Over the past couple of months, I have focused a great deal on uncovering some of the mystery and complexities of investing. Today, I’d like to continue that idea by taking a look at mutual funds. This is a subject that is very complex and a simple Google search of the topic yields millions of search results. Obviously, neither of us has that much time on our hands so let’s just keep this simple. Join me as I simplify the complex world of investing in mutual funds.
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In the simplest terms, I can think of, mutual funds are a way for regular people to take advantage of equities that would otherwise be inaccessible to them. You see, investing in mutual funds is a strategy where hundreds of investors pool their money to invest in a diverse lot of assets (typically stocks and bonds).
Let’s assume that we only have $50 each month to diversify our portfolio and stock ABC is currently selling for $150 per share and stock XYZ is selling for $300 per share. It doesn’t take a rocket scientist to figure out that we aren’t ( I want to say ain’t here, but the editors won’t let me) getting anywhere with numbers like that. What can we do?
Well, this is where investing in mutual funds come in handy. We can pool our $50 per month with hundreds of other investors who are also contributing to the same fund and purchase many different investment positions together. The mutual fund makes it possible for us to own partial shares across many different stocks.
With the understanding that mutual funds allow us to invest mutually, there’s still plenty of questions as to how a mutual fund works. Are they safe? Do you have to go through an investment firm to contribute? How do you access your returns? As we go further into this article, we will cover all of these basics and then some.
In my line of work, I speak with a lot of highly successful business owners. I’m talking about men and women who have millions of dollars in their bank accounts. Many of them have never entered into the world of investments as the majority of their net worth has been tied up in their illiquid business. After the sell their business or while they are preparing to sell their business, they come to me and say that they want to invest their money into a position that guarantees that they won’t lose any of their money.
It seems that there is a common misconception floating around out there that says we can invest without risk. I hate to burst your bubble if you’re one of the people who have been told investing without risk were possible, it simply isn’t true. All investments carry some degree of risk and mutual funds are no exception. You can lose money when investing in a mutual fund but the same is true of simply putting all of your cash into a savings account. Eventually, inflation is going to get you.
As much as I would like to be able to share some magical unicorn of no-risk, high-return investing, it just doesn’t exist. That doesn’t mean that we can’t put ourselves in the best position to grow our investments in a tolerable risk situation. That’s the beauty of mutual funds, they allow us to diversify our portfolio when we don’t necessarily have the capital to do so on our own.
Mutual funds allow us to hire a professional to manage our assets within the fund. Basically, we invest in the fund and the managing investor allocates the funds across many different positions. The money we invest into the mutual fund is pooled with other investors monies to reach the desired investment allocation for the entire pool of investors.
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Unlike purchasing a business or a piece of real estate, where you would have closing costs associated with its sale, a mutual fund is liquid. You can buy, sell, or trade your shares and at the end of the day, you either have cash or you have more shares, depending on what action you took during the day. Typically, you can buy or sell your fund shares once per day. Therefore, it is a much easier process to convert your shares to liquid assets in that regard.
Another cool thing about investing in mutual funds is the fact that you can reinvest your dividends. This can be done automatically so that you don’t have to babysit your earnings, as well. Similarly, you can make additional investments at any time. So if you have an extra good month and you find yourself sitting on a little more cash than usual, you can add it to your mutual fund at any time.
We all know that when we earn money, the government expects a slice of the pie. So how does taxation of mutual funds work? Well, if you buy your mutual fund in a non-retirement account, any dividends you earn are subject to taxation. As an example, let’s say you invest $100,000 and you see a return of $5,000 but you reinvest that dividend, you will owe taxes on it. And if you reinvest the dividend into the fund without personally realizing the proceeds, then you will have phantom taxation.
A rookie mistake that many financial advisors make is to buy a client a mutual fund a few days before an ex-dividend date and then sell it. I’ve also seen advisors that buy mutual funds at the end of the year, holding them from December until the year’s end. This action potentially opens their clients up to almost an entire calendar year of taxation.
So, when you’re dealing with mutual funds that you have purchased in a non-retirement account, you really need to be careful otherwise you’re going to face all kinds of taxation.
The first thing we must consider when answering this question is to determine the Net Asset Value of the mutual fund. The NAV is figured by the total value of the securities in the underlying portfolio divided by the number of the fund’s outstanding shares. The NAV of a mutual fund is not its price but rather the total value of the securities in the fund minus liabilities. For example, let’s say that all of the market prices of the assets add up to $12,340.00 and there were 160 outstanding shares, the NAV price would be $77.125. And this price will move daily based on the price and number of outstanding shares.
Besides the purchase price of the mutual fund, there are also mutual fee funds. Fees are broken into two different categories, annual fund operating expense and the shareholder’s fees. As their names imply, the annual fund operating expenses have to do with the basic costs of managing the fund and the shareholder’s fees are more personalized to the individual shareholder’s account.
