5 Facts About Even Your Best Mutual Fund

  • Best Mutual FundIf there was a popularity contest for the most popular investments, our investment blog is 100% certain that mutual funds would certainly be one of the finalists. Mutual funds are found in over half of U.S. households according to MarketWatch (April 12, 2012, Kirk Spano) and dominate the investment universe with more than $12 Trillion of assets under management. Ironically though, less than 10% of mutual fund owners even know anything about what they own or how they work, other than their general category of growth, income, high or low risk mutual fund!

Mutual funds are everywhere.  In fact, there are more mutual funds than individual stocks trading on the NASDAQ.  They are in employer sponsored retirement plans, personal investment portfolios, and even some Section 529 college savings plans. It seems that everyone wishes they either had a low risk mutual fund somewhere in their investments or knows someone that does. What is a mutual fund; do you really know? Should you invest in a mutual fund, particularly a low volatility mutual fund? If so, what is your best mutual fund to invest in for your your personal goals and retirement? Here are five facts to help you decide if even your best mutual fund as an investment makes sense for you.

What Is a Mutual Fund?

Asking “what is a mutual fund” may seem condescendingly basic, but most people cannot answer this basic question because they really don’t understand it and they never read the full prospectus.

So what is a mutual fund? Ever felt like you were a little fish in a big pond? If so, then you know what it’s like to be part of a mutual fund. A mutual fund is an investment vehicle that takes the money from hundreds, sometimes thousands, of investors and pools it together (the big pond). The investment management company has a fund manager who purchases stocks, bonds or other investments to meet the tactical asset allocation and asset management strategies stated by the fund. The fund manager generally has access to external and internal analysts who review each investment to ensure that it continues to make sense to keep it in the fund. The investor, or little fish, in theory gets the benefit of tactical asset allocation and diversification from the pooled funds to spread the risk among the different stocks and bonds.

Mutual funds are subject to regulations put in place by the SEC (Securities and Exchange Commission), a branch of the federal government. The SEC requires that every mutual fund have a board of directors and officers who are responsible for administering the fund on behalf of the investors.

Mutual funds generally fall into one of four categories. A money market mutual fund is made up of various money market funds and is the least volatile of the types. A bond or fixed income fund is made up of various types of bonds with differing maturity dates. It’s traditionally a low risk mutual fund. An equity or stock fund invests in stocks of various types, such as large cap (think S&P 500) or international companies. A hybrid fund takes a little from the other three and creates a fund that meets the investment objective. The investments within the fund may be used primarily for growth, income or a combination thereof. Your best mutual fund for your needs take into consideration a tactical asset allocation model to meet the fund’s objectives.

Closed-End Vs. Open-End Fund: Your Best Mutual Fund Type?

While all funds operate in a similar manner, there are some important differences. Most funds are “Open End” funds. Open End funds allow investors to enter and exit the fund at any time, somewhat similar to an individual stock. Prices are determined once a day after the market closes based on the closing price of each investment owned by the fund. The funds that most people are familiar with are Open End funds. These funds are part of most investment companies and are vital to many asset management strategies.

Conversely, “Closed End” funds are only open to investors when the fund is established. Investors can sell shares to other investors based on the market price of the fund. Prices are determined throughout the day, depending on the value. It can be more or less than the value of the fund’s investments. The fund’s investment management company will not buy back shares from investors.

ETFs, or Exchange Traded Funds, are a hybrid of both Open End and Closed End funds. ETFs are priced daily based on the investments held by the fund, like an Open End fund and buy and sell shares from investors. However, the fund trades at a market price throughout each day just like a Closed Fund.

Investors who include ETFs in their asset management strategies take on more risk than those who invest in Open or Closed Funds. As the value of individual stocks or bonds rise and fall, so does the value of the fund.

Managed Vs. Index Funds: Your Best Mutual Fund Type?

“What is a mutual fund type” you ask? A Managed fund consists of investments that the investment management company believes will beat the index used for investment in the future. If the fund uses the S&P 500 index, then the fund manager will only choose stocks they believe will beat the S&P over the long haul.

An Index fund tries to look like a specific index, such as the S&P. The fund manager will buy shares in each of the 500 stocks on the index to mirror its performance. The goal of an Index fund is to meet the index performance, not beat it. The majority of ETFs are Index Funds.

What is a Mutual Fund and their Advantages and Disadvantages of Each Type of Fund?

