Welcome to Part II of MAXuniversity!

February 14, 2007

Mutual funds are one of the most popular investment vehicles in the history of the universe. According to the Investment Company Institute, nearly half of all households in America have some money invested in mutual funds - either directly or through a retirement plan.

Part II of MAXuniversity is all about mutual funds. In it, we'll talk a bit about what a mutual fund is, go over the basic types of funds available today, and review the major advantages and disadvantages of mutual fund investing.

So what the heck is a mutual fund, anyway?

A mutual fund is a company that gathers money from many different individuals and institutions, pools that money together, and invests it in stocks, bonds, or even other mutual funds (and occasionally other things too.) In return the mutual fund company is paid a fee that's a percentage of all the money in the fund.

All mutual funds are strictly regulated by the Securities and Exchange Commission. The SEC reads and approves each mutual fund's prospectus and annual report, periodically audits mutual fund financial records, and generally makes sure everything with the fund is on the up and up.

Types of Funds

Internet funds, small cap funds, bond funds, emerging market funds, growth and income funds, global telecom funds, pacific region funds – with all these different kinds of funds out there, how is a potential investor supposed to choose which ones to invest in?

Don't panic. Despite all the fancy names mutual funds call themselves, there really are just a few basic types. Here's a rundown.

Load vs. No-Load

First of all, just about every mutual fund is either a load or a no-load fund. What's the difference? A load fund is one in which you pay some kind of sales fee, at the time of purchase (called a front end load), at the time of sale (called a back end load) or at regular periods along the way (called a level load). This fee generally amounts to about 5% of your initial investment, and it usually goes to the broker that sold you the fund.

No-load funds don't charge a sales fee to buy or sell shares.

Besides load funds charging a sales fee and no-loads funds not, there is absolutely no difference between the two. Load funds don't attract better money managers than do no-load funds. Load funds don't have lower annual expense ratios than no-load funds. When you buy shares of a load fund, you don't get a free honey-baked ham. So why would any thinking person ever want to invest in a load fund? The answer is, they wouldn't. To put it as plainly as we can, only suckers buy load funds.

Equity Funds

Equity Funds are mutual funds that invest primarily in stocks of publicly traded companies, like GM or Microsoft. That's pretty cut and dried, right?

Right. It does get a little bit tricky when you try to sort out all the different categories by which equity funds are identified. Bear with us, this isn't as complicated as it seems.

Equity funds are often described by the kind of stocks they invest in. Funds that invest in growth stocks (stocks of companies with positive outlooks for growth) are described as growth funds. Funds that invest in value stocks (stocks of companies that are currently considered to be cheap based on fundamental data like earnings, revenue, and assets) are described as value funds.

So far so good? In addition to putting stocks in either the value or growth camp, stocks are also defined by their overall market capitalization, or the total value of the company as calculated by total shares multiplied by outstanding market price. Small cap stocks have capitalizations less than $1 billion. If that doesn't sound very small to you, it's because large cap stocks have capitalizations over $5 billion (with some as high as $500 billion). Mid-cap stocks are between the two. Mutual funds can invest in any and all of the preceding types of stocks, so there can be small cap value funds, mid cap growth funds, or large cap core or blend funds.

Some mutual funds invest only in stocks of foreign companies. These are called International funds. Global funds are those that invest in stocks of both foreign and U.S. companies. Sector funds are those that invest in stocks of a particular industry or area, i.e., technology, real estate, and precious metals.

That said, it's important to remember that while fund classifications are useful as a starting point when picking a fund, it's up to the investor to take it from there and do a little research. Mutual fund managers have an unfortunate tendency to drift away from their stated investment strategies, so how a fund is classified isn't necessarily a completely accurate description of what it's invested in. Study the prospectus of any mutual fund you're considering buying. And if you already own a fund, it's crucial that you read its annual and semi-annual reports (your fund company should be sending these to you when they're published). If you discover that your fund isn't investing the way it says it is, it might be time to find a new fund.

Bond Funds

Bond funds invest in debt instruments (bonds) of corporations and governments, including state, local, federal, and foreign country bonds. Bond funds are generally a safer investment than equity funds because bonds are generally safer than stocks.

Some experts question paying a fee to join a bond fund. Good bonds are already almost risk free, so the diversification bond funds provide is unnecessary. This is not the case with higher risk bonds like junk bonds and emerging market bonds, where diversification offers the same benefits as with stocks. One thing that is for certain - since most bond funds provide pretty meager returns - the management fee you pay should be very low.

Income Funds

Income funds can invest in stocks that are bought primarily for their income (dividends) potential, not so much for their growth potential. A utility stock is an example of a stock in an income fund. They are generally safer than growth funds, buy more risky than straight bond funds.

Hybrid or Growth and Income

A Hybrid mutual fund is one that invests in both stocks and bonds.

Money Market Funds

Money market funds pool investor money and invest in short-term debt securities like treasury bills. Because T-bills are basically risk free, money markets are among the safest investments available - with the microscopic returns to prove it. The best you should realistically hope from a money market fund long term is returns that slightly exceed the inflation rate.

