Mutual funds have been the dominant player in the personal investment world for decades. Here’s everything you should know if you’re in the market to buy mutual funds.
How to invest in mutual funds
The mutual fund industry is a service industry, and just as McDonald’s doesn’t camouflage their restaurants with shrubbery so only the hamburger cognoscenti can locate them, mutual funds make their wares exceedingly easy to purchase. So easy, in fact, that it falls to consumers to be fine-print scrutinizing critical shoppers. As you know, if you’ve ever received a Snuggie under the Christmas tree, companies are willing to sell you just about anything. There are currently over 9,000 mutual funds on offer in the US alone by one count. So do your homework to make sure you buy the absolute most appropriate mutual fund, and not find yourself saddled with the financial industry’s answer to the Snuggie.
1. Select the mutual funds you want to invest in
Before we arm you with the tools to buy a mutual fund, make sure it’s the investment product you absolutely want to buy. Later in this article, we’ll discuss the pros and cons of mutual funds, and here you’ll find a detailed guide to help decide between actively managed investments, a category which includes most mutual funds, and passive, largely unmanaged ETFs.
If it’s mutual funds you’ve settled on, the big online investing platforms — you know their names, they don’t need our help advertising — may offer a plethora of funds from a variety of fund families. Here’s a guide to the various companies that manage and sell mutual funds, arranged by how much money they have under management. Bigger is not always better, as we learned in the case of JPMorgan when it was fined for pushing clients into their own inferior mutual funds. So before signing up with any company, Google the company with terms like “wrongdoing” and “SEC” and see if anything troubling comes up.
The biggest decision you’ll make in buying mutual funds is deciding the sector that the mutual fund will invest in. American companies with large market capitalization? Foreign companies with small market capitalization? If these terms are like Greek to you, you’re probably not ready to buy a mutual fund yet. Consider finding yourself a fee-only financial advisor who’s a fiduciary; this article will help explain what that means.
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Once you’ve figured out what kinds of mutual funds you want to buy, make sure they’re good quality in comparison to other funds that do the same thing. Many fund companies will provide ratings from Morningstar, the mutual fund rating agency, right next to all of their offerings. These range from one to five stars, five being the best. As the company explains here, these are unbiased assessments of how well a fund’s past returns have compensated shareholders for the amount of risk the fund has taken on. If a fund has 3 or fewer stars, best to look elsewhere. That being said, there are perks for buying all your mutual funds from one company or “family” of funds which might include no-fee trading and possible lower management fees of individual funds after you reach a certain investment level.
2. Pick the right investment provider
Unlike stocks, which aren’t generally marketed and sold by the company’s themselves, you can go straight to the mutual fund issuers and buy their wares. These are referred to in the biz as “proprietary” funds. You’ve probably heard of companies like Fidelity, Vanguard and BlackRock. This very moment you could go directly to any of their websites and buy a portfolio of their propriety, or a branded, mutual funds. What you’ll understand if you ever strolled into Burger King and tried to order a Big Mac is that these companies really want you to buy their funds, not someone else’s. Fidelity, for instance, sells a select few Vanguard funds but charges you a significant fee you wouldn’t have to pay if you went to Vanguard directly. Smart investors go out of their way to avoid unnecessary fees (more on that a little later).
If buying mutual funds yourself already sounds like a too much effort, open an account with a robo-advisor. They’ll invest your money in a whole platter of stocks, bonds and real estate, through various mutual funds and exchange-traded funds. Some robo-advisors provide handy services like financial advice, portfolio rebalancing to ensure your investments never go off course and tax loss harvesting to reduce your tax bill when investments go sour. It’s an alternative to the DIY option which won’t be for everyone.
3. Watch out for fees
Neither mutual fund companies nor online trading platforms are in the in the business for their health — they need to make money. So exactly how do they make it?
