SMART Mutual Funds

By David Chang

What are mutual funds?When it comes to investing, mutual funds are one of the most common ways to invest. Many investors enjoy selecting individual investments and monitoring their progress on a regular basis. This can be rewarding and fun if you have the time, experience and patience to research your investments and monitor their progress.

Like many people, you may already have a busy schedule or are uncomfortable with selecting your investments. Many people in this position sometimes choose to invest in mutual funds, which are investment vehicles that pool your money along with other investors into a portfolio of individual securities such as stocks and bonds.

What is a mutual fund? A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates. 

Mutual funds are the most common 401(k) and retirement account investments. They appeal to a wide range of investors for several reasons: They’re diversified, they’re professionally managed and they’re liquid, which means you can sell shares when you wish although you may have a loss if the fund has dropped in value.

First, the securities in the portfolio may pay dividends or interest income, which will in turn be passed along to you in the form of fund distributions. Second, the portfolio managers may sell securities that have appreciated in value and pass the gains along to you. And third, if the value of your mutual fund shares happen to rise, you can potentially sell them for more than you paid.

Keep in mind, however, that mutual fund investments fluctuate in value and your mutual fund shares may be worth more or less than their original costs when redeemed. There are many types of mutual funds with a wide variety of investment objectives and risk and return characteristics. Before investing, it is important to carefully consider what your desired goals are and when you expect to achieve them. The time horizon you have to work with is key to picking the right mutual fund.

Why do people buy mutual funds?

Mutual funds are a popular choice among investors because they generally offer the following features:

  • Professional Management. The fund managers do the research for you. They select the securities and monitor the performance. The portfolio is created and managed by investment professionals whose full-time job is to make investment decisions that benefit shareholders such as you. If you purchase mutual fund shares, you essentially own a piece of that portfolio and can potentially benefit in several ways. 

  • Diversification or “Don’t put all your eggs in one basket.” Mutual funds typically invest in a range of companies and industries. This helps to lower your risk if one company fails. To guard against market volatility risk, many people opt for a diversified approach. Investing in a mix of securities, or diversification, may help reduce risks if one security declines in value, others may increase in value and potentially help compensate for a loss in value. Fund managers facilitate this process by often investing in a wide variety of securities. Please note that diversification doesn’t guarantee against market loss in a declining market.

  • Affordability. Most mutual funds set a relatively low dollar amount for initial investment and subsequent purchases. As an investor in a mutual fund you may be able to take advantage of a variety of services such as live customer service, online customer service, automated reports and systematic investment plans, to name a few. Fees and costs associated with mutual funds can vary greatly from fund to fund, and can be an important criterion in investing in a particular mutual fund. But many investors find they are still lower than the costs of buying individual securities.

  • Liquidity and Choice. Mutual fund investors can easily redeem their shares at any time, for the current net asset value (NAV) plus any redemption fees. Mutual funds vary in composition and investment objective. Whether you wish to invest in high technology companies or municipal bonds, there is probably a fund suited to your investment objective. These funds can generally be bought or sold on any business day – which can make it easy to alter a portfolio as investors’ objectives change over time.

What types of mutual funds are there?

Most mutual funds fall into one of four main categories – money market funds, bond funds, stock funds, and target date funds. Each type has different features, risks, and rewards.

Money market funds 

Money market funds have relatively low risks. By law, they can invest only in certain high-quality, short-term investments issued by U.S. corporations, and federal, state and local governments. Money Market Funds pursue current income by investing in short-term money market instruments, such as U.S. Treasury bills, certificates of deposits and commercial corporate notes.

Money Market Funds are designed to maintain a stable share price of $1 and are widely considered the least risky mutual funds. It is important to keep in mind that there is no guarantee these funds will be able to maintain a stable $1 per share price, and they are not insured or guaranteed by the U.S. government.

Stock Funds

Stock funds invest in corporate stocks. Not all stock funds are the same. Some examples are: Target date funds hold a mix of stocks, bonds, and other investments. Over time, the mix gradually shifts according to the fund’s strategy. Target date funds, sometimes known as lifecycle funds, are designed for individuals with particular retirement dates in mind.

