By Laura Tanner
Learn more about Laura on NerdWallet’s Ask an Advisor
What if you had to build a portfolio from individual stocks for your 401(k) plan or other investment accounts? Would you have the time and interest to research the financials and outlook for specific companies? That’s what investing used to be like before mutual funds came along. What follows is a primer on the evolving world of mutual funds to help you understand the lingo and make educated choices when it comes to managing your money (or communicating with your investment manager). A future post will focus on exchange-traded funds and how they compare with mutual funds.
Strategies for Diversification
Typically a portfolio of stocks is diversified across several factors including:
- Market capitalization (size of company, calculated by multiplying share price by number of outstanding shares)
- Style (growth vs value)
- Geographical location (U.S., international developed markets (Europe, etc.), emerging markets)
If you need convincing of the power of diversification, here are a couple of examples:
- In 2007, stocks from international developed countries returned 11%, while there was a return of 5.5% on U.S. stocks.
- In 2009, there was a 79% return on stocks from emerging market countries, and a 26% return on U.S. stocks.
BTW, you know I am going to say this, but past returns are no indication of future returns, and I am not making any specific recommendations. The main point here is that if you construct and implement an investment plan which is diversified as described above, you are more likely to achieve your financial goals. Mutual funds and exchange-traded funds are tools to help you with this process. There are funds which target specific geographical locations, economic sectors, and market cap, for example.
The Basics of Mutual Funds
Mutual funds are investment vehicles where you pool your money with other investors to buy an agreed-upon basket of stocks and/or bonds, as delineated in the fund prospectus. Fees associated with mutual funds include commissions or loads and management fees. Annual expenses vary widely depending on the type of fund, ranging from as low as 0.1% to over 1%. If you have a fund with a 1% expense ratio, that translates to an annual fee of $10 for every $1000 invested. This may not sound like much, but investment costs can have a significant impact on your returns over time.
Trading: Mutual funds execute trade orders after the daily close of the stock market, when the day’s final price of individual securities is set. What this means to you is that you cannot time buying or selling of shares of mutual funds during the course of the trading day.
Taxes: When investing in a mutual fund, the managers are selling fund shares to fill orders and to maintain the portfolio within the investment guidelines of the prospectus. For you as an investor this means that capital gains are incurred (along with tax liability), over which you have no control.
Types of Mutual Funds
Mutual funds originated as portfolios of individual stocks or bonds. Fund strategies have evolved over time to meet investors’ needs and include:
- Balanced funds: A mutual fund holding a set proportion of stocks and bonds.
- Target date (or lifecycle) funds: A mutual fund that adjusts the asset allocation over the lifespan of the investor by decreasing the weighting to stocks and increasing weighting to bonds as retirement nears. So, a target date fund is like a dynamic balanced fund.
- Index funds: John Bogle of Vanguard has been one of the leading proponents of index funds, a low-cost alternative to other types of mutual funds. These funds, which originated in the 1970?s, have holdings that mimic a particular index, like the S&P 500. The argument for index funds is that it is hard for active investors (stock-pickers) to beat the relevant index. Index funds have grown in popularity, both for individual and institutional investors. They are simple to understand and lower in cost than actively managed funds.
A future post will talk about exchange-traded funds and how they compare with mutual funds.
Resources: Morningstar (mutual fund analyses), Investopedia (dictionary of financial terms), and “The Elements of Investing” by Burton Malkiel and Charles Ellis.