For the beginning investor, the notion of hand-picking your first six to 10 stocks can be a bit overwhelming. Selecting a mutual fund can serve as a convenient, cost-effective entry point into the world of investing that can be less risky than picking individual stocks.
A mutual fund is simply a collection of stocks, bonds, short-term money market instruments, other securities, or any combination of such assets. Investors buy shares in the fund, and a manager makes the decision to buy and sell the securities that make up the fund's portfolio. This is considered active management, and there are fees associated with each fund to pay for that.
There are all sorts of mutual funds to pick from these days, and they can hold a wide variety of investments. The list below outlines a few of the most common funds available:
|Bond||Composed of bonds. Called a "fixed-income" investment because these funds typically collect a set amount of interest.|
|General Equity (stock)||Composed of stocks. Funds are frequently limited to all large-, mid-, or small-cap equities. These fund types are often structured as "value," "growth," or "blend" funds.|
|Balanced||Mix of stocks and bonds.|
|Global/International||Targets foreign companies, though global funds may include some from the U.S. as well. Typically more volatile than domestic funds.|
|Sector||Targets companies in a specific sector of the economy, e.g., technology, energy, consumer goods, etc. Can be quite volatile.|
|Index||Matches the shareholdings of an index, like the S&P 500 or the Dow Jones Industrial Average.|
The biggest fund out there today is the bond-focused Pimco Total Return (PTTAX). That fund holds $244 billion in assets -- that's larger than the annual GDP of Finland.
Fees are all over the place and cover a variety of expenses associated with running a fund. Every fund lists its fees in the prospectus, and while it may seem a bit confusing at first, definitions for the variety of fees can be found in our handy mutual fund glossary. The most important definition for our purposes today is expense ratio. This is the percentage of total assets that is used to pay for fund expenses.
Fees vary from fund to fund, and they can have a significant effect on your returns. Let's compare two funds that return 10% annually on an initial investment of $10,000. Assuming we hold the money in our fund for 20 years, a fund with an expense ratio of 1.5% will reach $49,725. A fund with an expense ratio of 0.5%, however, will finish with $60,858 after the two decades are up.
FINRA has a useful fund analyzer that can help you compare the fees and expenses for a variety of mutual funds before you make your final decision.
Fund pros and cons
Frankly speaking, 80% of mutual funds do not beat the market. The higher the fees, the better the fund must perform in order to generate a meaningful return. And most of them never quite make it.
However, if there was no upside to mutual funds, we wouldn't bother dedicating an entire series to the topic. Advantages to mutual fund investing, if you find the right one, include:
- Exposure -- The best funds offer instant diversification, exposing your portfolio to a variety of sectors, industries, and companies.
- Volatility -- Bad news for one company won't sink your entire fund.
- Access -- Funds give you the ability to cash in on securities you may never have dreamed of buying individually, increasing the diversity of your portfolio even further.
- Cost -- You do not need to pay a commission every time you buy shares of a fund. Though a lot of funds sport an expense ratio of 1.5%, there are some bargains out there.
Mutual funds can be a great investment vehicle, if you take the time to separate the wheat from the chaff.
Mutual appreciation society
Though many funds are duds, there are also some great investments out there -- and you can find them. Research is essential, and there are no shortcuts around that. It's important to keep in mind that old investing cliche, because just like stocks, a fund's past performance is no guarantee of future success.
As you begin your research, there are many things to consider when comparing and eventually selecting the right fund. For starters:
- Fund fees.
- Tax efficiency.
- Manager tenure/turnover.
- Fund strategy.
- Consistency with your investment goals.
That last bullet may be more important than you think. Though funds offer investors exposure to securities they might not have picked on their own, there is no excuse for not knowing what those securities actually are and how they align with your investing philosophy.
For instance, some investors believe that oil prices are poised to decline further and therefore don't want to own ExxonMobil (NYSE: XOM ) or Chevron (NYSE: CVX ) . Yet these two stocks are often among the top holdings within portfolios of large-cap mutual funds. Similarly, if you avoid Altria (NYSE: MO ) , Las Vegas Sands (NYSE: LVS ) , and other "sin stocks" on personal grounds, you'll have a tough time with many mutual funds, as a big percentage of both stocks and many others are held by mutual funds and other institutional investors. If you've never looked at your fund's holdings, you may own them and never know it.
It may sound like a lot of work in the beginning (it is), but the research you put in initially can provide peace of mind in the long run.
Knowing that 80% of mutual funds don't beat the market can turn off many investors. The sheer number of funds can be overwhelming, but the availability of information on the Internet makes diving in a little bit easier these days. With resources from companies such as Morningstar, you can get excellent mutual fund data and analysis and is a great place to start your research. For another fund idea, click here to check out The Motley Fool's retirement-focused special free report.