The annual fund operating expenses are paid once per year, as you would expect, but what do they cover? Well, there’s the management fee that actually pays the fund’s manager or investor. This is the professional that allocates the group’s funds into different investment positions. Since they are providing a professional service, they deserve to be paid for it and that is the reason for the management fees.
The next fee that we often see in the AFOE is what’s known as a 12b-1 fee. The 12b-1 is capped at 1% and covers the cost of marketing and selling the fund. In addition, 12b-1 fees can cover the expenses of other shareholder services. Now, I’m not a fan of the 12b-1. I think it’s a weaselly way of getting more money out of people but it is a common fee.
Lastly, we have “other expenses.” I know, it’s a pretty vague term but that’s because it covers a wide variety of expenses. Expenditures that might be listed under “other expenses,” include custodial, legal, accounting, transfer agent expenses and other administrative costs.
At their core, shareholder’s fees come down to one thing… Sales Loads. Sales loads are a group of fees and commissions that a shareholder is responsible for when they buy or sell mutual fund shares. These come in a variety of flavors, so to speak, and they depend on the type of shares that are bought and sold.
It’s one thing to know the different types of fees that go along with investing in mutual funds, but understanding what those costs actually equate to is entirely another. There is an excellent article on The Real Cost Of Owning A Mutual Fund, that delivers the staggering truth behind the numbers.
|Non-Taxable Account||Taxable Account|
|Expense Ratio 0.90%||Expense Ratio 0.90%|
|Transaction Costs 1.44%||Transaction Costs 1.44%|
|Cash Drag 0.83%||Cash Drag 0.83%|
|—||Tax Cost 1.00%|
|Total Costs 3.17%||Total Costs 4.17%|
The article identifies the following studies:
If I’m being completely honest, the true impact of so many fees is an argument that goes both for and against hiring a professional to manage your investments. However, a good financial advisor with a fiduciary obligation is worth their weight in gold. The fees associated with a fund that is managed by a skilled professional providing you with a well-diversified portfolio that yields maximum returns will pay off in the long run.
Listen to our supplementary podcast for Greater Understanding Of How To Choose The Right Mutual Fund For You!
There are many different mutual funds available to us and each of them has its own unique design. We know about the different fees involved and that if we purchase our mutual fund in a non-retirement account that it is subject to taxation, but how do we know which fund is right for us? Many of us look at our performance statements from our 401(k)’s and say, “Well, ‘fund A’ performed really well. I choose that one!”
So what’s wrong with choosing our mutual fund based on performance indicators? Basically, past performance is not indicative of future results. Just because fund A did well in the past doesn’t mean it will yield similar results in the future. As we continue this in-depth look at the world of mutual funds, I am going to share some of my secrets to choosing the right fund. However, I want to be clear that this is not advice. There are far too many individual factors that need to be examined in order to give sound financial advice on this matter. Instead, view this as a means of simple education.
There are many different third-party rating systems out there and they each have their own metrics for how they determine what rating to give a particular fund. One of the companies that I trust the most is Morningstar. You might have noticed that I quoted some of their statistics earlier in the article. Morningstar rates a mutual fund based on its Risk-Adjusted Return (RAR). But what does that mean?
When they measure the RAR of a mutual fund, they are seeing how it is performing relative to other funds. They compare large-cap growth funds to other large-cap growth funds, mid-caps to mid-caps, and so forth. Based on these comparisons, Morningstar rates the funds on a star scale that ranges from 1-5. The top performers (relative to other funds) receive a five-star rating and the worst performers receive one star. The funds that receive three stars are regarded as average. Pretty simple, right?
Morningstar is actually gauging the fund’s risk by calculating a risk penalty for each fund, based on the expected utility theory. The expected utility theory is a commonly used method of economic analysis and it assumes that the investor is more concerned with the possibility of a poor outcome than a good one. So, basically, the star rating is a mathematical measurement that shows how well the fund’s past returns have awarded the shareholders.
In 1952, Harry Markowitz introduced mathematical statistics to the qualitative practice of building an investment portfolio. He was able to show that the most effective portfolios balanced risk and return. Although he won a Nobel Prize for his idea of “Portfolio Selection,” most people simply did not invest in that way.
Before the 1980s, most Americans participated in the stock market through undiversified portfolios of directly held stocks. This meant that many were essentially playing investment roulette. A recent study by Vanguard states that “This approach predominated until the 1980s. Since then, the use of diversified vehicles such as mutual and exchange-traded funds has made Markowitz’s insights available to the masses.”
The study went on to say, “by the end of the 1980s, mutual funds had increased from 6.2% of household stock market exposure to 15.2%, a roughly $200 billion change in the composition of household balance sheets. Investors’ welfare gain— their Markowitz dividend—amounted to $15 billion.” Diversification matters, folks, and mutual funds have made the path to a well-diversified portfolio much easier for many investors.
Life is hard, life is good, and life can be complicated. Let’s try to make investing in mutual funds at least financially simple.
Continue following along in our next article as we continue our Personal Finance for Business Owners series as we dive into Active or Passive Funds & ETFs.