  • Aggressive Growth Equity Funds attempt to invest in securities whose stock prices will increase over time (growth and capital appreciation). Often times fund managers invest in companies with the potential for rapid-growth companies in emerging industries or small but rapidly expanding businesses. These funds entail more risk and short-term price volatility than other types of funds, but they may also offer the potential for higher long-term returns than other types of funds.
  • Sector Funds focus on a particular industry or sector in the pursuit of capital appreciation. Sector funds specialize in a particular industry segment like health, natural resources, or health. Since sector funds concentrate on a single sector, they are less diversified than other funds, placing shareholders at risk if there is a downturn in the specific sector invested in. But if the sector does well, there is potential for greater growth.
  • International Equity Funds seek to obtain capital appreciation by investing in stocks of companies outside the United States. Overseas Equity Funds may invest in a particular country, region or specific business sectors located in other regions of the world. Investing overseas can be more risky than domestic equities, with additional risks including foreign currency fluctuations and geopolitical risks.

  • Domestic Value Funds look for stocks that are seen as undervalued, or low-priced, because the company or sector is currently out of favor with investors. Value funds often outperform growth funds when the economy isn’t strong. But there’s still a risk with value funds because not all companies recover from setbacks or recapture investors’ interest. 

  • Domestic Growth Funds pursue capital appreciation by investing in companies that are perceived to have stronger than average growth potential. Growth fund managers look for stocks whose prices they expect to go up as the companies’ products or services reach wider markets and their earnings increase. Generally speaking, growth funds have less short-term price fluctuation than aggressive growth funds, in part, because they invest in more stable companies. They are typically more risky than growth and income stock funds. Growth funds focus on stocks that may not pay a regular dividend but have potential for above-average financial gains.
  • Growth and Income Stock Funds differ from purely Growth funds in that they invest for both capital appreciation and dividend income to be distributed to shareholders. Income funds invest in stocks that pay regular dividends. Some of these funds are weighted more toward providing dividend income and others toward growth. Typically, Growth and Income Stock Funds have less price volatility and risk than pure growth funds, but more than Domestic Growth Funds. 
  • Large-Cap, Mid-Cap, Small-Cap funds are based on size, or market capitalization.  Large-Cap, companies tend to be more price stable and less vulnerable to major losses than small-cap companies. That’s true in part because they have larger financial reserves. On the other hand, small- and mid-cap companies may have more growth potential.

Index Funds

  • Index funds track a particular market index such as the Standard & Poor’s 500 Index. Many 401(k) plans offer index funds as part of their investment menu, and these funds tend to be popular choices. An index fund is designed to mirror the performance of a specific market index, such as the S&P 500 Index. If you believe that there’s no way for a mutual fund manager to consistently beat the market over the long term, you may prefer index funds to trying to select among managed funds.
  • In addition, index fund fees tend to be lower, sometimes significantly lower, than managed fund fees, because buy and sell decisions are based exclusively on changes in the composition of the relevant index so there’s no need for research or day-to-day investment decisions.
  • Of course, in a down market, an index fund will drop in value along with the index it mimics while some managed funds may achieve a stronger performance. That’s one risk of using these funds. Another risk is that many indexes—and therefore the funds that track them—are not as diversified as they seem. Because an index is typically weighted, a limited number of securities may determine the direction of the index. For example, the S&P 500 index emphasizes the performance of stocks with the highest market values.

Bond Funds

Bond funds have higher risks than money market funds because they typically aim to produce higher returns. Because there are many different types of bonds, the risks and rewards of bond funds can vary dramatically. Bond funds provide interest income from the underlying investments in the fund’s portfolio. While you’re investing in your 401(k), that income is reinvested to buy additional shares. Allocating a portion of your 401(k) contribution to these fixed income investments can play an important role in creating a diversified portfolio, reducing investment risk and helping you achieve your long-term goals.

  • Taxable Bond Funds are often sought by investors seeking current income rather than capital appreciation as their investment objective. The risk/reward characteristics of Taxable Bond Funds are determined by the bonds purchased by the funds and vary greatly.

