Investing Basics: Mutual Funds 101

Eileen St. Pierre, The Everyday Financial Planner

Mutual funds are the best way for individual investors to create a diversified portfolio for a low initial investment. But there are so many choices! Here are a few tips to help you select the right funds for your portfolio.

Using the same fund family makes transferring/switching easier and cheaper.

Suppose your company uses Fidelity to administer its 401(k). You have a menu of mutual funds from which to assemble your retirement portfolio. It’s easy to transfer money among your available choices when it comes time to rebalance your portfolio.

Look for key words in the fund’s name to clue you in on the fund’s style.

Each fund has a specific style and corresponding risk level. Benchmark index/indices are used to measure the manager’s performance. You need to make sure you are comparing apples to apples and not oranges. Here are some common types of funds:

Index Fund

• Buys shares of all the securities in a particular market index
• Known for having extremely low fees
• Easy for manager to maintain
• Referred to as a “passively managed” fund
• S&P 500 index fund is most popular stock index fund.
• There are many bond index funds also available.

Sector Fund

• Buys securities in a particular industry or market sector
• As a stand-alone investment, they are not very diversified.
• Watch out for inexperienced managers – where many get their start.
• Examples: Health Care, Energy, Commodities, Defense Funds

Value vs. Growth Stock Fund

• Value – Manager buys stocks he/she feels are undervalued (beaten down) and will rise in price in the future.
• Growth – Stocks have already started to increase in price due to positive signs of growth; manager feels growth will continue.
• Both referred to as “actively managed” funds.
• These funds have higher management fees than passively managed funds so make sure you are getting your money’s worth.

Income Fund

• May be pure stock, pure bonds, or a combination
• Stock – invests in stocks that pay high dividends
• Bond – invests in bonds that pay high levels of interest
• Be wary of tax implications see my Tax Efficient Investing  column for more information.

International vs. Global Funds

• International funds contain only non-US securities.
• Global funds also contain US securities.

Bond Funds

• The risk level is affected by the probability of default, term to maturity, and level of interest rates.
• Segmented by issuer: Corporate, Government (Treasuries, Agencies), and Municipal

Lifecycle or Target Date Funds

• The default investment for many workplace retirement plans
• Pick a date that closely matches your retirement date. For example, someone age 45 might choose a Lifecycle or Target Date 2035 Fund.
• The younger you are, the higher the % in stocks, less in bonds. As you get older, the portfolio will gradually shift out of stock into bonds.
• Remember, the closer you get to retirement, the lower the stock %. So if you want a less risky fund, choose a lower date – our risk-averse 45-year old mentioned above may instead choose a Lifecycle or Target Date 2030 Fund.

Make sure you read the fund’s prospectus.

The prospectus will list the types of fees the fund charges. Watch out for front-end loads (sales charges), back-end loads (redemption fees), and 12b-1 fees (0.25% to 1% for marketing). All funds will charge management fees, so it is important to compare your fund’s management fee with others in the same style. Morningstar  is a good place to go to compare mutual funds.

Visit my Basic Financial Management  page for other columns in my Investing Basics series.