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Mutual Funds 101: A Comprehensive Investor’s Guide

Perhaps mutual funds are the easiest and least nerve-wracking way to invest in the market. Actually, more new money has been introduced into funds during the past few years than at any time in history.

Before you jump into the pool and start throwing your money at mutual funds, you should know exactly what they are and how they work. This article will give you the basis you need to start understanding mutual fund investing.

What is a Mutual Fund?

A mutual fund simply is a pool of money provided by individual investors, companies, and other organizations. A fund manager is necessary to invest the cash the investors have contributed. Also, the fund manager’s goal always depends on the type of fund; a fixed-income fund manager, for example, would strive to provide the highest yield at the lowest risk.Mutual Funds 101 infographic

Closed vs. Open-Ended Funds & Load vs. No-Load

Mutual funds are divided along four lines: closed-end and open-ended funds; the latter is subdivided into load and no load.

Closed-Ended Funds

This type of fund has a set number of shares issued to the public through an initial public offering. These shares trade on the open market. This agrees with the fact that a closed-end fund doesn’t redeem or issue new shares like a normal mutual fund. It also subjects the fund shares to the laws of supply and demand. Consequently, shares of closed-end funds normally trade at a discount to net asset value.

Open-Ended Funds

A majority of mutual funds are open-ended. Basically, this means that the fund doesn’t have a set number of shares. Instead, the fund will issue new shares to an investor based upon the current net asset value. It will also redeem the shares when the investor decides to sell. Open-end funds always reflect the net asset value of the fund’s underlying investments because shares are created and destroyed as necessary.

Load vs. No-Load

A load, in mutual fund speak, is a sales commission. If a fund charges a load, the investor will pay the sales commission on top of the net asset value of the fund’s shares.

Meanwhile, no-load funds tend to generate higher returns for investors due to the lower expenses associated with ownership.

How the Mutual Fund Process Works

Let’s say you have $10,000 you want to invest in XYZ Fund. You download a new account application from the mutual fund’s website, fill it out, and mail it in along with a check. A few days later, your account is open.

How do I select a fund that’s right for me?

Every fund has a particular investing strategy, style or purpose. For instance some invest only in blue-chip companies while others invest in start-up businesses or specific sectors.

Finding a mutual fund that fits your investment criteria and style is absolutely vital. If you don’t know anything about biotechnology, you have no business investing in a biotech fund. You must know and understand your investment.

After you’ve settled on a type of fund, you may turn to Morningstar or Standard and Poors (S&P). Both of these companies issue fund rankings based on past record. You can take these rankings with a grain of salt. Past success is no indication of the future, especially if the fund manager has recently changed.

How do I begin investing in a fund?

If you already have a brokerage account, you can purchase mutual fund shares as you would a share of stock. If you don’t, you can visit the fund’s web page or call them and request information and an application. Most funds have a minimum initial investment which vary from $25 – $100,000+ with most in the $1,000 – $5,000 range.

The minimum initial investment may be substantially lowered or waived altogether if the investment is for a retirement account such as a 401k, traditional IRA or Roth IRA, and/or the investor agrees to automatic, reoccurring deductions from a checking or savings account to invest in the fund.

A detailed illustration of a 'Mutual Funds' word on a blackboard.

5 Things on How to Choose the Best Mutual Funds

The two greatest strengths of mutual funds are their accessibility and simplicity. Almost anyone can buy them and they are easy to understand. There are some basic things to keep on your check list if you want to choose the best mutual funds.

Use a Good Fund Screener

Before you begin looking for the best mutual funds, you’ll need a good tool to help you do the research. You can find and use all of the basic mutual fund selection criteria with Morningstar’s Fund Screener.

Use the Appropriate Benchmark for Measuring Performance

To choose the best mutual funds, you’ll need to know how to judge performance. Compare each fund’s historical returns to an appropriate benchmark, such as the fund’s relative category average or an index. For example, performance for most stock mutual funds is compared to the S&P 500 Index.

