Head to Toe

Blog

Financial Literacy Friday: Mutual Funds

Welcome back to another installment of Financial Literacy Friday!  I hope last week’s blog was helpful to some of you, and I’m excited about continuing on this week with mutual funds. This is a question I often get asked as many people have heard of mutual funds and most people have investments in mutual funds, but aren’t exactly sure what they are.  The quick definition is that they are an investment vehicle which pools the money of many investors together in order to buy stocks, bonds, and other assets.  These funds are overseen by the fund manager who allocates the investments in order to produce capital gains or income, depending on the state goals of the mutual fund.  Let’s dig a little deeper on what all of this means.

Investing in a Mutual Fund

Unlike stocks where you’re buying the individual company, such as Amazon, you’re buying shares of the mutual fund.  That mutual fund then takes the money from their many investors, and buys different stocks and bonds depending on the goals of the fund.  This means that while you’re able to gain the benefit from owning a large number of individual companies, you aren’t required to make the decision as to which companies nor do you have to go through the process of buying all those companies separately.  You are instead investing in the mutual fund company, such as Dimensional Fund Advisors, as opposed to Amazon or Apple.

Fees

Fees for mutual funds differ quite a bit, but are based on two major categories, annual operating fees and shareholder fees.  

  • Annual operating fees are charged each year based on the amount of assets in the mutual fund, usually in the range of 1-3%

  • Shareholder fees are the fees assessed when purchasing or selling shares of the mutual fund and are paid directly by the shareholders.  

In addition to these fees, a sales charge can be assessed either when you buys shares of the mutual fund or when you sell them.  This sales charge is known as the mutual fund’s load, so when you hear of a front loaded or back loaded mutual fund, that simply means that there will be a sales charge on either front (when you buy) or the back (when you sell).  There are also no load funds which don’t include a sales charge and are sold directly by an investment company.

Advantages and Disadvantages

Now that we have the basics down, let’s take a look at the pros and cons of using mutual funds in your portfolio.  

Advantages:

  • Diversification- It’s much easier to achieve a diversified portfolio using mutual funds than simply trying to buy as many individual stocks and bonds as you can.  A mutual fund also is more diversified throughout the various capitalizations of companies as well as sectors of the market.

  • Scale- Buying mutual fund shares means you’ll spend less on fees, commissions, and transaction fees needed to have a truly diversified portfolio without using a mutual fund.  

  • Ease of Access- Mutual funds trade on the major exchanges, which makes it very easy to buy and sell shares of them.

  • Management- For those who starting out their investment experience, it’s great to have a professional manager making the decisions of what to include and what not to include based on the research that they’ve done.  Given the variety of managers, fund goals, and styles, it makes it easy to find funds that are tailored to your goals.

Disadvantages:

  • Cash Drag- Because so many people are buying and selling shares of fund, mutual funds tend to have a decent amount of their assets in cash.  While this makes it very easy to get money out or put money in, it does mean there’s a portion of the investment that isn’t growing or returning benefits.

  • Costs- The costs I mentioned earlier are assessed regardless of performance, which means they can eat into profits and be more pronounced in down years.  This underscores why it’s important to choose the right funds, and avoid high loads.

  • Diworsification- This is a term used to describe mutual funds that acquire investments that are related in either market capitalization or industrial sector.  So while they seem to have a vast number of investments, they don’t actually provide the benefits of diversification.

Hopefully this provides a bit of background on mutual funds and gives a bit of a clearer picture of what they are (pooled investments from many investors), what they cost (annual operating fees, shareholder fees, and sales charges), and the advantages and disadvantages of adding them to your portfolio.  If there are further questions, please comment or send me an email and I’ll be happy to go over any point of confusion.  

financial literacy friday for nurses
Nathan Schorsch