Mutual Funds (101)

Mutual funds (low cost index funds) should be the foundation of every beginning investor’s portfolio. When the term, mutual fund, is used it generally refers to what is specifically called an open-end mutual fund. A mutual fund buys various sorts of assets. Then it sells shares of this investment pool to the general public. By law an open-ended fund must be willing to buy back their shares from their investors at the end of every business day at a price determined by the net asset value of all the underlying investments. There is no legal limit to how many shares of an open-ended fund can be sold to the public. Therefore, when customers want to buy, the fund managers or their computers must buy more shares with that money. When customers, want their money, the fund must sell some of its underlying assets to pay off their obligation.

Mutual funds are managed in one of two ways, active or passive. In the case of managed funds, people select the size and nature of the investments. In theory a genius fund manger could beat the index with his astute stocking picking skill every time. In practice it is very difficult to beat the index over long periods of time for the same reason it is difficult to beat the Las Vegas line over long periods of time. You may get on a hot streak, but you are competing against the collective wisdom of every sports gambler in the world. Sooner or later you too will revert to the mean. There are genius fund mangers that will enjoy a fabulous run. However, are you smart enough to pick them in advance? The odds say only one in four funds will beat the index in a given year. Over the course of twenty or so years that number drops to something like one in a hundred.

Index funds are simply run by computer programs to mimic the content of an index like the S&P 500. The program buys and sells stock so that the content of the mutual fund exactly replicates the contents of the S&P. This means that the cost of operating these funds is much less than retail managed funds sold by a commission sales force and managed by expensive fund managers. Total cost of ownership is critical component in making sound investment decisions, whether buying automobiles or mutual funds.

Mutual funds cover a number of major investment categories.

Money Market Mutual Funds buy and sell very short term fixed income notes. They are generally used as a substitute for the old fashioned bank account. The Money Market Fund at your bank or credit union is insured. The Money Market Fund at your broker is not insured. Keep that in mind. If you don’t know if your fund is insured, ask.

Bond Mutual Funds buy, sell, or hold bonds to maturity. The name of the fund will tell you what they are doing with your money. There are “investment grade” funds that buy the good stuff. There are “high yield” funds that buy junk bonds. There are funds that buy Treasury Bills, general called Government Funds. There are funds that specialize in tax free municipal bonds, for your taxable accounts. Obviously they don’t belong in a tax favored account like a 401(k). All of these variants are packaged using short, medium, or long term bonds. Again, what they are holding is in the name of the fund. For example, I own shares in an intermediate term tax exempt municipal bond fund.

Most of the action is in equity mutual funds. These are the funds that buy and sell shares of stock. They are categorized by the size of the companies they buy. Typically they are sold as large cap funds, small cap funds, or mid cap funds. If there are no other qualifiers this generally means they are buying U.S. shares. If they are identified as “Global Equity” or “International” stock mutual funds, they are buying shares in overseas markets. They are further defined by geographic region or the state of development of the underlying economies. For example a Developing Markets Mutual Fund might invest in places like Brazil, Russia, India, and China. There are specialty funds that invest in one particular kind of company, like oil and gas. There are even funds that buy, sell, and hold precious metal in a bank vault on your behalf along with shares of mining companies.

Finally there are hybrid funds and life cycle funds that buy all sorts of different investments, both bonds and equities to give you a balanced and diverse portfolio without requiring you to make any further decisions once you put your money down.

There are many reputable mutual fund families. However, before you buy be sure to compare what you are considering with the comparable offerings from Vanguard and Fidelity.

Good luck

And—“Let’s be careful out there.”