Chapter 2
Mutual Funds: Pros and Cons
In This Chapter
Seeing how mutual funds work
Discovering reasons to choose mutual funds
Considering the drawbacks
I’m not sure where the mutual in mutual funds comes from; perhaps it’s so named because the best funds allow many people of differing economic means to mutually invest their money for
Easy diversification
Access to professional money managers
Low investment management costs
No matter where the word came from, mutual funds, like any other investment, have their strengths and weaknesses that you need to know about before you invest your money. This chapter discusses the advantages and disadvantages of mutual funds.
Getting a Grip on Mutual Funds
A mutual fund is a collection of investment money pooled from many investors to be invested for a specific objective. When you invest in a mutual fund, you buy shares and become a shareholder of the fund. The fund manager and his team of assistants determine which specific securities (for example, stocks or bonds) they should invest the shareholders’ money in, in order to accomplish the objectives of the fund and keep shareholders happy.
A misconception some investors hold regarding mutual funds is that they invest in stocks and, therefore, are too risky. They don’t, and they’re not. By using mutual funds, you can invest in a whole array of securities, ranging from money market funds, bonds, stocks, and even real estate.
All mutual funds aren’t created equal. Some funds, such as money market funds, carry virtually zero risk that your investment will decline in value. Bond funds that invest in shorter-term bonds don’t generally budge by more than several percentage points per year. And you may be surprised to find out in Chapter 13 that some conservative stock funds aren’t that risky if you can plan on holding them for a decade or more.
Because good mutual funds take most of the hassle out of figuring out which securities to invest in, they’re among the best investment vehicles ever created:
Mutual funds allow you to diversify your investments — that is, invest in many different industries and companies instead of in just one or two. By spreading the risk over a number of different securities representing many different industries and companies, mutual funds lessen your portfolio’s instability and the chances of a large loss.
Mutual funds enable you to give your money to the best money management firms and managers in the country.
Mutual funds are the ultimate couch potato investment! However, unlike staying home and watching television or playing video games, investing in mutual funds can pay you big rewards.
What’s really cool about mutual funds is that when you understand them, you realize that they can help you meet many different financial goals. Maybe you’re building up an emergency savings stash of three to six months’ living expenses (a prudent idea, by the way). Perhaps you’re saving for a home purchase, retirement, or future educational costs. You may know what you need the money for, but you may not know how to protect the money you have and make it grow.
Don’t feel bad if you haven’t figured out a long-term financial plan or don’t have a goal in mind for the money you’re saving. Many people don’t have their finances organized, which is why I write books like this one! I talk more specifically in Chapter 3 about the kinds of goals mutual funds can help you accomplish.
Financial intermediaries
A mutual fund is a type of financial intermediary. (Now that’s a mouthful!) Why should you care? Because if you understand what a financial intermediary is and how mutual funds stack up to other financial intermediaries, you’ll better understand when funds are appropriate for your investments and when they probably aren’t. A financial intermediary is nothing more than an organization that takes money from people who want to invest and then directs the money to those who need investment capital (another term for money).
Suppose that you want to borrow money to invest in your own business. You go to a bank that examines your financial records and agrees to loan you $20,000 at 8 percent interest for five years. The money that the banker is lending you has to come from somewhere, right? Well, the banker got that money from a bunch of people who deposited money with the bank at, say, 2 percent interest. Therefore, the banker acts as a financial intermediary, or middleman — one who receives money from depositors and lends it to borrowers who can use it productively.
Insurance companies do similar things with money. They sell investments, such as annuities (see Chapter 1) and then turn around and lend the money — by investing in bonds, for example — to businesses that need to borrow. (Remember, a bond is nothing more than a company’s promise to repay borrowed money over a specified period of time at a specified interest rate.)
The best mutual funds are often the best financial intermediaries for you to invest through because they skim off less (that is, they charge lower management fees) to manage your money and allow you more choice and control over how you invest your money.
Open-end versus closed-end funds
Open end and closed end are general terms that refer to whether a mutual fund company issues an unlimited or a set amount of shares in a particular fund:
Open-end funds: Open end simply means that the fund issues as many (or as few) shares as investors demand. Open-end funds theoretically have no limit to the number of investors or the amount of money that they hold. You buy and sell shares in such a fund from the fund company.
