What is a Mutual Fund?

2014 update to readers: while mutual funds are great, and it is worth your time to learn about them, I have now become a big fan of passive index investing through ETF’s

Definition of a Mutual Fund

For starters, a mutual fund is an investment vehicle that pools money from investors (this is where you come in) and then invests that money into a combination of investment vehicles, usually in the form of stocks, bonds, and money market accounts. Investors can purchase mutual funds in the form of shares. Mutual fund managers use the pooled money to choose which investment vehicles are appropriate for the strategy of the fund. It is worth noting that an emerging trend in mutual funds is to replace a human manager with a computer in the form of a mathematical algorithm that choose what and when to buy and sell various investment vehicles.

Why Should I Buy a Mutual Fund?

Two simple reasons:

1. Diversification: Buying a mutual fund is a great way to seek investment gains while diversifying your risk. Mutual funds distribute risk through the purchase of many different investments.
2. Lack of Time to Educate Yourself: 20Somethingfinance.com strongly recommends that you do not purchase individual investments (stocks and bonds) unless you have done a great deal of homework on what you are getting into. Most people simply do not have the time. Paying a small management fee to a mutual fund company is usually worth it – they are professionals who earn a living by being good at what they do.

What Types of Mutual Funds Can I Buy?

Mutual funds specialize in a number of different sectors and types of companies. The majority of funds, as you will find, either invest in domestic companies, international companies, or a combination of the two (global funds). The specific sector (or type of industry) that these funds invest in vary and most funds are a combination of many different sectors, which are chosen by the fund manager based on what type of sector(s) he/she/mathematical formula thinks is going to perform well now and in the future. Some examples of different sectors that mutual funds may invest in are: real estate, technology, health care, natural resources, and retail, to name a few. Many mutual funds won’t focus on a specific sector at all, rather, they focus on a specific strategy such as only buying stocks of companies that are most likely going to be acquired by another company, or buying stocks in companies that have a low price to earnings evaluation.

How do I Buy a Mutual Fund?

You can purchase mutual funds through a number of tax sheltered accounts (401K, Traditional IRA, Roth IRA, Roth 401K) or through taxable personal accounts through an online broker or direct from the mutual fund company. If you would like to consolidate all of your investments into one account go with a discount brokerage. Discount brokerages will sometimes charge you a small fee (usually around $20) for your first purchase of shares of a mutual fund. Subsequent purchases of that fund are usually at no additional fee. If your discount broker does not have a mutual fund that you would really like to get into, then you can call the fund company and purchase shares directly from them, often times at no additional charge.

How to Choose a Mutual Fund

If you’ve shifted through all the jargon thus far, now is the time to really pay attention. It is very tempting to go out and purchase the best performing mutual funds based on historical performance, but this strategy can be a path to failure. Why? For starters, all of the past success of a mutual fund could be due to the fact that they had a genius fund manager at the helm who may no longer be with that fund. Like any investment you make in life, do your due diligence, and RESEARCH, RESEARCH, RESEARCH. Stocks and bonds tend to average out over the long-term, so it is worth noting that a fund that has historically been the best for the past three years, could very well be a laggard for the next three.

You can, and should focus on the consistent factors of a mutual fund that give it and your money the best chance for success over the long-term. Those factors are:

1. Expense Ratio: I would hesitate on recommending any mutual fund that had more than a 1.2% overall expense ratio. Lower fees mean you get to keep more of your money. If you can find a good fund manager at under a 1.2% expense ratio, you have yourself a winner.
2. Fund Manager: Some fund managers are brilliant and loyal. Others, not so much. When it boils down to it, you are not really purchasing a mutual fund by name, rather, you are purchasing the skills of that fund’s particular manager at the time that you buy that fund. If you find a fund manager who has great long-term historical performance success (five, or even better, ten years) and isn’t jumping between fund companies, you probably have a good one.
3. Load/No-Load: 20Somethingfinance.com thinks loads are a scam. Loads are basically paying a fund manager a set percentage of your overall assets when you move into or move out of a fund (often-times between 4-6%). When there are thousands of equally well-performing no-load funds available, why waste your money? Go with the No-Load!
4. Size of Fund: Here’s the catch-22 of well performing funds. A lot of them will attract performance chasing investors. The more money a fund has to invest, the less nimbly they can purchase and sell investment vehicles. I tend to stay away from mutual funds that have assets exceeding $10 Billion plus. Many fund companies will recognize this and start nearly identical funds with the same manager. Stay away from lethargically large funds.
5. Diversification: Don’t put more than 10% of your investments into any one sector. Rather you should opt for funds that invest in a variety of sectors. 20Somethingfinance.com does not consider international funds to be sector funds unless they specifically invest in only one region.

What questions about mutual funds do you have?

Related Posts:

• Index Funds Vs. Mutual Funds