Mutual Funds
Mutual funds are stock portfolios managed by a firm that commingles your funds with other investor funds and then invests them en masse. Instead of owning individual stocks, you purchase shares in the mutual fund. You can place an order for a mutual fund with your broker at any time, but your investment will only occur at the end of that day's trading — after the mutual fund company has accounted for that day's gains and losses. You buy into a mutual fund at its net asset value (NAV), which is the market value of the securities held by the mutual fund.
Many mutual funds attempt to earn the same return as major market indexes. If you invest in stock funds, you are investing either directly or indirectly in stock market indexes, which spreads your portfolio across hundreds of stock investments. It's far less risky than investing all of your funds in one or two risky stocks.
Alert
Most mutual funds are open-ended and can be purchased and sold at net asset value (NAV). Closed-ended funds do not accept new investments and may trade above or below NAV. It's generally a bad idea to purchase a closed-ended fund above its NAV — it has the same effect as paying a “load” fee on an open-ended fund.
Mutual funds generally fall into two categories:
Actively managed mutual funds: Funds that are staffed by money managers and analysts who attempt to buy and sell the right stocks at the right time to beat the return on a particular stock market index.
Passively managed funds, or index funds: Funds or index funds that track a market index as closely as possible, making them similar to index exchange-traded funded (ETFs, detailed on page 167).
Actively managed funds allow you to bet on the expertise of a team of professionals. However, few mutual fund management teams beat the return on the S&P 500 in the long run, and actively managed mutual funds tend to charge high fees. Many actively managed funds also trade stock frequently, which will leave you on the line for taxes on realized gains.
If you are considering investing in a mutual fund, ask your broker to order the mutual fund's prospectus. (You can also find one online.) The prospectus will give you important information about the manager and how long the manager has run that fund — investment philosophy and portfolio composition may have changed with a new manager in charge.
The prospectus will also give you details about the fees the fund charges. Look under the heading “Shareholder Fees” for the fund's fee structure, which may or may not include the following:
Load fee: The charge to buy into the fund
Redemption fee: The charge to sell shares
Management fee: The charge to pay analysts and portfolio managers
12b-1 distribution fee: The charge to cover marketing costs and other expenses
All these expenses can add up quickly. If you hold an actively managed high-fee fund for ten years, the fees could easily cost you 15 percent. When it comes to mutual funds, fees matter!
If you are considering buying shares in a mutual fund for a taxable account, make sure you investigate the fund's “turnover rate” (the percentage of stock owned in a given year that was sold during the year). It's typically “hidden” in a table deep in the prospectus. The higher the turnover rate, the more likely it is that you will have to pay taxes on the fund's distributions, which may include short-term gains taxable at high ordinary income rates.
If a mutual fund holds its average investment for three years, its turnover rate will be 33 percent. In a taxable account, it's best to hold funds that have lower turnover rates to avoid paying your returns out as tax payments.
Target Maturity Funds
If your head is spinning about creating an asset allocation plan for yourself, and you're hesitant to hire a financial advisor, particularly if your retirement lies far down the road, you might want to opt for a target maturity mutual fund. Managers of these funds change the allocation between stocks and bonds over time. If your retirement date is decades away, for instance, they invest larger portions of assets in higher-risk securities like small-capitalization and foreign stock as well as a range of fixed income securities.
Alert
Target maturity funds often invest in mutual funds managed by the same company, which means you might pay a reduced fee for target maturity fund management but also unwittingly pay full mutual fund management fees. Essentially you end up paying two fund management teams while only reaping the rewards for investing in one — a good deal for mutual fund management, but not for you.
As your target date approaches, the asset allocation gradually shifts to lower-returning and less-risky securities like large-cap domestic stocks and higher quality, shorter-term bonds. When you choose a reputable target fund manager, you don't have to worry about rebalancing your portfolio. Barclays' Lifepath Portfolios, which currently charge a total fee of about 1.2 percent per year, appears to be a lower-cost option in the industry.
