Are you looking for a good way to invest long-term without the hassle of having to buy and trade single stocks or bonds? If so, mutual funds may be a good option for you.
What Are Mutual Funds?
A mutual fund packages a collection of assets, like stocks, into a single asset owned by a group of investors.
So instead of one person buying individual stocks and bonds, a group of investors pool their money and invest in a diverse portfolio of stocks and bonds. The price of a mutual fund is the total value of the assets in the fund divided by the number of the fund’s outstanding shares. It fluctuates each day based on the value of those assets at the end of each day. This is also called it’s “Net Asset Value” (NAV).
If you decide to invest in a mutual fund, don’t get too caught up in watching the value of your fund go up and down on a daily basis. The real value of a mutual fund is its long-term performance, so it’s better to see how the fund has performed over a 5 or 10-year basis.
Types of Mutual Funds
There are two basic types of mutual funds: Actively managed funds and passively managed funds. Funds that are actively managed have a portfolio manager who uses research to figure out which securities to include in the fund.
Other mutual funds, known as passively managed funds are tied to an index such as the S&P 500 or Canadian Securities Exchange (CSE).
Let’s break down this a little more.
Actively Managed Funds
An actively managed fund has a manager, who selects the fund’s investments. This manager tries to beat the performance of a particular index, such as the S&P.
So, the fund managers pick an index like the S&P and try to do better. If the S&P is up 5% in a given year, the managers want the mutual fund to beat that 5%.
Passively Managed Funds
A passively managed fund, meanwhile, doesn’t care if it goes over the 5% yearly gain of the S&P. It’s good enough to just match that performance. For this reason, passive funds are sometimes known as index funds.
How do Mutual Funds Make Money?
Mutual funds make money for the investor in three ways:
- Net Asset Value Increase: This happens when the fund holdings increase in price but aren’t sold by the fund manager, so the value of the fund’s shares also go up. It’s just like if you own a piece of stock and the price goes up: you don’t get any cash, but the value of your investment increases, and you would make money if you sold it.
- Dividend Payments: Income earned by a fund from dividends on stocks and interest on bonds held in the portfolio. Almost all of the income received during the course of the year is distributed to the fund owners, who usually have a choice to either reinvest that money to buy more shares of the fund, or receive a check
- Capital Gain: If a fund sells a stock that has gone up in price, it’s called a capital gain, and these are distributed to the fund’s investors annually.
Pros of Investing in Mutual Funds
There are many advantages to investing in mutual funds including:
- Easy Diversification: The main advantage of investing in a mutual fund is diversification. You’re not married to a single stock, so if, say the CEO of a company turns out to have been cooking the books for years, you’re not at risk of losing everything just because one company’s stock is now worth 27 cents. Because a mutual fund can own dozens of different stocks, you can survive one company not doing as well as the others.
- Added Flexibility: A mutual fund is able to react quickly to changing market conditions. This allows you to have your investments on autopilot, letting the fund decide which assets to buy so you don’t have to spend all of your time reading the financial news.
- Liquidity: Finally, unlike other investments such as real estate, mutual funds are liquid. You can buy or sell a mutual once every trading day.
Cons of Mutual Funds
There are some disadvantages to investing in mutual funds including:
- High cost: This is especially true of managed funds. Management is expensive, and the fees tend to be high, which can eat into your returns.
- Fees: We just said “fees” under cost, but this time we’re talking about “loads,” which is basically a sales commission you pay when you purchase a mutual fund. We’ll cover more about fees in a minute.
- Lack of financial advice: Unless you want to pay extra for it (are you sensing a theme here?), most mutual funds do not come with advice.
- Performance: When it comes down to it, most managed funds don’t outperform their benchmarks. The market may do better, but you’re still paying for the active management of the fund.
Now that you know the advantages and disadvantages of mutual funds, how do you actually get started investing in them?
How to Start Investing in Mutual Funds
- Figure out your budget. Depending on the fund, it may have a larger or smaller minimum investment. Calculate what you can afford and start there.
- Pick one: Active or Passive. For lower costs, passive investing is best.
- Find a broker who offers the right kind of fund for your budget. Remember, some brokerages require an account minimum so keep that in mind while you shop around.
- Know what you’re paying for. Read the fine print to find out what kind fees a fund charges and how much they’re charging you. We cover more about fees down below.
- Grow and maintain your portfolio. Keep an eye on the fund’s performance and rebalance the mix of assets at least once a year to make your money go further.
Mutual Fund Fees
There are generally two types of fees a mutual fund charges you need to keep in mind when investing in mutual funds.
Annual Operating Fees
Annual Operating fees go toward paying managers, accountants, marketers, and lawyers. All mutual funds have these, and you’ll have to pay at least something to keep the power going at the fund’s office. Also known as “expense ratios” or “advisory fees,” you’re looking at paying between .25% and 1.5% of your investment per year. As you might expect, the more actively managed a fund is, the higher the percentage.
Shareholder Fees are sales commissions and other one-off costs when you buy or sell a mutual fund. These expenses include:
- Exchange fee: Some funds charge shareholders a fee if they exchange or transfer shares to another fund offered by the same investment company.
- Redemption fee: You might get charged this fee if you sell your shares too soon after purchasing them. This time limit depends on the fund and could be from as little as a couple of days to over a year.
- Account fee: This fee is charged for account maintenance, especially if your balance falls below a specific minimum amount.
- Transaction fees: A flat-rate fee can range from $10 to $75 when buying or selling shares in a mutual fund
Load Funds vs. No-Load Funds
Loads are a type of shareholder fee common for many mutual funds. A load or “sales load” is a commission paid to a third-party broker when you buy front-end load or sell back-end load shares in a mutual fund.
Funds that do not charge a sales commission are called no-load funds. But keep in mind even a no-load fund may still charge other shareholder fees such as account fees or redemption fees.
A lot of companies are offering both no-load and transaction-free mutual funds, and they are worth looking out for.
What About That Letter at the End of a Mutual Fund Name?
Most mutual funds are named with a single letter, like ‘A’ or ‘D.’ This refers to how the series the fund belongs to, and each series has a different cost structure and benefits.
- A Series: Funds that are sold by a financial advisor or purchased directly by an individual investor, rather than being sold or purchased from a broker. These mutual funds generally have a lower minimum investment requirement. Advisors can earn commissions from selling them.
- D Series: Funds for investors who buy a fund through a broker, but without an advisor. Because you’re not using an advisor, D Series funds typically have lower fees. But you won’t get any advice, either.
- F Series: F is for “Fee.” These series are available to investors who negotiate fee-based arrangements with their financial advisor. In other words, the investor pays any fee directly to the advisor. This series or class of mutual funds generally has a lower management fee than a retail series.
- I Series: Most of the time “I” stands for “Institutional.” A lot of Series I funds have a high minimum, so only really rich investors (or institutional investors like pension funds or university endowments) are able to buy these.
Our Foolish Investing Advice on Mutual Funds
Mutual funds can be a good long-term investment that doesn’t come with the hassle of picking individual stocks and bonds. Once you have a grasp of the basics we covered here, you’ll be well on your way to building a solid portfolio.
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