This comes down to who you talk to. Financial advisors who like Managed Funds will tell you that a staff of experts can look at each stock in the fund and will beat the performance of its comparable index. On the flip side, those who prefer Index Funds say that picking stocks to outperform a specific index is tough to do and may not meet clients’ asset management strategies. While most Managed Funds beat their index during a particular year, they tend NOT to outperform the index over the long term.

Managed funds have more costs than Index funds. Managed funds have more staff to pay, so their costs are higher. Managed funds also have more tax consequences. Because they trade more frequently and often at a profit, that profit is spread among the investors creating a taxable event. This can happen even in years when the fund loses money. Managed funds in 401(k) and IRA plans are not affected by this. On the other hand, an Index Fund doesn’t have the same flurry of activity in terms of buying and selling, so they are less likely to generate a taxable event, making it a smart investment management solution.

Best Mutual Fund Costs

Every fund, even your best mutual fund, has fees and every investor pays them. Fees can range from less than 1 percent to more than 3 percent each year. The investment management company is required to disclose all fees prior to investing, but very few people actually know what fees they pay and how it kills their performance over the long run. There are several types of fees and the Financial Industry National Regulatory Authority (FINRA) has a tool available to the various types of fees listed below.

• Expense ratios include the fund’s annual recurring expenses such as legal fees, payments to the Board, professional management, audit and legal fees. Some funds may also include 12-b1 (aka marketing) fees. Some Index funds have expense ratios as low as 1/10 of 1 percent and some Managed Funds have expense ratios over 2 percent each year. Your best mutual fund to invest in may or may not have a low expense ratio; it really depends on their performance.  One does not mind paying more in fees for your best mutual fund if their fund consistently outperforms.

• Share class expenses are sales charges an investor pays for investing in a mutual fund. Each fund generally has four classes. Class A charges 4 – 5.75 percent of the investment amount, but has a relatively low annual expense ratio. Class B places a sales charge on withdrawals made before a specified date after the initial investment is made (i.e., 5 years), then the shares convert to Class A. Class C investors pay a sales charge for a year or two after the initial investment, but the funds never convert to another Class. Class C shares have a higher expense ratio, unlike Class A. Class I has no sales charges and has a lower annual expense ratio than Class A. The catch is that it has an extremely high minimum initial investment (thus the lower fees). Class R funds are found only in retirement plans. Low risk mutual funds tend to fall into all classes.

Managed funds tend to have much higher fees, simply because there is so much more activity and they make payments to those who conduct the transactions. The fees are deducted from the share value of the mutual fund and are not included in the expense ratios or share classes, making it difficult for investors to follow. It’s estimated that these “hidden” fees can range from less than a half percent to over 3 percent annual for Managed funds in addition to their reported expense ratios. Some low volatility mutual funds that we follow have lower fees while maintaining the best tactical asset allocation.

A Final Word of Caution on Picking your Best Mutual Fund to Invest In

A fund may have stellar returns and be your best mutual fund in your portfolio this year, but they rarely have back to back year out-performance. Just because a fund has performed well in the past doesn’t mean it will continue to be your best mutual fund in the future. Funds that invest in international companies or are global in nature are subject to risks, such as fluctuations in currency valuation, the economic climate of the country and political instability. These should be low risk mutual funds with a global tactical asset allocation strategy. Domestic investment funds do not generally have these risks and should use low risk mutual funds with a strategic tactical asset allocation. Bond funds have their own risks including credit risk, interest rate fluctuations and prepayment risk.

Low Risk Mutual FundsWhen reviewing your best mutual fund as an investment for your portfolio, you need to look at the objectives of the fund as well as any fees or charges associated with the fund and the overall risk of the fund. The SEC requires all mutual funds to have a prospectus which provides detail on the investment objectives, holdings, fees and information on the investment company. While many people may put the prospectus in their circular file, this document contains important information that should be reviewed prior to investing your money.

Mutual funds, particularly low risk mutual funds, can be a great investment tool. Smart investors take time to learn how low volatility mutual funds work and their costs before investing. Remember, just because your best friend’s brother made a huge gain with XYZ Fund in his 401(k) last year, you may not do as well holding the XYZ Fund as part of your investment portfolio. While mutual funds are popular, be sure that it’s in your best interest to invest in one.

If you have an interest in getting an expert evaluate your mutual funds to show you the risks that you have and compare them to other possibilities that may work well with your investment strategies, contact us at (888) 938-5872 and we can show you a few pretty interesting things; like funds that did not lose money in 2001 and 2008

 

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