Trading fees: online platforms will generally assess a one-time trading fee to buy most mutual funds. 50 dollars is not unusual. How much this represents to you largely depends on how much you’re investing. Since many mutual funds have no minimum investment, if you’re a young investor with 500 dollars, fifty bucks obviously represents a huge 10% right off the top. (Hint: avoid this particular scenario like a kissing booth during a strep outbreak!) If you’re investing $10,000, it still represents a not insignificant .5% of your investment. Increasingly, platforms offer pretty substantial lists of NTF (no trading fee) funds. If you’re dealing with the industry biggies, there shouldn’t be any hidden fees associated with these — other than MERs of course. So what the devil are MERs?
MERs: MER stands for Management Expense Ratios, and it’s how much the fund assessed every year to operate the fund. Mutual funds are run by fund managers, highly educated math whizzes entrusted with trading the contents of the fund based on whether they foresee the value of the fund’s investments going up or down. The fund managers have assistants and the company spends truckloads of cash marketing the funds with glossy fund pamphlets and tropical boondoggles for brokers. MERs are expressed as a percentage, and one that might look quite small, like 1 or 2 percent, but it’s important to understand this percentage is shaved off the value of the entire fund annually whether or not the fund made or lost money. Over time, these innocent looking MERs add up–way up. Check out how a 2% MER over 25 years can shave $170,000 off of the historically reasonable gains on a $100,000 investment.
Loads: It’s not uncommon for trading platforms to “waive” trading fees for mutual funds that come equipped with loads. Considering that load is just a fancy term for sales commission, there’s no waiving going on at all, they’re just putting the fee in a different place. Loaded mutual funds are named based on when the fee is charged. Class A shares are “front-loaded” meaning they assess the fee just as soon as you buy the fund, B shares are “back-loaded,” meaning they’ll charge a fee when you sell it, and C shares spread the fee over some, or the entire period, you own the fund, usually a period of a year.
4. Manage and rebalance your portfolio
Trading mutual funds should never be undertaken for emotional reasons. If the American stock market experiences a big tumble one day, emotionally, you might be tempted to move your money to cash or foreign stocks. According to the first rule of investing buy low, and sell high–this would obviously be the absolute worst thing you can do.
That said, you should plan to periodically adjust your investments to maintain a consistent asset allocation since inevitably some investments will do better than others and will become a disproportionately large part of your portfolio. Plan on rebalancing your portfolio annually. If you’re math impaired and have a hard time following guides like this one on rebalancing, consider signing up with an automated investing service.
Advantages of investing in mutual funds
Flexibility: Able to react quickly to changing market conditions.
Affordability: Provides investors with the ability to buy essentially fractional shares of companies that otherwise might be too expensive to purchase.
Diversification: A single mutual fund may contain dozens or even hundreds of separate stocks or issuers.
Liquidity: Mutual funds can be bought and sold once every trading day.
Opportunity: Provide excellent job opportunities for mutual fund managers and support staff. (Business school student loans don’t pay themselves!)
Disadvantages of investing in mutual funds
Cost: management fees of mutual funds tend to be very high.
Fees: may have built-in “loads,” which are essentially sales commissions.
Liquidity: Other investments may be traded throughout the trading day rather than only once per day.
Spotty returns: Over the long term, the vast majority of actively managed mutual funds have failed to outperform benchmarks.
Should I invest in mutual funds?
Truth be told, you often won’t have any choice in the matter as to whether you invest in mutual funds.
Many so-called defined contribution plans, like 401(k)s only offer mutual funds among their investing options. And because of the insane-to-pass up tax benefits and employer matching funds, you should probably put as much of your salary as you can muster into these plans. So yee-haw mutual funds in this case!
And if it comes down to a Sophie’s Choice situation between putting your money in one, two, or even five individual stocks or putting it in a mutual fund, you should consider investing in the mutual fund because of something called — diversification. With a mutual fund, one price will buy you positions in dozens, even hundreds of different stocks. Gamblers and stock pickers love to entertain audiences with stories of turning $100 into $10,000, but they loathe to tell you their stories of how many hundreds of thousands in losses it took until they hit their big score. When you spread your investments should one go sour, it won’t drag down your entire portfolio.
