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What is a Mutual Fund?

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At work, a bunch of us have been talking about investing some of our money. The problem is that most of us represent the average American family making about $50,000 per year with a spouse and child or two. None of us have a ton of money to invest and we’ve heard that if we want to buy stocks, it’s wise to start with $5,000 or more so we can have an appropriately diversified portfolio.

None of us know a lot about investing and since each of us only have about $3,000 each to start with, we were thinking that we could find 100 people total making our combined assets $300,000 to get started. As we get paid, we could invest more in to the fund each month and even bring in more people as we tell them about our pool of money.

Since we’re not skilled investors, we want to hire somebody to invest the money for us. We’ll pay him or her a percentage of the total assets and they can buy or sell with that money as feel it is necessary. Is my idea new and revolutionary? This story is a basic profile of a mutual fund and here’s what you need to know about the funds that make up your 401(k).

Ponzi Scheme?

If you didn’t see the title of this article, you may have first thought I was describing a Ponzi Scheme and to be honest, you wouldn’t be far off but in this case, my 100 friends and I formed a mutual fund in its simplest form. (In actuality, when a bunch of retail investors come together like this, it’s called an investment club)

Mutual funds can invest in stocks, bonds, commodities, or other products. They may be actively managed by a human manager or they may automatically track an index with very little help from a human. These passively managed funds have gained popularity as investors try to cut down on fees.

You would need a lot of money and lawyers to start a mutual fund of your own but if you’re invested in a 401(k), you’re already own shares of mutual funds. Since you’re not going to start one of your own, here’s what you should know:

  • Purchasing shares in a mutual fund doesn’t take place in a market like the New York Stock Exchange. Shares are purchased directly from the fund or a broker.
  • The price you pay is based on the fund’s net asset value plus fees.
  • Shares may be redeemed by selling them back to the fund or the broker. You don’t have to find a buyer on the secondary market as you would with stocks.
  • You can purchase partial shares in the fund meaning that even the smallest payroll deduction each week will give you more of a stake in the fund.

Advantages

The greatest advantage of mutual funds is that you don’t have to be a financial genius to invest. You can gain exposure to the international markets even if you couldn’t find most European or Asian countries on a map. You also get instant diversification. If one stock in the portfolio has a really bad year, the whole fund doesn’t suffer. Finally, there are all kinds of mutual funds on the market including target date funds that allow you buy a fund targeted to your year of retirement and adjusts the asset mix as you get nearer to it.

Disadvantages

Mutual funds have a lot of fees and those fees can take a big bite out of your gains. Don’t believe me? Here a few of the fees you made be charged for owning shares of a mutual fund:

  • Sales Charge (Load Fees)
  • Purchase Fees
  • Deferred Sales Fees
  • Redemption Fees
  • Exchange Fees
  • Account Fees
  • Management Fees
  • Distribution Fees (12b-1 fees)

Second, mutual fund managers have a really hard time beating the market. In fact, it’s nearly impossible to beat the market over a long period of time but if you own actively managed mutual funds, you’re paying somebody a lot of money to try to beat those almost impossible odds. If you want to read a more complicated version, click here.

Are Mutual Funds Bad?

It depends. Many mutual funds are a poor investment but not all of them are. Vanguard mutual funds, for example, have extremely low fees and stellar performance. Passively managed index mutual funds work well and many are offered as part of 401(k)s with fees close to the increasingly popular ETF.

Please, don’t be a hero with your money and don’t let a few bad reports of financial advisers keep you from seeking help. Not all mutual funds are poor investments but if you don’t know how to tell the difference, find a fee only adviser that you trust and get their advice.

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4 Responses to “What is a Mutual Fund?”

  1. Most mutual funds are bad! Any time you engage in a zero sum game(like the stock market) the fees will be what keeps you from achieving the average rate of return. Look for funds with ER of .1% or less, Vanguard is the best w/o question!

    Just a .5% difference in fees can literally cost you hundreds of thousands of dollars if you are even contributing half the max 401k contribution over 40 years.

    • David M says:

      Hundreds of thousands of dollars? Want to run some numbers to prove this?

      So no one should invest in international mutual funds? I don’t.think even vanguards international funds are .1 of 1% annually! Are there domestic funds even that low?

      • Sure.. My ER for Vanguard 500 admiral is .06%

        Here’s a preview of the article I’ll be posting on Thursday:

        Max has his 401k invested in a low cost 500 index fund with a 0.2% ER. James has his 401k invested in an actively managed fund with 1% ER. Over 40 years, let’s assume both funds have the same rate of return of 5% per year(before fees). In each case we start off with $0 and contribute a modest $10,000 to our 401k. Using a 401k calculator, we see that after 40 years:

        Max’s 401k value, using a low cost 500 index fund: $1,205,868

        James’ 401k value, using actively managed fund: $988,265

        Very conservative example leads to a $200,000+ difference.

      • Sarah in Alaska says:

        Vanguard’s international funds appear to vary from .2 – .5.

        The domestic funds I am in are .11


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