Closed-end funds: Closed-end funds are those where the mutual fund companies decide upfront, before they take on any investors, exactly how many shares they’ll issue. After they issue these shares, the only way you can purchase shares (or more shares) is to buy them from an existing investor through a broker. This process happens with buying and selling stock, too.
The vast majority of funds in the marketplace are open-end funds, and they’re also the funds that I focus on in this book because the better open-end funds are superior to their closed-end counterparts.
Open-end funds are usually preferable to closed-end funds for the following reasons:
Management talent: The better open-end funds attract more investors over time. Therefore, they can afford to pay the necessary money to hire leading managers. I’m not saying that closed-end funds don’t have good managers, too, but generally, open-end funds attract better talent.
Expenses: Because they can attract more investors, and therefore more money to manage, the better open-end funds charge lower annual operating expenses. Closed-end funds tend to be much smaller and, therefore, more costly to operate. Remember, operating expenses are deducted out of shareholder returns before a fund pays its investors their returns; therefore, relatively higher annual expenses depress the returns for closed-end funds.
Brokers who receive a hefty commission generally handle the initial sale of a closed-end fund. Brokers’ commissions usually siphon anywhere from 5 to 8 percent out of your investment dollars, which they generally don’t disclose to you. (Even if you wait until after the initial offering to buy closed-end fund shares on the stock exchange, you still pay a brokerage commission, although it is generally a lot less than the initial sale commission.) You can avoid these high commissions by purchasing a no-load (commission-free), open-end mutual fund. (See “Funds save you money and time,” later in this chapter, for details on no-load funds.)
Fee-free selling: With an open-end fund, the value of a share (known as the net asset value) always equals 100 percent of what the fund’s investments (less liabilities) are currently worth. And you don’t have the cost and troubles of selling your shares to another investor as you do with a closed-end fund. Because closed-end funds trade like securities on the stock exchange and because you must sell your shares to someone who wants to buy, closed-end funds sometimes sell at a discount. Even though the securities in a closed-end fund may be worth, say, $20 per share, the fund may sell at only $19 per share if sellers outnumber buyers.
You could buy shares in a closed-end fund at a discount and hold on to them in hopes that the discount disappears or — even better — turns into a premium (which means that the share price of the fund exceeds the value of the investments it holds). You should never pay a premium to buy a closed-end fund, and you shouldn’t generally buy one without getting at least a 5 percent discount (to make up for its deficiencies, versus its open-ended peers, especially higher expenses).
Sorry to complicate things, but I need to make one clarification. Open-end funds can, and sometimes do, decide at a later date to “close” their funds to new investors. This doesn’t make it a closed-end fund, however, because investors with existing shares can generally buy more shares from the fund company. Instead, the fund becomes an open-end fund that’s closed to new investors!
Opting for Mutual Funds
To understand why funds are so sensible is to understand how and why funds can work for you. Keep reading in this section to discover their many benefits. (Funds also have their drawbacks — I cover them in the section, “Addressing the Drawbacks,” later in this chapter.) In Part II of this book, I compare mutual funds to other investing alternatives so you can clearly understand when funds are and aren’t your best choice.
Fund managers’ expertise
Mutual funds are investment companies that pool your money with the money of hundreds, thousands, or even millions of other investors. The company hires a portfolio manager and a team of researchers whose full-time job is to analyze and purchase investments that best meet the fund’s stated objectives.
Typically, fund managers are Chartered Financial Analysts (CFAs) and/or graduates of the top business and finance schools in the country, where they study the principles of portfolio management and securities valuation and selection. In addition to their educational training, the best fund managers typically have a decade or more of experience in analyzing and selecting investments.
A mutual fund management team does more research and due diligence than you could ever have the energy or expertise to do in what little free time you have. Investing in mutual funds can help your friendships, and maybe even your love life, because you’ll have more free time and energy!
Consider the following activities that an investor should do before investing in stocks and bonds:
Analyze company financial statements: Companies whose securities trade in the financial markets are required to issue reports every three months detailing their revenue, expenses, profits and losses, and assets and liabilities. Unless you’re a numbers geek, own a financial calculator, and enjoy dissecting tedious corporate financial statements, this first task alone is reason enough to invest through a mutual fund and leave the driving to the mutual fund management team.