Picking individuals stocks is a lot like playing the lottery with your life savings. The top best performing 4% of stocks accounted for the entire wealth creation of the US stock market since 1926 which means there were lots and lots of losing stock pickers. Think about it: when you’re buying a stock, you’re buying it from someone who’s selling. The seller has decided the stock is worth selling at say, $10 dollars a share because she’s sure it’s definitely going to go down, but you’re sure it’s definitely going to go up. Who’s right? What makes you so sure you’re so much smarter than that seller? For this reason, diversification is the answer. The more diverse your holdings, the less vulnerable you’ll be to unexpected stock or even sector dips. So, again, score one for the mutual funds. Yay funds!
But hold the phone for just a second. Just because mutual funds are better than investing in individual stocks, are they necessarily the absolute best way to invest your money? Maybe not. Those fees that we discussed above are the enemy of good returns; studies have shown over and over again that fees are directly predictive of returns in a very simple way; the higher the fees, the lower the returns. But, you’ll naturally retort, those fees have to be worth it, right? The big brains who pick stocks in mutual funds must be able to justify their fees by their boffo returns, and all the people who earn fortunes managing mutual funds will swear that their expertise is well worth the fee you pay. Science begs to differ with their conclusion. In fact, most studies show that almost all actively managed funds will fail to outperform the overall market over the long term.
So what’s a girl or guy to do? The alternative to mutual funds, aka active investing, is passive investing. Passive investing is basically leaving your money alone for a long period of time in a low-fee account that seeks to mirror, rather than outperform a market. This can be accomplished in one of two ways — either through a particular kind of mutual fund called an index fund, which tends to have significantly lower fees than actively managed funds because it simply maintains holdings in proportion to indexes, like the S&P 500 for instance.
But the product that’s made the biggest mark on the passive investment world is the ETF, short for an exchange-traded fund. Like mutual funds, ETFs are basically investment wrappers that allow you buy a large basket of individual stocks or bonds in one purchase, but unlike mutual funds, which are priced just once a day, ETFs can be bought and sold during the entire trading day just like individual stocks. Because they’re largely unmanaged by humans, ETFs (and many index funds) have fees that are a small fraction of those of actively managed mutual funds. These MERs normally come in at between 0.05% and 0.25%.
The long term benefits of a low-fee passive strategy are remarkable thanks to compound returns, which are basically returns on returns. Play around with a compounding calculator like this one to get a feel for what time can do to money that’s unfettered by fees. Between the years of 1950-2009, the stock market grew by 7% per year. So, had you invested $10,000 during that time, the miracle of compounding could have turned your that investment into a cool hundred thousand in about 33 years. Automated investing services have sprouted up in order to guide both beginning and seasoned investors to plot a course to financial freedom through low-cost, highly diversified portfolios of ETFs.
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Owing to the volume of research that favours a passive over active approach, there’s been a veritable geyser of money moving from active to passive management. A vocal minority of investors have warned that this rush to the exits by active investors has created new, huge opportunities for active investors to make a lot of money by zagging while the rest of the world zigs, and potentially devastating pitfalls for the passive horde. (Could there be an ETF bubble?) But the henny pennying remains purely theoretical, while the arguments for passive investment superiority has been thoroughly supported by history, notably in a landmark 2004 study undertaken by Vanguard. And since in pure dollars, mutual fund assets are far larger than those of ETFs in the US, we probably have a long time before reaching the much warned about state of 40% of all investments passively invested, a condition that’s been dubbed “peak passive".
The truth is, nobody can say anything with any certainty. The only thing we have to go on is historical stock market returns; and you should remember that any stock market investment, whether passive or active, is speculative and there’s always a chance you lose a good bit or all of your investment.
Certainly, a pretty good argument could be made for diversification in not only financial sectors and geographic regions, and probably dividing assets between both passive ETFs and actively managed mutual funds.
When to invest in mutual funds?
Wherever you ultimately decide to invest your money, our advice is to start investing as soon as you possibly can. The most powerful tool you have is time, thanks to the miraculous power of compounding. It’s what Warren Buffett calls the eighth wonder of the world and it could potentially make a little money into a lot more if you just give it time to grow.
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