Mutual Fund Basics
Before investing in mutual funds, it's important to understand exactly how these funds work. Many people who invest in mutual
funds don't really know how these funds operate; they just figure they get some sort of exposure to the stock market.
In short, mutual funds pool money of investors and then invest the money in securities or other investment vehicles. Let's say a
mutual fund has 100,000 customers, with each customer averaging a $10,000 investment. This mutual fund would then invest that $1 billion in
a variety of ways. Most mutual funds will invest in stocks, but some will invest in bonds as well or even just leave a significant portion
in cash.
At the end of the day, the fund has a net asset value (NAV). The NAV is simply the amount a share of the mutual fund is worth. For
example, let's say each of those $10,000 investors received 1,000 shares. This means each share was valued at $10. If the mutual fund
increased its holdings by 5%, the shares would rise to $10.50 apiece.
When you research mutual funds, make sure you know the type of fund you want to invest in. If you are looking for exposure to US
stocks, buy a mutual fund that solely invests in US stocks. If you are looking for a "less risky" fund, then buy a bond fund, but realize
that these funds will underperform the stock funds over time.
Mutual funds make money by charging fees. A lot of these fees are "hidden" in the sense that the investor pays them over time
instead of upfront. However, by doing just a minute of research, you can quickly find out what fees the mutual funds charge and how
much.
There are three key fees to look out for:
- The management fee. All mutual funds charge a management fee. This fee is typically between .7% and 2%. It's
best to find mutual funds that do not charge more than 1.1%, but this is sometimes unavoidable if you want to invest in an exotic
mutual fund like foreign small caps.
- 12b-1 fee. This is a fee the mutual fund charges to advertise the fund. A lot of this fee goes to broker
dealers to market the fund. Some, but not all, mutual funds have a 12b-1 fee. In general, do NOT invest in funds that have 12b-1 fees.
This fee is unnecessary to the maintenance of the fund and is just an extra fee for you.
- Load fee. Some mutual funds charge an up-front fee called a "load." NEVER invest in these funds. Research has
shown that funds that charge loads do not perform any better than no-load mutual funds. Most likely, whoever is trying to convince you
to invest in a mutual fund that charges a load gets some sort of kickback if you choose to invest. Do not be a sucker, NEVER invest in
a mutual fund that charges a load.
When researching mutual funds, make sure you keep the fees you pay to a minimum. The more fees you pay, the worse your mutual fund
will perform. Mutual funds are not like cars in the sense that the more expensive ones are better. Higher fee mutual funds are more often
than not the worst mutual funds to invest in.
|