Talk with the muckety-mucks: Most fund managers log thousands of frequent-flier miles and hundreds of hours talking to the folks running the companies they’re invested in or are thinking about investing in. Because of the huge amount of money they manage, large fund companies even get visits from company executives, who fly in to grovel at the fund managers’ feet. Now, do you have the correct type of china and all the place settings that etiquette demands of people who host such high-level folks?!
Analyze company and competitor strategies: Corporate managers have an irritating tendency to talk up what a great job they’re doing. Some companies may look as if they’re making the right moves, but what if their products are soon to lag behind the competition’s? The best fund managers and their researchers take a skeptical view of what a company’s execs say — they read the fine print and check under the rugs. They also keep on top of what competitors are doing. Sometimes they discover investment ideas better than their original ones this way.
Talk with company customers, suppliers, competitors, and industry consultants: Another way the mutual fund managers find out whether a company’s public relations story is full of holes instead of reality is by speaking with the company’s customers, suppliers, competitors, and other industry experts. These people often have more balanced viewpoints and can be a great deal more open about the negatives. These folks are harder to find but can provide valuable information.
Attend trade shows and review industry literature: It’s truly amazing how specialized the world’s becoming. Do you really want to subscribe to business newsletters that track the latest happenings with ball bearing or catalytic converter technology? They’ll put you to sleep in a couple of pages. Unlike popular mass-market publications, they’ll also charge you an arm and a leg to subscribe.
Are you, as the investor, going to do all these tasks and do them well? Nothing personal, but I doubt that you will. Even in the unlikely event that you could perform investment research as well as the best fund managers, don’t you value your time? A good mutual fund management team happily performs all the required research for you, does it well, and does it for a fraction of what it costs you to do it haphazardly on your own.
Funds save you money and time
Chances are the last thing you want to do with your free time is research where to invest your savings. If you’re like many busy people, you’ve kept your money in a bank just to avoid the hassles. Or maybe you turned your money over to some smooth-talking broker who sold you a high-commission investment that you still don’t understand but are convinced will make you rich.
Mutual funds are a cheaper, more communal way to get the investing job done. A mutual fund spreads out the cost of extensive — and expensive — research over thousands of investors. How does a mutual fund save you time and money? Let me count the ways:
Mutual funds can produce a much better rate of return over the long haul than a dreary, boring bank or insurance company account. You can purchase by writing a check or calling a toll-free number. What does it cost to hire such high-powered talent to do all the dreadful research and analysis? A mere pittance if you pick the right funds. In fact, when you invest your money in an efficiently managed mutual fund, the cost should be less than it would be to trade individual securities on your own.
Mutual funds manage money efficiently through effective use of technology. Innovations in information-management tools enable funds to monitor and manage billions of dollars from millions of investors at a very low cost. In general, moving around $5 billion in securities doesn’t cost them much more than moving $500 million. Larger investments just mean a few more zeros in the computer data banks.
The most efficiently managed mutual funds cost less than 1 percent per year in expenses. (Bond funds and money market funds cost much less — good ones charge just 0.5 percent per year or less.) Some of the larger and more established funds, including index funds (see Chapter 10), charge annual expenses of less than 0.2 percent per year.
Many mutual funds don’t charge a commission (load) to purchase or redeem shares. Commission-free funds are called no-load funds. Such opportunities used to be rare. Fidelity and Vanguard, the two largest distributors of no-load funds today, exacted sales charges as high as 8.5 percent during the early 1970s. Even today, some mutual funds known as load funds charge you a commission for buying or selling shares in their funds. (See Chapter 7 for the complete story on fund fees.)
Fund diversification minimizes your risk
Diversification is a big attraction for many investors who choose mutual funds. Here’s an example of why, which should also explain what diversification is all about: Suppose you heard that Phenomenal Pharmaceuticals developed a drug that stops cancer cells in their tracks. You run to the phone, call your broker, and invest all your savings in shares of Phenomenal stock. Years later, the Food and Drug Administration (FDA) denies the company approval for the drug, and the company goes belly up, taking your entire nest egg with it.
