In simplest of terms, a mutual fund is created by a group of people who pool their money to invest in stocks, bonds and other securities. Mutual funds are one of the most common investments found in brokerage accounts. Check out these recent statistics:

• Morningstar Research reports there are over 26,000 mutual funds.
• eHow.com estimates 25 trillion dollars is invested in mutual funds worldwide.
• The ICI Fact Book reveals that about 75% of all IRAs hold mutual funds.

 

Why are they so popular? Maintaining a diversified investment portfolio can be time consuming and difficult, not to mention stressful. In addition to flexibility and ease of withdrawals, mutual funds offer access to professional money management and diversification at a relatively low cost.

 

Prospectus

Each mutual fund issues a prospectus, a lengthy document, which outlines the funds’ guidelines and objectives in excruciating detail. If you can suffer through it, you’ll find insight into how the fund will be managed and what type of investments it will hold. Often times, websites such as Morningstar.com or the mutual fund company itself, will provide easier to understand graphs and information about the fund.

 

Shopping Carts

So how do mutual funds actually work? Surprisingly, a lot like a shopping cart:

• Fund managers push their “shopping carts” through the aisles of the “stock” market. They bring a shopping list (the prospectus) with them each time they go so they know what to buy. Research analysts tag along to help the manager decide which companies are a “good buy.” 
• To act as a personal shopper, fund managers charge a daily fee for their services called an “expense ratio.” You will never see this charge on your investment statements. It is deducted from the mutual fund’s daily balance.
• Each mutual fund is a separate shopping cart. Some fund managers are responsible for more than one cart. Often, different fund managers will buy the same companies (just like you and other shoppers might buy the same laundry detergent).
• Some mutual fund carts only hold stocks of companies in specific industries like healthcare or technology, small companies or international companies.
• Some fund managers are more active about buying and selling what’s in their carts, while others are more passive and only make a few changes each year.
• If the shopping cart gets too full, the fund manager will sell some companies in his cart to other fund managers and individual investors.
• Individual investors buy a piece of the mutual fund. That’s where the fund manager gets grocery money to buy more stuff for his cart.
• The value of each mutual fund shopping cart depends on the value of everything inside it.  Overall volatility and movement of the stock market also affect its value.
• Some mutual funds carts have toppled over because they had lousy securities or the manager made large bets on risky companies. Mutual funds are not guaranteed or insured by the FDIC. 

 

Where Do You Get Mutual Funds?

One of the great things about mutual funds is you can pick them on your own or ask for professional help. You can buy them from a stockbroker, directly from the mutual funds companies or hire an investment adviser to buy them for you. 

 

Do-It-Yourself:  If you have the time, the interest and the expertise, you can build your own investment portfolio and select mutual funds for yourself. Some online brokerage firms, such as Fidelity, have tools to help you make your own selections. You can also contact the mutual funds directly. Mutual funds that work directly with the investor are called “no-load” mutual funds, because they don’t pay commissions to brokers to distribute them. Some no-load mutual funds, like Vanguard, hire their own brokers to work directly with investors over the phone.

 

A Few Tips on Picking Funds

If you are going to pick funds yourself, here are a few tips to get started:

• Shrink that list of 26,000 funds. Most professional advisers have a screening process they use to sort and select funds for their clients.
• If you’re not working with a broker, there’s no reason to pay a sales charge to buy the fund; that means you can skip the A, B, and C share “load funds.”
• You don’t want to put too much money with any one fund, so make sure the minimum purchase is small enough for your portfolio. For example, if you’ve got $10,000 to invest, you’d want to identify funds with a $1,000 or less minimum so you can spread your money around (if you have $100,000, then you could increase the minimum purchase to, say, $10,000).
• Use Morningstar’s “Star” Ratings to compare a fund’s performance and its risks against its competitors.
• Screen for funds with a track record. Review the fund’s 3 and 5 year performance numbers. Make sure the manager who generated those returns is still managing the fund.
• With so many funds available, there’s room to be choosy. Look for funds that cost 1% or less per year. Just like anything you buy, the cheapest isn’t always the best, nor is the most expensive. 
• Check the fund’s turnover ratio, which indicates how frequently the fund manager buys and sells. A high turnover ratio can lead to higher transaction costs for the fund and may be counter-productive.
• Last year’s top performer can be this year’s worst performer. Look for consistent performance.
• One of the prime benefits of mutual funds is diversification. Too much in one security might hurt performance or be too volatile. Make sure that no more than 5% of the fund’s money is invested in one stock or bond.

 

Buy from a Broker:  For investors looking for help, stockbrokers and registered representatives regularly recommend “load” mutual funds. It is important to note that securities regulations require that stockbrokers make suitable mutual fund recommendations to investors. Brokers receive commissions for selling these mutual funds to their customers.

 

Hire an Adviser:  Investment advisers will manage your portfolio, including mutual funds, for a charge of 1 to 2% per year (based on the value of your individual account). Technically, this professional is called an investment adviser representative and the firm is called a Registered Investment Adviser, or RIA. Most investment advisers use no-load mutual funds when building an investment portfolio for their clients. Sometimes they will also include load funds, but the investment adviser can usually get them “at cost” without the applied sales charge; the load fund is then referred to as being “load-waived.” It is important to note that lines have blurred over the years between these different purchase options. For example, some stockbrokerage firms also act as investment advisers (if they are appropriately registered). 

Whether you choose them yourself, or with the help of an adviser, mutual funds can be a good way to get diversification and professional management in your investment portfolio.

 

David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.