Q. My friends say I should invest in mutual funds, but I don’t really understand what a mutual fund is. Can you explain how they work and why I might want to invest?
A. Although mutual funds have been around since the late 1700s, the oldest mutual fund currently in existence was started in 1924. They have increased in popularity over the last century and are the primary investments available in many 401(k)s, health savings accounts, and 529 college savings plans. A mutual fund is best thought of as a group of investors banding together to hire a professional manager to invest their money. However, a mutual fund is actually a legal structure distinct from other similar funds, such as hedge funds, and is heavily regulated by the government to help ensure appropriate disclosure and accounting practices to protect the general public. Due to this regulation, compared with many available investments, they are quite safe from the risk of the manager running off with your money. Of course, mutual funds still carry the risks of the underlying investments, such as stock market risk for stocks and interest rate risk for bonds.
Mutual funds provide significant benefits that most individual investors should find very attractive. The first is professional management. By investing through a mutual fund, you are no longer responsible for making day-to-day investment decisions, buying and selling individual securities like stocks and bonds, monitoring the investments, or calculating returns. In fact, you can go away to a deserted island for years and know your money is continuing to be responsibly invested.
Another benefit of the mutual fund structure is that the investors benefit from economies of scale. While it would be very expensive to hire a professional to buy and sell investments for you, when thousands of investors go in together to hire the professional, the cost is dramatically reduced. The fund, by virtue of its size, may have access to investments that individual investors do not and certainly is in a better position to negotiate lower commissions, bid-ask spreads, and other expenses.
Mutual fund investors also benefit from easy diversification. While individual investors may find it difficult to keep track of 20 different stocks, they can buy literally thousands of them in seconds through the purchase of a broadly diversified mutual fund. This diversification reduces the uncompensated risk that an individual stock picker runs.
The final benefit of mutual funds is daily liquidity, or the ability to rapidly turn an asset into cash. If you’ve ever had trouble selling a house or other illiquid asset, you know how useful liquidity can be. A mutual fund can be sold and turned into cash or invested into any other investments on any day the market is open.
Of course, mutual funds can have downsides as well. Obviously, when you give up control to a professional, you have less control as to when an individual stock or bond is bought or sold. However, the two main downsides are manager risk and fees. Manager risk is the risk that the manager picks the wrong stocks to buy and sell. Mutual fund fees can be excessive as well, including expense ratios of more than 1 percent of the assets in the fund each year, marketing fees, and commissions (called loads) for the salespersons who sell them. However, both of these risks can be minimized by investing only in no-load, low-cost, broadly diversified index mutual funds, such as those available from the mutual fund giant Vanguard. In these funds, the manager is essentially a computer who works very cheaply and just buys all of the stocks, guaranteeing the investors will receive the same return as the overall market.
The two main mutual fund structures investors will run into are traditional open-ended mutual funds and exchange-traded funds (ETFs). One is not necessarily better than the other; there are low-cost, well-managed funds of both types. The main difference is that a traditional mutual fund can only be bought and sold at the close of market each day, and an ETF can be bought and sold any time the market is open.
The most important consideration when evaluating mutual funds is the type of asset a mutual fund invests in. Mutual funds generally specialize in one type of asset, such as stocks or bonds. They may even subspecialize into specific types of stocks, such as utility or real estate companies. Mutual fund selection is often the final step in putting together a written investing plan. If the plan calls for you to invest in international stocks, you need to make sure the mutual fund you are looking at for that portion of the portfolio actually invests in international stocks.
After that, many investors are tempted to simply look for the fund with the best past returns. Unfortunately, this is such a poor method of choosing mutual funds that funds are required by law to tell you in writing that past performance is not an indicator of future performance. A much better predictor of future returns is the cost (or expense ratio) of the mutual fund. Over time, higher costs going to management erode into returns, leaving less for investors.
Finally, consider the strategy of the mutual fund manager. An index fund simply buys all of the stocks (or bonds) in the market to achieve the market return. An actively managed fund tries to buy the good ones and sell the bad ones in an effort to beat the market. While in the short run, this is certainly possible (in any given year, 45 percent of funds might beat a similar index fund), over the long run, it becomes increasingly difficult to choose a winning active manager, especially after expenses and taxes. Over a lengthy investing career, the likelihood of choosing an active manager who can beat an index fund falls to less than 10 percent, and there is precious little evidence that investors can choose the winners in advance.
Mutual funds are an excellent way to invest and should be the main building blocks in the portfolios of the vast majority of investors. They provide professional management, liquidity, economies of scale, and diversification.