Your money would’ve been much safer in a mutual fund. A mutual fund may buy some shares of a promising, but risky, company like Phenomenal without exposing investors like you to financial ruin. A fund owns stocks or bonds from dozens of companies, diversifying against the risk of bad news from any single company or sector. So when Phenomenal goes belly up, the fund may barely feel a ripple.
Diversifying like that on your own would be difficult — and expensive —unless you have a few hundred thousand dollars and a great deal of time to invest. You’d need to invest money in at least 8 to 12 different companies in various industries to ensure that your portfolio could withstand a downturn in one or more of the investments.
Mutual funds typically invest in 25 to 100 securities, or more. Proper diversification increases the probability that the fund receives the highest possible return at the lowest possible risk, given the objectives of the fund.
I’m not suggesting that mutual funds escape without share-price declines during major market downturns. For example, during the early 2000s bear market, many mutual funds declined in value. But again, the investors who were most harmed were those who held individual stocks that, in the worst cases, ended up plummeting to zero as companies went bankrupt or those investors who loaded up on technology and Internet stocks that dropped 80 to 90 percent or more. The same fate befell investors who were overloaded with stock in financial firms like AIG, Bear Stearns, Lehman, and so on that plunged far more than the broad market averages in the late 2000s bear market.
Although most mutual funds are diversified, some aren’t. For example, some stock funds, known as sector funds, invest exclusively in stocks of a single industry (for instance, healthcare). Others focus on a single country (such as India). I’m not a fan of such funds because of the lack of diversification and because such funds typically charge higher operating fees. It’s also worth noting that investors who bought sector funds investing exclusively in Internet stocks got hammered in the technology stock crash of the early 2000s. Many of those funds dropped 80 percent or more, whereas broadly diversified funds fared far better. (The same thing happened in the late 2000s to investors in financial sector funds.) I talk more about narrowly focused stock funds in Chapter 13.
Funds undergo regulatory scrutiny
Before a fund can take in money from investors, the fund must go through a tedious review process by the Securities and Exchange Commission (SEC). After it offers shares, a mutual fund is required to publish in its prospectus (see Chapter 8) historical data on the fund’s returns, its operating expenses and other fees, and its rate of trading (turnover) of the fund’s investments.
But know that government regulators aren’t perfect. Conceivably, a fund operator could try to slip through some bogus numbers, but I wouldn’t lose sleep worrying about this, especially if you invest through the larger, reputable fund companies recommended in this book.
You choose your risk level
Choosing from a huge variety of mutual funds, you can select the funds that meet your financial goals and take on the kinds of risks that you’re comfortable with. Funds to choose from include
Stock funds: If you want your money to grow over a long period of time (and you can put up with some bad years thrown in with the good), select funds that invest more heavily in stocks. (Check out Chapter 13 for the complete story on stock funds.)
Bond funds: If you need current income and don’t want investments that fluctuate as widely in value as stocks do, consider bond funds (see Chapter 12).
Money market funds: If you want to be sure that your invested principal doesn’t drop in value because you may need to use your money in the short term, you can choose a money market fund (see Chapter 11).
Most investors choose a combination of these three types of funds to diversify and help meet different financial goals. I get into all that information in the chapters to come.
Fund risk of bankruptcy is nil
Mutual funds don’t work like banks and insurance companies, hundreds of which have failed in recent decades. (The number going under spiked during the late 2000s recession.) Banks and insurers can fail because their liabilities (the money customers have given them to invest) can exceed their assets (the money they’ve invested or lent). When a big chunk of a bank’s loans goes sour at the same time that its depositors want their money back, the bank fails. That happens because banks have less than 20 cents on deposit for every dollar that you and I place with them. Likewise, if an insurance company makes several poor investments or underestimates the number of claims that insurance policyholders will make, it too can fail.
Such failures can’t happen with a mutual fund. The situation in which the investors’ demand for withdrawals of their investment exceeds the value of a fund’s assets simply can’t occur because for every dollar of assets that a fund holds for its customers, that mutual fund has a dollar’s worth of redeemable securities.