  • High-Yield Bond Funds or “Junk Bonds” are more aggressive bonds that pay a higher interest rate to compensate for the added risk of lower investment grade ratings of the company issuing the bond. A more conservative investor may choose a fund comprised of government or high-grade corporate bonds that are safer but pay a lower interest rate.

  • Tax-Exempt Bond Funds are designed to provide tax-free income by investing in bonds issued by government municipalities. The risk in these bond funds correlates to the credit rating of the issuing government body. Even though they are classified as “Tax-Exempt” funds, income received from these funds may be subject to the alternative minimum tax.

  • These are the different types of issuers of bonds:
    • US Treasury bond funds, which invest in bills, notes or bonds issued by the federal government
    • Agency bond funds, which invest in bonds backed by a pool of mortgages and issued by either agencies of the federal government or government-sponsored enterprises
    • Municipal bond funds, which invest in tax-exempt bonds issued by cities and states in order to fund public projects
    • US corporate bond funds, which invest in bonds issued by US companies
    • International bond funds, which invest in bonds issued by corporations based overseas or by governments other than the US

You can differentiate bond funds from each other in two ways: by the types of bonds a fund owns and by the average term of the bonds in the fund. The average maturities of the bonds in a fund may be grouped as:

  • Short term, with an average maturity of one year or less
  • Intermediate term, with an average maturity of 2 to 10 years
  • Long term, with an average maturity of 10 years or longer

The longer a bond fund’s average maturity, the more sensitive it is to changes in interest rates. As rates go up, the net asset value (NAV) of the fund drops. And as rates drop, the NAV increases. From an investment perspective, what matters most is a bond fund’s total return. That’s the interest the underlying bonds pay, which is reinvested to buy more shares, plus any increase or decrease in the value of your principal. The greater the total return, the better your investment is doing.

A long-term bond fund has greater potential than a short-term bond fund to generate high total returns when rates are falling, but its total return is more likely to decline when rates are rising. The most volatile bond funds, called high-yield funds, invest in low-rated bonds with the greatest risk of default.

Balanced Funds

Balanced Funds pursue capital appreciation by investing in both stocks and bonds. Many people consider Balanced Funds a more conservative investment than stock-only funds, as they offer the diversification inherent in mixing stock and bond holdings. They are similar to target-date funds where there is a mix of stocks and bonds but they don’t change their mix over time like target-date funds.

Balanced funds are the most truly diversified mutual funds because they invest in stocks, preferred stocks and bonds in order to provide both potential growth and current income. By holding both asset classes, balanced funds tend to be less volatile than either pure stock or pure bond funds.

The major drawback of a balanced fund may be that it tends to under-perform pure stock funds in a bull market because only a portion of the fund’s assets is invested in stock. The average stock allocation, which is typically about 60 percent of the total portfolio, is spelled out in the fund’s prospectus, along with any limits the fund manager must follow.

For example, a manager may have the right to shift investments in changing economic environments but be required to keep a minimum of 25 percent in stocks or bonds at any given time. Changes in the current interest rate may also affect a balanced fund’s performance, especially if the fund is invested in long-term bonds in a period when interest rates are rising. That will tend to reduce the fund’s total return.

Capital Preservation

Stable value funds and guaranteed investment contracts (GICs) are designed to preserve capital. That means they make investments that have a low risk of losing money.

Stable value funds guarantee the value of your principal, which is your initial investment, and promise a fixed rate of return. They may buy US Treasury and corporate bonds as well as interest-bearing contracts from banks and insurance companies.

Or all of the fund’s assets may go into GICs. GICs are insurance company products that resemble individual bonds or CDs—the issuer has use of your money for the term of the contract, and pays a fixed rate of interest in return. While it is highly unlikely a stable value fund will lose money, such as scenario has occurred.

Pros and Cons of Capital Preservation

Stable value funds and GICs typically pay interest at a higher rate than money market mutual funds. That’s one reason some investors who want to diversify a 401(k) account that contains more volatile investments, such as stock mutual funds, may choose these funds.