Keep in mind that mutual funds are best used for long-term investing (more than 3 years). Therefore, put the heaviest weight in your selection criteria on the 5-year return. Also, look at the 10-year return if the fund has been around that long.

If the fund outperforms the benchmark for the 5-year returns, keep it on your radar. Otherwise remove it from consideration.

Check Length of Manager Tenure

Many investors tend to overlook manager tenure, which is how long the manager has been managing the fund.

Look for manager tenure of at least 3 years. Also, make sure the timeframe you’re reviewing represents the same timeframe the manager’s been at the helm of the fund.

If, for example, you’ve found a fund that has an outstanding 5-year return but the manager tenure is only 1 year, it means the current manager receives no credit for 4 of the past 5 years’ performance.

Keep Fees and Expenses Low

Fees and expenses are a direct drag on investment returns. Thus, funds with low fees and expenses tend to perform better over long periods of time than those with higher relative expenses. Only consider mutual funds with an expense ratio below 1.00

Look for Low Turnover

Turnover is a measure of a fund’s trading activity. This means how often the fund manager is buying and selling the stock or bond holdings in the fund. Turnover is often expressed as a percentage, called Turnover Ratio.

A low turnover ratio (20% to 30%) indicates a buy-and-hold strategy and low trading costs, which is generally best for investors. A high turnover ratio (more than 100%) indicates a strategy of significant buying and selling of securities, which creates higher relative trading costs.

5 Tips on Investing in Mutual Funds

If you’re looking for tips on investing in mutual funds, it’s better you look first at the things on how to choose the best mutual funds. Afterwards, check out this easy list of tips to start or to continue on track toward investing success.

Know Your Risk Tolerance

Before choosing your funds, you need to have a good idea of how much risk you can tolerate. Your risk tolerance is a measure of how much fluctuation or market risk you can handle.

For example, if you get highly anxious when your $10,000 account value falls by 10% (to $9,000) in a one-year period, your risk tolerance is relatively low—you can’t tolerate high risk investments.

Determine Your Asset Allocation

Once you determine your level of risk tolerance, you can determine your asset allocation. This is the mix of investment assets such as stocks, bonds and cash that comprises your portfolio.

The proper asset allocation will reflect your level of risk tolerance. That can be described as either aggressive (high tolerance for risk), moderate (medium risk tolerance) or conservative (low risk tolerance).

Learn How to Choose the Best Funds

With thousands of mutual funds to choose from and hundreds of different fund families offering them, an investor can suffer from choice overload and possibly make needless mistakes. Without a doubt, no-load funds are the best choice for mutual fund investors.

Now that you know your asset allocation, you need to begin choosing the best mutual funds for you and your investment goals. If you have a broad choice of mutual funds, start by using a fund screener. You may also simply compare performance to a benchmark. You’ll also want to consider important qualities of mutual funds, such as fund fees and expenses.

Build Your Portfolio of Mutual Funds

Building a portfolio of mutual funds is like building a house. There are many different kinds of strategies, designs, tools and building materials. However, each structure shares some basic features.

To build the best portfolio of mutual funds, you must go beyond the sage advice, “Don’t put all your eggs in one basket:” A structure that can stand the test of time requires a smart design and a strong foundation. Also, it requires simple combination of mutual funds that work well for your needs.

Know the Basics on Mutual Fund Taxation

How does one reduce taxes on mutual funds? Which types of funds are best for taxable accounts? Why did you receive a 1099? Understanding mutual fund taxation will help you improve your overall returns by being a smarter investor.

As they saying goes, “Nothing is sure in life but death and taxes.” However, taxes can be minimized or even avoided with regard to mutual fund investing. Therefore, with knowledge of the basics on mutual fund taxation, you can increase your overall investment portfolio returns.

 

See Also: Hedge Fund: What is it all about?

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