That’s not to say that you can’t lose money in a mutual fund. The share price of a mutual fund is tied to the value of its underlying securities: If the underlying securities, such as stocks, decrease in value, so, too, does the net asset value (share price) of the fund. If you sell your shares when their price is less than what you paid for them, you get back less cash than you originally put into the fund. But that’s the worst that can happen; you can’t lose all your investment in a mutual fund unless every single security owned by that fund simultaneously becomes worthless — an extraordinarily unlikely event.
You may be interested to know that the specific stocks and/or bonds that a mutual fund buys are held by a custodian — a separate organization or affiliate of the mutual fund company. The employment of a custodian ensures that the fund management company can’t embezzle your funds (like hedge fund crook Bernie Madoff did) or use assets from a better-performing fund to subsidize a poor performer.
Funds save you from sales sharks
Stockbrokers (also known as financial consultants) and commission-based financial planners make more money by encouraging trading activity and by selling you investments that provide them with high commissions — limited partnerships and mutual funds with high-load fees, for example. Brokers and planners also get an occasional message from the top brass asking them to sell some newfangled investment product. All this creates inherent conflicts of interest that can prevent brokers from providing objective investment and financial advice and recommendations.
The better no-load (commission-free) fund companies discussed in this book generally don’t push specific products. Their toll-free telephone lines are staffed with knowledgeable people who earn salaries, not commissions. Sure, they want you to invest with their company, but the size of their next paycheck doesn’t depend on how much they persuade you to buy or trade.
You have convenient access to your money
What I find really terrific about dealing with the best mutual fund companies is that they’re set up for people who don’t like to waste time going to a local branch office and waiting in line. I don’t know about you, but I enjoy waiting in lines, especially in places like a bank, about as much as I enjoy having my dentist fill a cavity.
With mutual funds, you can make your initial investment from the comfort of your living room by filling out and mailing a simple form and writing a check. (Computer lovers can open and fund accounts online as I discuss in Chapter 16.) Later, you can add to your investment by mailing in a check or by authorizing money transfers by phone or online from one mutual fund account to another.
Selling shares of your mutual fund for cash is usually easy. Generally, all you need to do is call the fund company’s toll-free number or click your computer mouse at your investment firm’s Web site 24/7. Some companies even have representatives available by phone 24 hours a day, 365 days a year. (Signature guarantees, although much less common, are still sometimes required by fund companies.)
Many mutual fund companies also allow you to wire money back and forth from your local bank account, allowing you to access your money almost as quickly through a money market fund as through your local bank. (As I discuss in Chapter 11, you probably need to keep a local bank checking account to write smaller checks and for immediate ATM access to cash.)
When dealing with a money market fund, in particular, the ease of access is even greater. Most money market funds also offer check-writing privileges. These accounts often carry a restriction, however, that your bank checking account doesn’t have: Money market checks must be greater than a specified minimum amount — typically $250.
If you like to conduct some transactions in person, some of the larger fund companies, such as Fidelity, and certain discount brokers, such as Charles Schwab and TD Ameritrade, have branch offices in convenient locations.
Addressing the Drawbacks
Although I’m a fan of the best mutual funds, I’m also well aware of their drawbacks, and you need to know them, too. After all, no investment vehicle is perfect, and you need to understand mutual fund negatives before you take the plunge.
Still, the mutual fund drawbacks that I’m concerned about are different from the ones that some critics like to harp on. Here’s my take on which mutual fund drawbacks you shouldn’t worry about — and which ones you should stop and think about a little more.
Don’t worry about these . . .
If you’ve read some articles or heard some news stories about the downsides of mutual funds, you may have heard of some of the following concerns. However, you shouldn’t let them trouble you:
The investment Goliath: One of the concerns I still hear about is the one that, because the fund industry is growing, if stock fund investors head for the exits at the same time, they may get stuck or trampled at the door. You could make this argument about any group of investors including institutions. Little evidence suggests that most individual investors are prone to rash moves. Mutual funds have grown in importance simply because they’re a superior alternative for a whole lot of people.