Blended Funds
Blended funds typically invest in a mix of stock and bonds in fairly fixed proportions over time, offering another way to gain immediate broad portfolio diversification. Fees for blended funds vary, but they can be high. You can always make your own blended fund by purchasing low-cost exchange-traded funds and rebalancing the asset allocation of your fund annually.
If you want simple investing, Vanguard's Wellington Fund (VWELX) is a blended fund that allocates 60 to 70 percent of its assets to stocks and 30 to 40 percent to bonds. The vast majority of mutual funds charge more than 0.50 percent per year in fees; the Wellington Fund charges 0.29 percent per year in fees. Vanguard requires relatively high initial investments when its funds are purchased directly through the company; however, you can frequently buy into Vanguard's funds with lower minimum investment amounts through Charles Schwab and other brokers.
Alert
When a broker seems to strongly favor a certain mutual fund, make sure you know whether the fund charges a “load” fee or sales charge. Mutual funds with a load fee frequently charge investors 1 to 3 percent of the investment upon purchase — most of which goes to the broker making the recommendation.
Index Funds
An index is in essence a portfolio of stocks. The S&P 500 tracks 500 stocks, while the Dow Jones Industrials tracks 30 stocks. Index funds are mutual funds that attempt to earn the return of a certain index for investors. Because indexes include a wide assortment of stocks or bonds, purchasing index funds immediately provides you with a diversified stock or bond portfolio.
Exchange-Traded Funds
Exchange-traded funds (ETFs) are portfolios of investors' commingled funds run by a professional investment management company in the same way as an index mutual fund; however, you buy and sell ETFs like stock. ETFs and most mutual funds track broad stock market indexes — lists (baskets) of thirty or more stocks held as if in a single portfolio. The advantages of ETFs over mutual funds include the following:
ETFs frequently have lower management expenses than mutual funds tracking the same index. ETFs are purchased and sold as a stock, which means you pay commissions when the shares are bought and sold; a mutual fund may or may not charge a commission. Still, mutual funds usually have higher fees.
When mutual funds sell a stock at a profit, they generate taxable gains that you must pay taxes on in the year the gain is recognized. ETF holders recognize capital gains only when they sell their investment, which usually decreases tax liability.
Mutual funds are priced daily, at the end of the day. ETFs are actively priced during the day, which means you can purchase or sell them any time during stock market hours, allowing you to jump (or dump) on the best price.
While thousands of mutual funds compete for your dollars, ETFs are fewer in number, and thus easier to research and select.
Because ETFs track indexes, they are standardized except for fees, simplifying your homework to finding the one with the lowest fees.
If you are buying into a mutual fund or ETF that tracks a broad U.S. market index, make sure that the ETF or mutual fund company charges no more than 0.50 percent per year in fees. ETFs and mutual funds exist that track the S&P 500 and charge under 0.20 percent per year in fees. In a world where mutual fund managers find it very difficult to out-perform the S&P 500 index (and the average mutual fund charges about 1.4 percent in fees), buying an ETF or mutual fund that tracks the S&P 500 and that has an ultra-low expense ratio is a smart way to invest in stocks.
Fact
Standard & Poor's Depositary Receipts (“SPDRs,” pronounced “spiders”), an ETF tracking the S&P 500, trades like a stock under the symbol SPY. Annual fees on SPY are only about 0.1 percent, making the commission you pay your broker on the purchase and sale of shares likely lower than the fees you would pay a mutual fund tracking the same index.
You can research ETFs through your brokerage firm, or online at the CEFConnect or the American Stock Exchange Web site. Before you buy an ETF, compare it with other ETFs that invest in largely the same stocks to find the one that charges the lowest fees. You can find all the information you ever wanted and more about the ETF you are considering by going to the Web site of the ETF sponsor (such as iShares, Vanguard, or Barclays.com and downloading a prospectus.