However, the interest rate on a stable value fund or GIC is generally guaranteed for only a predetermined time, sometimes as brief as three months, and varies with changing market conditions. Further, if you want to shift money out of the account, you may have to pay a penalty—sometimes a substantial one. That’s not the case when you move money from a stock or bond fund into another investment.

One downside of capital preservation alternatives is that they’re less likely to provide long-term protection against inflation. That can be a problem. You don’t want to find yourself short of the income you need in retirement.

Target Date Funds

During the past twenty years target-date funds have become very popular with almost $700 billion invested in them. Target-date funds, also known as life-cycle, retirement, or “set-it-and-forget it funds, are generally a type of mutual fund that were first introduced in the early 1990s.

Mutual funds offer instant diversification by pooling money and invests in stocks, bonds, and alternative investments. This give small investors access to a diversified portfolio of investments. Regular mutual funds generally invest in their asset category like small or large companies and domestic or international companies.

Target-date funds are a hybrid category that are based on dates. The fund automatically rebalances and reallocates the asset mix of stocks, bonds, and cash according to the selected time frame. As you get closer to retirement or the target-date, the fund automatically shifts to a more conservative allocation. This is known as the “glide path”, where the risk levels are adjusted over time in order to meet the goal of investors’ starting to withdraw the money that particular year.

For example, if you plan on retiring in 2030, then you would select a 2030 target-date fund. The 2030 fund will be more aggressive than a 2020 fund but less aggressive than a 2040 fund. So a 2050 fund will have a more aggressive asset allocation (with more stocks) than a 2020 fund. The fund is supposed to match the time frame you need the funds invested.

There are several benefits of target-date funds. Target-date funds like a mutual fund offer instant diversification but take it one step further by offering instant asset allocation. It makes it more convenient for people to invest without having to worry about adjusting or setting their own asset allocation.

Instead of having to choose a number of investments and figure out the right amount of each one, you can choose a single fund and remove the guesswork. The only thing you have to do is pick a date. The funds also automatically rebalance when appropriate.

Some of the drawbacks are that expenses of target-date funds are generally higher than a fund that invests directly in stocks and bonds. They are also only based on target year, not on the preferences of the investor. Even though the retirement year may be the same, investors may have different goals and risk tolerances.

Also for some investors the target-date fund can be generic and not personalized enough for their needs. Some target-date funds are also “to” retirement while others are “through” retirement. You have to do some research to find out which one will be right for you. There are currently over 600 target-date funds to choose from.

The retirement date may be the same for many of these funds, they each have their own fee structure, risk profile, and vary widely in their asset mix. It is difficult to compare them to one another or any one benchmark. You will have to do research to pick the right one.

While there are some downsides, target-date funds are a simple way for many people to invest for retirement without having to do it themselves. CLICK HERE for more information and to see my favorite target date funds.

What are the benefits and risks of mutual funds?

Mutual funds offer professional investment management and potential diversification. They also offer three ways to earn money:

  • Dividend Payments. A fund may earn income from dividends on stock or interest on bonds. The fund then pays the shareholders nearly all the income, less expenses.

  • Capital Gains Distributions. The price of the securities in a fund may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, the fund distributes these capital gains, minus any capital losses, to investors.

  • Increased NAV. If the market value of a fund’s portfolio increases, after deducting expenses, then the value of the fund and its shares increases. The higher NAV reflects the higher value of your investment.

All funds carry some level of risk. With mutual funds, you may lose some or all of the money you invest because the securities held by a fund can go down in value. Dividends or interest payments may also change as market conditions change.

A fund’s past performance is not as important as you might think because past performance does not predict future returns. But past performance can tell you how volatile or stable a fund has been over a period of time. The more volatile the fund, the higher the investment risk.

How to buy and sell mutual funds

Investors buy mutual fund shares from the fund itself or through a broker for the fund, rather than from other investors. The price that investors pay for the mutual fund is the fund’s per share net asset value plus any fees charged at the time of purchase, such as sales loads.

