The following is adapted from Keep It Simple, Make It Big.
With mutual funds, for as little as $50 a month, you can own part of every publicly traded company in the US economy. For another $50 a month, you can own part of the entire world economy. And for another $50 a month, you can own a piece of nearly all the debt.
Clearly, mutual funds are a powerful investment tool. They allow individuals to bundle together small amounts of money to form large pools of money and get professional-quality investing at a reasonable price.
They allow every American to own a piece of the economic action.
One of the best parts of mutual funds is how easy it is to invest in them. If you have a 401(k) or Roth IRA, you’re probably invested in mutual funds, even if you don’t realize it.
But the ease of mutual funds can backfire. Many people invest in mutual funds without having any real knowledge of what they are. As you get deeper into mutual funds, you can run into a lot of jargon that makes things difficult to understand.
To get the most out of this remarkable investing tool, you need a baseline of knowledge, so here’s a Mutual Funds 101, with an explanation of the common terminology you’ll see, as well as a breakdown of the fees and expenses you should expect.
Types of Mutual Funds
Mutual funds come in many flavors.
Open-ended funds are the most common type of mutual funds that allow individuals to purchase and redeem shares daily directly from the company at the value of the investments the company holds at the end of the trading day.
Closed-end funds are a less common type of mutual fund that trades like a stock on exchanges. Once the individual securities are purchased, the manager doesn’t change the mix of securities. The fund may trade below, at, or above the combined market values of the securities it holds.
Exchange-traded funds (ETFs), which are quite common and increasing in popularity, are closed-end mutual funds that match various investment indexes, such as the S&P 500 or the Dow Jones Industrials.
Investment Objectives
Mutual funds are commonly classified by their investment objective. Here are some popular examples.
Money Market: Funds that seek to keep the share price valued at $1 and offer short-term market rates of interest. They offer check-writing privileges.
Fixed Income or Bond: Funds that invest primarily in debt securities issued by corporations, governments, government agencies, and government-sponsored corporations. Funds will specialize as government bond funds, corporate bond funds, foreign bond funds, or global bond funds. Within each specialization subspecialties exist. For example, you can invest in a government bond fund that invests in Treasury Inflation Protected Securities or TIPS.
Growth: Funds that invest in the stocks of companies that are expected to increase in value. Asset appreciation is favored over dividends.
Equity Income: Funds that invest in stocks of companies that pay dividends. May invest in a limited number of bonds.
Foreign: Funds that invest in non-US-based companies.
Global: Funds that invest in non-US- and US-based companies.
Balanced: Funds that invest in both stocks and bonds. Often, they seek to replicate a diversified portfolio.
Sector Funds: Funds that invest in the stocks of companies in a single sector such as utilities, finance, healthcare, or natural resources.
Target Date: Funds that invest in a range of investments designed to be prudent for a person retiring in a certain date range. These are popular in company-sponsored retirement plans and are often the default option.
Mutual Funds by Asset Class
Mutual funds are also often characterized by their asset classes based on a grid.
For equities, there are two types of investing styles, value and growth, and three generally accepted market capitalizations: large, mid, and small. Large, for example, are companies valued at over $10 billion.
Management companies will use objective, style, and market capitalization categories to describe mutual funds. For example, large-cap growth, mid-cap value, or small-cap blend. Some funds may merely call themselves growth or value.
Always read a fund’s prospectus to ascertain the exact securities in which the fund invests. Labels can be inaccurate.
Fees and Expenses
Mutual funds are tightly regulated, and as a result all the expenses associated with investing in them are disclosed to and quantified for investors every six months in prospectuses.
The expenses associated with mutual funds are management fees, sales charges, and marketing expenses.
Management fees, which are typically less than 1 percent, compensate the management company for the tasks associated with security selection, purchase, and administrative overhead.
Sales charges apply to mutual funds purchased through a professional. These mutual funds are often offered in two share classes, A and C.
A shares contain a front-end sales charge. The maximum is 6 percent. There is no deferred sales charge.
C shares do not have a front-end charge. They typically have a 1 percent deferred sales charge if sold within twelve or eighteen months of purchase.
However, the majority of long-term mutual funds purchased—85 percent—do not have a sales charge. They are either purchased directly from the mutual fund company, thus with no need to compensate an investment professional, or they’re held in an account where the professional is paid by other means, such as a flat 1 percent fee.
Marketing expenses are typically 12b-1 fees, which are commonly used by advisor-distributed funds to compensate the advisor for service and initial sales. It can be as high as 1 percent in load funds and no higher than 0.25 percent in no load funds.
A Powerful, Popular Investment Strategy
The first mutual fund, the Massachusetts Investors Trust, was created in 1924. It is still in existence today, but it is far from the only one. There are now nearly 8,000 mutual funds in the United States.
Mutual funds have grown to be one of the most popular investment strategies in the country, and they are a key part of the vast majority of people’s retirement portfolios.
With an understanding of the terminology and basics of this powerful, popular investment strategy, you can begin better incorporating it into your own financial plan.
For more advice on mutual funds, you can find Keep It Simple, Make It Big on Amazon.
Michael Lynch is a CERTIFIED FINANCIAL PLANNERTM professional with nearly twenty years of experience working with American families to craft plans that fund their dreams, educate their children, and finance their retirement. Michael has contributed to the Wall Street Journal and Investor’s Business Daily, and hosted Smart Money Radio for a decade. He’s served as an adjunct faculty member at Fairfield University and currently teaches financial planning to employees of corporations like Madison Square Garden and Yale New Haven Health Systems. Michael is a five-time Financial Planner of the Year for MetLife and a 2019 inductee to the Barnum Financial Group Hall of Fame. You can enjoy his latest articles and videos at www.michaelwlynch.com.
Mutual funds are sold by prospectus only, which is available from your registered representative. Please carefully consider investment objectives, risks, charges, and expenses before investing. For this and other information about any mutual fund investment please obtain a prospectus and read it carefully before you invest. Investment return and principal value will fluctuate with changes in market conditions such that shares may be worth more or less than original cost when redeemed. Diversification cannot eliminate the risk of investment losses.
Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. 6 Corporate Drive, Shelton, CT 06484, Tel: 203-513-6000. CRN202210-272629