Because all of this information can become mind-boggling, it's a good idea to review the differences between ETFs and mutual funds:
ETFs |
Mutual Funds |
Low management expenses |
May have high management fees |
No loads or sales fees |
May have high load and sales fees |
Bought or sold like a stock |
Bought or sold only at the end of the day |
Investor pays a commission to purchase |
Brokers may waive commissions (for a limited number of mutual funds) |
Taxed on gains only when you sell |
Annual distributions require annual tax payments |
Tracks indexes |
May track indexes or practice active portfolio management |
*Information applies to open-ended mutual funds.
Core Funds
Some mutual fund companies sell core funds. Typically, core funds track a single asset class like large-cap domestic stocks or corporate bonds. These may or may not attempt to track a leading market index like the S&P 500. Don't let yourself be influenced by the word “core” in the name; it is put there in an attempt to sell more shares of the fund. You are in control of your own portfolio, and you get to decide which funds or ETFs make up the core of your portfolio.
Large-Capitalization Value Funds
Large-cap value funds usually invest almost entirely in domestic stocks with market capitalizations greater than $5 billion that also are considered “value stocks.” There are as many opinions about what constitutes a “value” in the stock market as there are investors, but generally value stocks are those that trade at low price-to-book and price-to-earnings multiples relative to the average stock.
Large-Capitalization Growth Funds
Large-cap growth funds are mutual funds that typically invest in domestic companies with market capitalizations greater than $5 billion. These businesses are also expected to grow faster than the average publicly traded company.
Fact
Market capitalization is the total value of common stock owned by investors. Large-capitalization (“large-cap”) companies generally have a market capitalization greater than $5 billion; “small-cap” companies have a capitalization under $2 billion; “mid-cap companies” fall somewhere in the middle; and “micro-cap” companies have a market capitalization under $200 million.
Mid-Capitalization Funds
Mid-cap funds generally invest in companies with market caps between $2 billion and $5 billion dollars. You can also find mid-cap value and mid-cap growth funds. Why would you choose mid-cap or small-cap funds over large-cap? Investors generally require a higher return on riskier investments, which means that you are likely to earn higher returns in the long run on mid-cap stocks than you are on less-risky large-cap stocks, and also more on small-cap stocks than mid-cap stocks.
Small-Capitalization Funds
Small-cap funds invest in companies with market capitalizations less than $2 billion. At times you may be holding mid-cap stocks in a small-cap fund because the stock has risen substantially. Small-cap value and growth funds are also available.
International or Global Funds
International or global mutual funds invest primarily in markets outside of the United States. International mutual funds that are actively managed may charge high fees, so it is worthwhile to make sure you know how high the fees are for a particular international or global fund. You can also invest overseas through exchange-traded funds (ETFs).
The most widely followed international index is the Morgan Stanley Capital International Europe, Australasia, and Far East (EAFE), which tracks about 1,100 stocks in 21 developed markets outside of the United States and Canada. The EAFE doesn't include stocks in riskier emerging markets like Egypt, China, and Slovenia, among others.
Essential
Market capitalization is determined by the price required to buy 100 percent of a company's shares. So if Company A has 100 shares trading for $10 each, its market capitalization is $1,000 ($10 × 100). If Company B is trading at $100 per share, but it only has five shares, its market capitalization is $500 ($100 × 5).
Load and No-Load Mutual Funds
Load mutual funds can be purchased through your broker or directly through the mutual fund company, who then charges a commission and an additional “load” fee. This is a flat fee charged either when you first buy into the fund (“front-end sales load”) or when you sell your shares in the fund (“deferred sales load”).
The load is paid to the broker selling the fund; it's a hidden commission, and it can be large. The U.S. Securities and Exchange Commission allows mutual funds to charge a maximum of 8.5 percent, but most load funds charge 1 to 3 percent.
No-load mutual funds can be purchased through your broker or directly through the mutual fund company, although they may charge a commission. If you are considering a mutual fund with a load and find an equivalent no-load fund, buy the no-load fund.
