A mutual fund is an investment that pools money from a group of investors to invest in a specific set of investments (such as stocks or bonds). Mutual fund companies create mutual funds and then employ professional mutual fund managers to oversee and adjust each mutual fund’s holdings as market conditions change.
When you buy a mutual fund, you buy shares, each of which represents a portion of the investments held by the mutual fund. For example, if a fund owns 50 different stocks, and you own shares of the mutual fund, you own a piece of each of those 50 stocks. When the value of the fund’s investments increase or decrease, so does the value of your shares in the mutual fund.
How to Buy and Sell Mutual Funds
On the stock markets, shares of stocks change hands constantly throughout the standard trading day. Buying and selling mutual funds works differently: though you can place orders to buy and sell funds through brokers or brokerages at any time during the trading day, your orders are not filled until trading ends at 4:00 p.m. each day. This delay occurs because each mutual fund must tally up the value of its underlying securities—the net asset value (NAV)—at the end of each day to determine the fund’s new share price.
Mutual Fund Expense Ratios
Running a mutual fund costs money. Expenses include everything from fund manager salaries to office supplies to transaction costs for buying and selling securities. A fund’s expense ratio is an annual fee, expressed as a percentage, that’s charged to shareholders to cover the fund’s overall operating expenses. Many investors make the mistake of disregarding expense ratios because they seem so small—usually 0.15–2.00% or so. This mistake can cost thousands of dollars over time.
How Expense Ratios Impact Fund Returns
What is the impact of expense ratios on $10,000 invested for 20 years? Take a look at this chart:
|Fund ABC||Fund XYZ|
|Annual rate of return||10%||10%|
|Value after 20 years||$65,107.17||$51,120.46|
Though the ratios differ by only 1.32%, over 20 years that difference adds up to $6,246.44 in added fees … and in the above example, those fees would reduce the real rate you would realize.
The longer you leave your money invested in a high expense ration fund, the more money you lose!
Active Funds vs. Passive (Index) Funds
Mutual funds typically break down into one of two types: actively managed funds and passively managed funds.
Actively managed funds
Managers of actively managed funds use their expertise and research to hand-pick the fund’s investments on an ongoing, “active“ basis in order to maximize returns.
Passively managed funds
Passively managed funds, or index funds, attempt to replicate the performance of a particular market index, a group of investments that serves as a benchmark for the performance of other investments. For example, an index fund that mirrors the S&P 500 index will hold most (if not all) of the stocks included in the S&P 500 index in the same proportion in which they compose the actual index. You can get similar performance by investing in Exchange Traded Funds (ETFs).
Actively managed funds tend to have higher expense ratios than index funds: the average expense ratio for an actively managed fund is 1.50% or more, while most index funds have expense ratios below 0.25%. Why? Actively managed funds require more research, more trading fees, more decisions, and more people to do that research, execute those trades, and make those decisions.
Why Most Actively Managed Funds Aren’t Worth It
A large number of studies have shown that during periods of at least five years, only 33% of actively managed funds that invest in securities like those in the S&P 500 actually beat the performance of the S&P 500 index. Actually, that number may be quite high … by up to a factor of ten! This makes index funds the best bet for most individual mutual fund investors.
Where to buy mutual funds
You can buy mutual funds directly from the mutual fund company or better yet, set up an investment account at one of the brokerage houses listed below. By setting up an account at an online brokerage, you aren’t limited to the types of investments you can purchase.
- Scottrade – you can buy Focus Morningstar ETFs commission free!
- optionsXpress – one of the easiest online brokerages to set up. No paper forms or signatures required.
- TradeKing – offers regular trades and broker assisted trades for only $4.95.
- tradeMonster – offers mobile trading.
- optionshouse – this is basically the least expensive online brokerage for investors.
- Zecco – has commission free trades available.