Doing business long distance: Some people, particularly older folks who grew up doing all their saving through a local bank, feel uncomfortable doing business with a company that they can reach only via a toll-free number, the mail, or a Web site. But please recognize the enormous benefits of mutual funds not having branch offices all over the country. Branch offices cost a lot of money to operate, which is one of the reasons why bank account interest rates are so scrawny.
If you feel better dropping your money off in person to an organization that has local branch offices, invest in mutual funds through one of the firms that I recommend in Chapter 9. Or do business with a fund company that’s headquartered near your abode. (See the Appendix for the main addresses of the fund companies recommended in this book.)
Fund company scandals: A number of funds (none that were recommended in the previous editions of this book) earned negative publicity due to their involvement in problematic trading practices. In the worst cases, some fund managers placed their own selfish agendas (or that of certain favored investors) ahead of their shareholders’ best interests. Rightfully, these fund companies have been hammered for such behavior and forced to reimburse shareholders and pay penalties to the government. However, the amount of such damage and reimbursement has been less than 1 percent of the affected fund’s assets, which pales in comparison to the ongoing drag of high expenses discussed in the next section. The parent company responsible for an individual fund should be an important consideration when deciding which funds to entrust with your money. Avoid fund companies that don’t place their shareholders’ interests first. (I definitely don’t recommend those companies in this book.)
Worry about these (but not too much) . . .
No doubt you hear critics in the investment world state their case for why you should shun funds. Not surprisingly, the most vocal critics are those who compete with fund companies.
You can easily overcome the common criticisms raised about fund investing if you do your homework and buy the better available mutual funds, which I show you how to do in this book. Make sure that you consider and accommodate these factors before you invest in any mutual fund:
Volatility of your investment balance: When you invest in mutual funds that hold stocks and/or bonds, the value of your funds fluctuates with the general fluctuations in those securities markets. These fluctuations don’t happen if you invest in a bank certificate of deposit (CD) or a fixed insurance annuity that pays a set rate of interest yearly. With CDs or annuities, you get a statement every so often that shows steady — but slow — growth in your account value. You never get any great news, but you never get any bad news either (unless your insurer or bank fails, which could happen).
Over the long haul, if you invest in solid mutual funds — ones that are efficiently and competently managed — you should earn a better rate of return than you would with bank and insurance accounts. And if you invest in stock funds, you’ll be more likely to keep well ahead of the double bite of inflation and taxes.
If you panic and rush to sell when the market value of your mutual fund shares drops (instead of holding on and possibly taking advantage of the buying opportunity), then maybe you’re not cut out for funds. Stock fund investors who joined the panic taking place in late 2008 and early 2009 and sold got out at fire sale prices and missed out on an enormous rebound that took place beginning in early 2009. Take the time to read and internalize the investment lessons in this book, and you’ll soon be an honors graduate from my Mutual Fund University!
Mystery (risky) investments: Some mutual funds (not those that I recommend) have betrayed their investors’ trust by taking unnecessary risks by investing in volatile financial instruments such as futures and options (also known as derivatives). Because these instruments are basically short-term bets on the direction of specific security prices (see Chapter 1), they’re very risky when not properly used by a mutual fund. If a fund discloses in its prospectus that it uses derivatives, look to see whether the derivatives are used only for hedging purposes to reduce risk instead of as speculation on stock and bond price movements, which would increase risk.
Investments that cost an arm and a leg: Not all mutual funds are created equal. Some charge extremely high annual operating expenses that put a real drag on returns. (Again, you won’t find such funds on my recommended lists in this book.) I talk more about expense ratios and how to find great funds with low expenses in Chapter 7.
Taxable distributions: The taxable distributions that funds produce can also be a negative. When fund managers sell a security at a profit, the fund must distribute that profit to shareholders in the fund (dividends are also passed through). For funds held outside tax-sheltered retirement accounts, these distributions are taxable. I fill you in on taxes and mutual funds in Chapter 10.
Some people — especially brokers and self-anointed gurus who advocate investing in individual securities — argue that taxes on mutual fund distributions are a problem big enough to justify the avoidance of mutual funds altogether, especially for higher-tax-bracket investors. They don’t have to be. If you’re concerned about the money you’re investing outside of tax-sheltered retirement accounts, don’t worry — I have a solution: See my recommended tax-friendly funds in Chapters 11 through 13.