Mutual funds were born in the 20th century, but it is possible mutual funds (or at least many of them) will die in the 21st century as alternatives like hedge funds and exchange-traded funds (ETFs) lure investors with higher returns, less regulation, and/or lower fees. Regardless of mutual funds’ future, there are a few things every investor needs to know about them.
For the uninitiated, a mutual fund is nothing more than a package of securities (most commonly stocks or bonds). Mutual funds allow investors to trade dozens or hundreds of different securities at once, yielding an opportunity for instant diversification, even if you only have a $1,000 to invest. If you invest in your company’s 401(k) plan, chances are you own shares of at least one mutual fund. So, what do you need to know about mutual funds?
1. Mutual funds are “expensive”. If you buy or sell shares of an individual stock, you’ll have to pay your broker a fixed trade fee, but that nothing else. Not so with mutual funds. Mutual funds charge fees to cover various expenses. These expenses include, for example, the management of the fund (deciding where and how to invest) and the administrative cost of mailing investor statements and processing investor trades. In addition, some mutual funds charge a “load”. A load is a sales charge, i.e., a commission you pay the fund company for the privilege to invest in their fund. There are ample no-load mutual funds to choose from, however.
2. Mutual funds are not, necessarily, better. The goal of a mutual fund is to do better than the market during a specified period of time in order to meet a specified goal. These goals vary among funds. For example, some funds geared towards retirement-age investors strive to retain value with low risk, lower-return investments whereas other funds may take wild risks to chase massive long-term gains. Either way, funds are built to beat the market. Trouble is, many don’t.
3. It’s about the long haul. Just like most prudent investing strategies, mutual funds are best-suited for long-term investing. We’re talking 10, 20, 40 years. So when you’re choosing investments for your retirement portfolio or to meet other goals, pay little attention to those quarterly and one-year results. See how the funds have done in the long haul—over ten years or more.
4. Finally, pay attention to bear markets. When times are good on Wall Street, it’s pretty hard not to do well. Money managers earn their keep when things get ugly. The sign of a good fund manager isn’t by how much he or she makes in good years, it’s how little he or she loses in bad ones.
5. It’s about the manager, not the fund. The manager makes the mutual fund. The manger is the one that provides guidance for the fund and makes critical trading decision. The manager will determine whether you earn or lose money when you invest in his or her fund. Therefore, when you’re researching a mutual fund, you want to know who is behind it. Hint: Many funds change money managers often, so you’ll need to do a little bit of homework.
If you are beginning to invest in mutual funds or already hold a number of positions and want to know how those fund managers are managing your money, I highly recommend fund-rating service Morningstar.