Fund of Funds

A mutual fund whose portfolio is made up of other mutual funds is called a fund of funds. Some large mutual fund families offer funds that invest only in the mutual funds of that family, often with no extra expenses than the individual funds in the fund levy. Other 'true' fund of funds invest in any mutual funds they think will achieve the highest return. Fund of funds offer about the quickest and easiest route to a truly diversified portfolio that exists in the investing world today. On the downside, some fund of funds returns are hindered by an additional layer of expenses (the expenses of the fund of funds itself, plus the expenses of all the funds the fund of funds has invested in).

Closed-end funds

The common kind of mutual fund is open-end, which means there is almost no limit to the amount of shares of itself it can sell.

A closed-end fund is set up differently. It issues a set amount of shares, which trade on an exchange like shares of a stock. And like a stock, if you want to purchase shares of a closed-end fund, you have to do so from an existing shareholder. Because of this, some out-of-favor closed-end funds trade at a lower price than the fund's NAV (the NAV, or net asset value, is the price of the fund, and is all the assets in the fund divided by the number of shares outstanding). Other, more popular closed-end funds trade at a higher price.

Index funds

To understand what an index fund is, it helps to first know what an index is. An index is a group of stocks that are picked by certain companies that are meant to represent a particular sector or segment of the economy. The oft-quoted Dow Jones Industrial (it becomes less and less "industrial" as the years roll on) Index is a group of 30 stocks of prominent American companies like Coca-Cola, Intel and General Motors. The S&P 500 consists of 500 companies chosen by Standard and Poors. Among other prominent stock indices are the Russell 500 Index, the Wilshire 5000 Equity Index, and the NASDAQ Composite Index.

An Index fund is a mutual fund that tries to mimic, as closely as possible, the holdings of a particular index. The manager of an S&P 500 fund does nothing but track the S&P 500 Index. If a stock is added to the S&P 500, the fund manager purchases that stock. Whenever Standard and Poor's drops a particular stock, the fund manager sells their holdings in that stock.

Index funds are what is called a passively managed fund. Managers of index funds don't actively seek out new investments; they follow as closely as they can the holdings of one of these indexes. Because costs of running an index fund are so low (all index fund managers need is some software to help allocate stocks in their proper weight to the index) a well-trained monkey could do the rest) index funds generally have a lower expense ratio than actively managed funds.

Mutual Funds – Why We Like 'Em

We think mutual funds are just great (we did start an entire website about them after all.) Here's why:

Expert Management: Mutual fund investors are handing off the responsibility of managing their money to people who know a lot more about investments then they do. Most mutual funds maintain sophisticated, well-staffed research facilities. Mutual fund managers frequently meet with representatives of companies they're considering investing in. They tour factories, pour over complex financial data, and ask tough questions to CEO's. We're quite happy having them do these things instead of us. Aren't you?

You've got better things to do with your time (we hope): Here's a list of things we'd rather do than to research potential investment opportunities, listed alphabetically: 1. Anything 2. Everything. Finding good investments is time consuming. It's tedious. It's expensive (how much is a subscription to Value Line™?!).

Mutual fund managers do the research for you. It's their job, and believe it or not, most of them even like it. That's not to say you should write a check to a mutual fund and cross your fingers. It's still each investor's responsibility to monitor the performance of the funds they're invested in and make changes when things aren't going the way they're supposed to. But trying to do yourself what mutual funds companies do for you would be pretty close to impossible.

The Big Pool: Put your little bit of money together with a lot of other people's little bits of money and pretty soon it becomes a whole lot of money. And investing a whole lot of money has certain distinct benefits over investing a little bit of money, including ease of diversification, reduced transaction costs, and shared research expenses.

Diversify, Young Man: As we said in part I of MAXuniversity, diversification is the practice of spreading your investment money out among many different types of investments in order to reduce the volatility of your portfolio. Mutual funds provide the cheapest and quickest way to achieve diversification available today. Whatever amount you invest in a fund is automatically divided amongst the 30 or 80 or 300 securities the fund holds. And that's a very good thing.

Mutual Funds – The Negatives

There are a few negatives to mutual fund investing, but in our opinion the good far outweighs the bad. Even so, lets quickly run down some of the issues often sighted as drawbacks:

Loss of direct control over your investments: When you hand your money over to a mutual fund, the manager decides what the fund buys and sells, you don't. If you're the type of person who doesn't like to sit in the passenger seat, this could be a problem.

Taxes: Because you lose direct control over your investments, you also lose control of your tax situation. If a fund sells a stock for a profit, you are liable to pay a tax on that profit even if you haven't sold any of your shares in the fund. Because you don't control when a fund sells a stock, you don't have control over the tax liability you are incurring.

Expenses: Having someone else manage your money isn't free. As we've said, mutual funds charge shareholders a management fee that is a percentage of the money each investor has placed in the fund. This fee varies wildly from fund to fund. Obviously, the lower the fee, the better (for an equity fund, an expense ratio above 1.75% is difficult to justify), but in our opinion, paying a reasonable management fee to a good fund is well worth the cost.

You have to pick: Like with every type of investment, some mutual funds are better than others. There are so many different funds, and so many different investing styles and categories, that trying to choose the right ones can be a daunting task. In part III of MAXuniversity, we reveal our top secret fund picking methods that we think just might revolutionize the industry.

Next up, MAXuniversity part III - Picking funds the MAXfunds way.