Mutual Fund Basics

Scott Leonard, CFP (President, Leonard Wealth Management, Inc.) gives expert video advice on: What are the most common mistakes people make when investing in mutual funds?; Are mutual funds a safer investment than individual stocks? and more.

What is a mutual fund?

A mutual fund is nothing more than a pooled investment that has some form of professional management. The management buys into an investment strategy that is usually determined by the mutual fund itself, via a prospectus. An example of that would be a mutual fund thats going to invest in large cap growth stocks. You could have a bunch of individuals come in with relatively small amounts of money that is pooled in a mutual fund. The professional manager can go out and buy that class of stocks that theyre trying to implement.

What are the pros and cons of investing in mutual funds?

On of the pros of investing in a mutual fund is first and foremost the ability to get broad diversification. With a small amount of money you can get a large number of securities. When you start looking at other markets, especially international markets, it is really not practical for an individual to buy international securities in foreign countries. A foreign mutual fund really gets you exposure to securities you wouldnt be able to get to on your own. Another advantage to mutual funds is that many people will look at is the professional management. You have a manager — or a management team — that is there really helping to implement the strategy. They are professional traders, people who earn a lot of money, but you as a individual arent necessarily paying a lot to that person to manage the mutual fund because you are in that pooled strategy. The real risk associated, or the cons associated, with mutual fund investing is the lack of control that we have as investors. We make an assumption that these managers are good and are doing a really good job for us. Where we lack control for the most part is going to be in forced taxation through the selling of securities inside a mutual fund. That could potentially become a problem if a lot of investors in that mutual fund want their money back. That could force the managers to sell securities to give them back their money. This may be realization of capital gains which you as an investor who stays in that mutual fund is going to get stuck paying. You could actually be forced to pay taxes for transaction charges that are being generated by other investors.

What are the fees and costs I pay to invest in mutual funds?

When youre investing in a mutual fund there are some different levels of costs or fees. Some of them you see and some of them you dont. One of the cost that any investor is going to bare is just the cost of purchasing the security. So, even though mutual funds are big institutions usually they are still paying the commission or trading cost to buy securities. One of the advantages of a mutual fund is usually those costs are going to be less then if you were to go buy the securities yourself since they are large institutions. We dont see those fees but those are represented in the net performance we do see in a mutual fund. The fees we really see are the management fees. The expense ratio, really what the fund is charging to actually provide the service to us as investors. And, on top of that, then there are going to be different types of lodes and commissions that you might pay and marketing fees also associated with a mutual fund.

What is a load fund?

A load, when it relates to a mutual fund, is really a sales charge. It is the commission thats being paid back to the brokerage firm for selling you into a mutual fund. There are three main types of loads. Theres a front-end load which is just a certain percentage (lets say three to five percent of your initial investment amount) thats going to be paid back to the brokerage firm. Then theres a back-end load that usually decreases over time. That load might start as high as seven percent and go down over the years. If you sell out of the fund before that load goes away then youre going to payout a charge for leaving. The last type of load is an ongoing sales charge and thats typically three-quarters of a percent to one percent which is paid every single year on that investment back to the institution. That is, its really involved with your securities. Whats interesting is no one of these loads is necessarily better than the other. It really is a process of how much money youre investing, how long youre going to be in an investment and what your overall strategy is, on which load might be better or worse for you.

What is a no load fund?

A true no load fund is a mutual fund that has no sales commissions involved with it at all. It doesnt mean that its free — there is still that management fee that the mutual fund is earning. But, there are no added charges that are being paid to any individual or brokerage firm for selling you or putting you into that investment. Typically we find no load funds are less expensive than loaded funds.

What is a 12b-1 fee?

A 12b-1 fee is an ongoing fee that the mutual fund charges and then pays out to a third party. It is not technically a load, but it can be considered one in the sense that it is an outside charge in order to keep the investor really invested in the product. Many times, a 12b-1 is how brokers continue to receive money for having you invest in a mutual fund. A lot of the discount brokerage firms, that trade mutual funds for free, are actually receiving a 12b-1 fee from the mutual fund company to be in that kind of no-cost platform that they have. 12b-1 fees are just going to take away from your performance a little bit every year in order for you to have access to that fund.

What is a fund manager?

The fund manager is the person whos in charge of making the day to day decisions about which securities are going to be owned by that mutual fund. If it is a stock mutual fund and its buying stocks, it is the fund manager that is deciding which stocks are going to be in the fund, which ones were going to purchase and which ones were going to sell, over the life of the fund.

What are the most common mistakes people make when investing in mutual funds?

When it comes to mistakes relative to investing in mutual funds, one of the biggest is not having a reason why youre actually looking at this fund, not having a set goal on how this fund plays into the overall aspect of your portfolio. And whats driving that are really, many times some of the other problems with mutual funds, is – and its – number one is buying based on past performance. Everyone hears it, that past performance is no indication of future performance, but yet no one believes it. But its so true, that so many people buy mutual funds because of their past performance. But any investment is going cycle through good times and bad times. And so not having a reason to buy a fund and only buying on past performance, is really gonna – what its going to do, is its going to create a portfolio of funds that look very similar. You dont have your broad diversification there. Thats one of the key problems we see is a past performance. And that relates to other indications, people might buy based on its rating. Theres independent rating companies out there, and they say, “Well, it has a good rating by whoever.” The problem is, is that those ratings are almost always based on past performance also. Another concern with this is if a fund has a lot of turnover, means it turns over stocks a lot, its going to be very tax expensive for you. Returns are illustrated, or shown, on an absolute basis, or a total return basis. Theyre not shown net of taxes. So if you have a fund that has a high turnover, youre, especially if youre a high taxpayer, your net result could be much lower than what you would be getting on fund that has maybe lower historical returns, but much less turnover. So thats another key issue that most people miss, is where that turnover might be. Another thing I think that people miss is if youre buying a fund, especially if performance is a key issue, is how long is the manager been at the helm of that fund, because if its really an actively managed fund, where the manager is in there picking and choosing the stocks, if that managers left, and a new managers there, that past performance is really tied to the managers performance, not actually the mutual funds performance. So thats another key thing we want to look at. The mistake most: people dont look at is manager tenure as it relates to the performance theyre looking at at a fund. So once again, this all ties back to performance, which should really be one of the last considerations youre looking at with a fund. But the big mistake is putting that up front and then not realizing how that may affect you. Lastly, another consideration is if a fund is very trendy and youre buying it because its a very trendy fund, if that fund goes out of trend; there might be a lot of people that leave; pull their money out of the fund, and if you want to stick with it as a long term investor, that could be very damaging to you once again from a tax perspective. The manager must sell securities to pay out the people that are leaving the fund. You will actually end up paying the taxes as a result of those trades. So trendy funds, a fund that just gets a lot of money really quick, probably is going to lose a lot of money really quick, because its a hot fund, Hot funds are dangerous for long term investors.

Are mutual funds a safer investment than individual stocks?

When it comes to comparing stock mutual funds to individual stocks, we talk about which might be a safer investment. Theyre really just two different ways to get at the same investment. If you as an individual were going to go out and buy 3 stocks, and a mutual fund was going to go out and buy the same exact 3 stocks, theres really no difference in risk between those 3 stocks. A mutual fund should really be looked at the way in which youre going to go out and invest in stocks. If you get the next step beyond that — in the human nature of things — a professional money manager hopefully is going to be less likely to make emotional decisions and make the wrong decisions around managing money that an individual might make. From that stand point managers might be more disciplined. In the investment strategy, mutual funds would be less risky when the managers have a very disciplined strategy.