Your Continuing Education -- How do Mutual Funds Work?
I'm sure a lot of you have the Bitcoin bug, don't you? It's pretty much the only thing my clients and people in my family want to talk about, which is exactly why we're going to avoid it. For now.
Let's talk about a more traditional way to invest your money - let's talk about the Mutual Fund.
Do you know how they work? My guess is you might not. In fact, the ratio of people that actually know how they work to the amount of people that invest in mutual funds is probably the lowest in finance. 401k accounts in America hold roughly 19% of all mutual fund assets totaling around $3.3 trillion. That's trillion with a "T". To put that in perspective, it's twice the amount of U.S. currency currently in circulation (approximately $1.6 trillion).
If you have a job and you utilize your 401k, you probably invest in mutual funds.
The first thing that's important to understand about mutual funds is that they are not necessarily an investment, per se, but a vehicle or conduit to help you invest.
Mutual funds are structured as investment companies, and those investment companies issue you shares that allow you the ability to participate in a pool of specific investments.
In other words, owning a mutual fund is simply pooling your money with others to have access to a broad portfolio of investments.
Let's say you own 100 shares of a mutual fund, and that mutual fund has 1,000 shares outstanding (for sake of example). Your proportionate ownership of that fund is 10% (100 divided by 1,000). If that mutual fund owns a portfolio of 20 stocks, you have a 10% proportionate ownership of the value of those stocks. Make sense?
As you can imagine, this has truly opened up the world of investing to the masses. Having the ability to own a large, diversified portfolio of stocks and bonds used to be a realm for only the truly wealthy. Mutual funds made it possible for average people, too.
What do mutual funds invest in?
In the example above, I mentioned the hypothetical fund owning stock in 20 different companies. What else could they invest in? The list is fairly staggering, but let's keep it simple. Your mutual fund menu will generally offer you these main courses:
1. Stocks (sometimes called equity)
2. Bonds (sometimes referred to as fixed income)
3. Commodities (think gold or silver)
4. Real Estate
5. Other financial instruments
From there, you can dive into an eclectic assortment of different flavors...like small cap equity, foreign stocks, or corporate and government bonds!
Open-end, Closed-end, ETF, No-Load vs. Load, and Share Classes...Oh my!
Then, of course, the industry has done a really good job of adding an extra dollop of confusion by creating an endless variety of structures to the mutual fund.
An Open-end Fund is the most common and traditional type of fund. This type of structure means that the fund can continuously issue new shares when people want to buy, and when you're ready to sell, the fund will redeem those shares for cash. They only transact business once per day, however, utilizing the closing price at the end of the day.
A Closed-end Fund is a much trickier version. The Closed-end Fund can issue shares only one time - at it's creation through an initial public offering. Investors then have to buy and sell the shares on an open exchange for the remainder of it's existence. This creates a crazy dynamic of premiums and discounts to the real value of the fund that we'll have to cover in another post. If you don't understand a vehicle like this when you come across it, ask for help.
The ETF, or Exchange Traded Fund, is an extraordinarily popular version of the mutual fund that has the benefits of an Open-end Fund, but the ability to be traded at any time of the day. They also tend to have much lower expense structures due to the nature of having lower operating costs, but might require you to pay a commission to buy and sell the shares in your brokerage account.
Finally, there is the lunatic alphabet soup of share classes to contend with and the need to understand No-Load vs. Load Funds. As if the different structures weren't enough, there are also different classes of shares for Open-end funds. The most typical you are likely to see are A-shares, C-shares, and I-shares.
A-shares carry a front-end load, which is a fee charged to the investor as a percentage of their investment used to pay the financial advisor a commission. This is in addition to the internal operating expenses.
C-shares carry what is called a "level load". It is simply a higher internal expense ratio that is split between paying the financial advisor his/her ongoing commission as well as the operating expenses of the fund.
I-shares are what are called the "institutional class". They typically have lower internal expenses and no front-end load, but require a much larger minimum investment.
What about those expenses you mentioned?
As you've probably guessed, there is a cost to creating and running these investment vehicles called mutual funds, and that cost is expressed as an internal expense ratio that is deducted from the money invested in the fund. I refer to this as "friction" because that fee is determining how much of your money is actually going into productive investments.
Open-end and Closed-end funds tend to have internal fees that average around 1% to 1.2%, depending on your source - and index funds are much cheaper. ETFs tend to be less than 0.50% and some as low as 0.04%.
These fees are used to pay for professional portfolio managers, accounting, administration, legal fees, and record keeping.
This is confusing, Jeff. What should I do?
While this information is daunting, it doesn't have to overwhelm you. Remember, making the decision to invest is the most important decision you have to make.
Find a fund in the flavor you're looking for (i.e. U.S. equity), then make sure you're purchasing a fund that doesn't come with a load. At that point, as long as the fund has a reasonable expense ratio (which you can find on the fund fact sheet or fund prospectus from the company's website), you're in business. Anything over 1% for a typical U.S. equity fund is pretty steep.
Your other option is to hire a financial advisor. As long as the advisor is trustworthy and transparent in disclosing how he or she gets paid, you'll be just fine.
Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Terms & Conditions page for a full disclaimer.