Why buy a mutual fund?
The main reason investors buy mutual funds is for diversification. A fund can have anywhere from twenty securities to several hundred. These can include stocks, bonds, and cash. If your investable assets are below $50,000, mutual funds can be an ideal tool to diversify your portfolio. By investing, you are actually paying for a professional manager or team of managers to oversee your investment. Since mutual fund companies have a lot of money to invest, they may have the advantage of meeting directly with a company’s CEO and senior management before investing. This is certainly an advantage that they have over an individual investor. If you’re busy living your life or don’t have the investment skills to research individual stocks, buying a mutual fund may be the ideal investment.
I need to sell fast, no problem!
Most investors think of a mutual fund as a long-term investment. However, selling a mutual is as easy as selling a stock. If you place an order to buy or sell a mutual fund, you’ll receive close-of-day prices; not at the exact time you call to place the order.
Mutual Fund Pitfalls
As with all securities, mutual funds have their drawbacks. Although a manager is required to invest in accordance with the mutual fund’s prospectus, you have no control over which individual shares your manager buys or sells. If you object to a certain action, such as your manager buying tobacco stock, you have no recourse except, of course, to fire the manager and redeem the manager’s stock.
Hot one year, cold the next
With a mutual fund, your money is pooled with other investors. This can create a tremendous problem for you and the fund manager. The money can flow into a mutual fund that you own. This may force the fund manager to keep that money in cash or to invest in other stocks outside of the fund’s intended purpose. Typically, this is the reason why a high-yield fund may suffer in its performance the following year. Remember, your mutual fund company is also involved in your bottom line. The more money they have in assets under management, the more commissions they bring to your business.
In addition to entries, there are redemptions that your fund manager should take into account. In the event of a mass exodus from the fund you have invested in, your fund manager must sell shares to pay off the shareholders who have sold the fund. In many cases, a mutual fund may have cash to account for redemptions. This can cause you problems and can affect your overall performance.
tax, tax, tax
A big problem and perhaps the biggest drawback to investing in a mutual fund is the tax liability you will have at the end of the year. If your mutual fund manager sold shares due to shareholder redemption or simply sold shares because he believes that a particular stock within the mutual fund’s portfolio has reached its full potential return, your fund experiences a capital gain. This capital gain is passed through to you and must be claimed as such on your tax return; even if you have not sold any shares. These profits must be distributed to all shareholders before the end of the year. Your fund will typically report these gains in November or December. If you’re contemplating investing in a mutual fund later in the year, you should call and ask when the distribution date will occur so you don’t get stuck with a tax bill. Here’s a double whammy: If your fund had capital gains on some stocks but still suffered a loss in NAV (net asset value), you may still be required to pay tax on capital gains generated earlier in the year. .
Note: This only applies to taxable accounts. If you are a mutual fund investor and you are in a non-taxable account such as a 401k or IRA, the above does not apply as you do not pay taxes until you withdraw your money from your retirement funds.
Most fund managers do not outperform their benchmark
If you’re a little worried, there’s more sobering news. Most fund managers do not outperform their unmanaged benchmarks. Researchers at Standard and Poor’s conducted a study in 2006 and found that only 38% of large-cap fund managers managed to outperform the S&P 500 (the standard benchmark by which a large-cap fund manager would be judged). ) over a period of 3 years. Over a 5-year period, that number drops to 33%. It gets much worse for small-cap investors. Small-cap fund managers lagged their benchmark by 24% over a 3-year period and only 21% outperformed the corresponding index over a 5-year period. That means that over a 5-year period, you have a 67-79% chance of losing to an unmanaged index. In addition to the reason mentioned above, there is the human factor. Throughout the history of the market, investors have been searching for the holy grail of investing. If the smartest, highest-paid mutual fund managers haven’t found it after 100 years, it probably doesn’t exist.
Fees and commissions
As an investor, you are, in effect, paying a fee to a company to invest your money professionally. I can’t think of a single fund company that will send you an itemized bill at the end of the year. However, by law, mutual fund companies must submit a prospectus detailing each fee they charge. If you have insomnia, they are highly recommended readings. Before investing, call the fund company and consult with your financial planner. Learn about your investment before you send them your hard-earned money. Remember, mutual funds take their expense fees from you, regardless of how successful they are.
Here’s a highlight of mutual fund fees and expenses:
1) Class A Share Fund Fee – These are generally known as “loaded funds” and will charge a percentage of 1-6%. Over time, this can take a large amount off your total return.
2) Class B Share Fund Fee – These are generally known as “back-end-loaded funds” and will charge a percentage when you sell your shares. Most back-end fund charges will dissipate if they are kept for several years. For example, if you hold a reserve fund for 5 years, the mutual fund company may waive your fee.
3) Investment Management Fees: This money is used to cover advertising expenses and salaries necessary to manage the fund.
Knowing your fund’s expense ratio is critical if you are to have a successful investing career. The average expense ratio for a mutual fund is around 1.5%. This means that for every $10,000 you invest, $150 is deducted for expenses no matter how your mutual fund performed.
Do you think that expenses are not important? Consider this fact: $100,000 invested over 25 years will turn into $684,500 if it achieves an 8% return. If you get just another 2% more over a 25-year period, you’ll have almost $1,100,000; a difference of $415,500. This could be the difference between sipping mojitos on the beach and having to take a job as a receptionist at Walmart in your “golden years.” Invest wisely and consult with a financial advisor. Your future may depend on it.