funds. The Wall Street Journal, C1.

The feeling is mutual (1993, April-May). Modern maturity, 55-59.

Gould, E. (1992). The New York Times guide to mutual funds. New York: Times Books.

Newman, R. (1997, September 21). Buying bond mutual funds. The Record, B4.

Quinn, J. B. (1997). Making the most of your money. New York: Simon and Schuster.

Rowland, M. (1998). The new common sense guide to mutual funds. Princeton: Bloomberg Press.

Schultz, E. (1996, February 21). Bewildering class structure is lurking in the shadows of mutual fund investing. The Wall Street Journal, C1.

Tyson, E. (1995). Mutual funds for dummies. Foster City, CA: IDG Books.

Updegrave, W. (1996). The right way to invest in mutual funds. New York: Warner Books.

Wall Street Journal (1997). Guide to understanding personal finance. New York: Lightbulb Press, Inc.

Additional information about mutual funds can be found in Rutgers Cooperative Extension publication E222, Investing in Mutual Funds. This course is available online at the RCE Publications page.

Author Profile

Patricia Brennan, M.A., a certified financial planner, (CFP) has been a family and consumer sciences educator with Rutgers Cooperative Extension of Morris County since 1981. She is a tenured associate professor at Cook College, Rutgers University. Mrs. Brennan is also an Accredited Financial Counselor (AFC) and a Certified Housing Counselor (CHC). Pat teaches over 80 personal finance and housing classes annually. Her areas of expertise include long-term investing, asset allocation, life-cycle financial planning, and selecting mutual funds. As part of her Cooperative Extension responsibilities, she records a weekly three-minute morning radio program on station WMTR as well as daily radio spots on "Consumer Concerns" on WGHT, Pompton Lakes. She also writes for Morris County newspapers, appears regularly on Cablevision’s cable TV show "Money Counts" and has made guest appearances on CNBC’s "The Money Club" and News 12 New Jersey. She earned a B.S. degree in home economics from Immaculata College and her M.A. in teaching from Montclair State University.