Stock Mutual Funds
Few investors, especially busy folks in their 40s and 50s, want to spend the time to choose individual stocks to buy. Even if they did, it's difficult to build a diversified portfolio one stock at a time. Managing market risk, sector risk, and especially company risk is easier through investing in pooled investment accounts called mutual funds. The mutual fund buys the stock so you don't have to.
Is a large mutual fund better than a small one?
Not if you're looking for an active manager who invests in small- or mid-cap stocks. If the fund is too large, it will be too unwieldy for the manager to quickly take a position in a small company that may have a limited amount of stock available.
Common Fund Types
Mutual funds are run by managers who publish their investment objective in the fund's prospectus. The broad categories of stock mutual funds are large cap, mid cap, and small cap. Each mutual fund then goes an extra step and chooses companies that are considered growth companies — companies reinvesting profits to grow — or value companies — companies that are priced cheaply in the manager's view. Funds that invest in both growth and value are called blend funds.
How to Choose and Compare Funds
Morningstar — available online at
Mutual funds are run by corporations, of course, meaning that they, too, bear all the same costs of payroll, capital investment, and other operating costs of any other corporation. They pay for marketing, sales and their asset management teams. The mutual fund pays these costs out of investor assets, meaning that a part of each dollar you invest in the fund will be used by the manager to defray operating costs. If the costs are high, they can significantly affect the performance of the fund.
Morningstar publishes its fund reviews each month and many libraries carry copies. If your access to the web is limited, your local library should have a Morningstar subscription for you to use. The fund company will often mail out tear sheets with the Morningstar data, as well.
Here are some important things to look for when picking a mutual fund:
A manager who's been in the job at least three years
A fund with at least five years of performance history
A Morningstar rating of at least three stars
An expense ratio below 1 percent for U.S. large cap and below 1.4
percent for U.S. small and mid cap and international stock
A fund that performs at least as well as its peers
Mutual funds don't pay their own taxes on the investments they hold. Instead, they distribute their interest, dividends, and year-end capital gains from selling stock to their shareholders every year. Capital gain distributions are usually made in the fall each year and represent taxable income — but not actual cash — to the investor. If you're thinking about buying a mutual fund, check to see when this distribution will be made. It represents profits realized by the fund and its shareholders earlier in the year; if you buy the fund just before the distribution you pay tax on gain that you never benefited from.
Sales Loads
Mutual funds are distributed directly to the public by the fund itself or are sold through a commissioned broker. Funds sold through brokers compensate those brokers via sales loads that are applied to the purchase price or sale price, or that are evenly applied each year you own the fund. You won't see the sales load, but it will affect the performance of your fund. “A” shares are funds with front sales loads that are deducted from the amount you pay when you initially buy your shares; “B” shares apply the commission to the amount of shares you sell — so-called back-end loads; and “C” shares apply an annual fee for the length of time you own the fund.
No-load funds are distributed directly by the fund itself or through entities with fee agreements other than commissions. Your fee-only financial planner will recommend no-load funds because you are compensating him separately for his advice. Online brokerages such as Fidelity and Schwab will offer no-load funds because the funds are paying the brokerages through another agreement to be part of their offering.
Be sure your fund keeps at least a three-star rating at Morningstar. Funds with lower ratings can suffer from an excessive number of investors selling out of the fund. When shares are sold, the fund may need to sell some of its profitable stock to pay those defecting investors for their shares. The capital gains tax liability is passed to remaining investors.
Many funds — load and no-load alike — charge investors 12b-1 fees. These fees are meant to cover the ongoing marketing costs of the fund. Like all fees, they affect the performance of the fund. Most load funds and many small or newer funds that don't yet have an asset base large enough that their management fees cover their expenses will charge a 12b-1 fee.