Mutual fund shares are “redeemable,” meaning investors can sell the shares back to the fund at any time. The fund usually must send you the payment within seven days. Before buying shares in a mutual fund, read the prospectus carefully. The prospectus contains information about the mutual fund’s investment objectives, risks, performance, and expenses. You can also purchase mutual funds from a financial advisor who can help you choose the right ones for you and your goals.

Understanding fees

As with any business, running a mutual fund involves costs. Funds pass along these costs to investors by charging fees and expenses. Fees and expenses vary from fund to fund. A fund with high costs must perform better than a low-cost fund to generate the same returns for you.

Even small differences in fees can mean large differences in returns over time. For example, if you invested $10,000 in a fund with a 10% annual return, and annual operating expenses of 1.5%, after 20 years you would have roughly $49,725. If you invested in a fund with the same performance and expenses of 0.5%, after 20 years you would end up with $60,858.

It takes only minutes to use a mutual fund cost calculator to compute how the costs of different mutual funds add up over time and eat into your returns. See the Mutual Fund Glossary for types of fees.

How to Choose SMART Funds!

Once you have selected your asset allocation or mix of investment classes, you will want to choose a fund that represents that class. If you chose a passive strategy, here are the things to look in choosing an index or exchange-traded fund (ETFs).

  • Cost-Effective – Passive funds have low expenses. Research shows that fees are one of the greatest factors in determining the performance of an investment. The average expense ratio for mutual funds are anywhere from 1 to 3%, compared to 0.15% for passive funds. All passive funds don’t have the same fee structure, so you want to see which one will give you the most value.
  • Minimal tracking error – One of the critical components of the asset allocation strategy is for each fund to remain in their class category. Tracking error measures how much the specific security precisely replicates its intended underlying index. The higher the variance (tracking error) from its selected benchmark, the less appropriate the fund can represent its asset class. You want a fund that that stay within in its class and minimizes variance.
  • Liquidity – Liquidity is the price difference between the buying and selling price. More liquid securities will have a tighter spread. Poor liquidity can create real problems if you need the money for an emergency or short-term goal. Look for funds that have sufficient liquidity to allow withdrawals any time.

If you have chosen an active strategy, here are the traits to look for in an actively managed mutual fund:

  • Consistent, Thoughtful Strategies – Successful funds tend to be driven by consistent, repeatable strategies. Most strategies will hit a rough patch of lackluster performance eventually, but the key to long-term success is staying focused on the strategy and riding them out. You do not want to see a manager who suddenly switches strategies midstream to either accommodate the next hot fad or marketing folks trying to sell the fund.
  • Experienced, Successful Management – Experienced, successful managers are less prone to get caught up in fads or short-term trends. They are also likely to demand more from newer analysts, deepening the quality of the managers at their fund and organization.
  • Low Expenses – As mentioned before, expenses have greater predictive value than any other data point when it comes to investments. True, there will always be a handful of costly funds with great performance, but they’re less likely to enjoy continued success than those with lower expenses. Realistically, returns on stocks and bonds may be modest for the next decade, so every penny saved in expenses can have a big impact 10 years from now. Load funds (commission charged upfront) seriously degrades the principal and compound interest your investment will earn in the long-run.
  • Responsible Fiduciaries – You want a fund manager that act in the best interests of shareholders. Invest in funds where the managers are compensated based on long-term performance, who have skin in the game and invest in their own funds, and communicate regularly with fund holders. Funds with large sums of managers’ money at stake often are managed in a more tax-efficient manner!

Avoiding fraud

By law, each mutual fund is required to file a prospectus and regular shareholder reports with the SEC. Before you invest, be sure to read the prospectus and the required shareholder reports. Additionally, the investment portfolios of mutual funds are managed by separate entities know as “investment advisers” that are registered with the SEC. Always check that the investment adviser is registered before investing.

David Chang

Award-Winning Entrepreneur, Wealth Manager and CEO | Chief Editor, Author, Keynote Speaker, Consultant ArtofThinkingSmart.com | Political Consultant | Army Officer National Guard | Living To Fulfill Needs, Solve Problems, and Live Passionately!

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