Smart Mutual Fund Investing: Minimizing Fees, Maximizing Returns

Mutual funds are a popular investment vehicle, especially for retirement accounts like 401(k)s. They are a relatively hands-off way to invest in a diverse range of assets, providing access to a professionally managed portfolio.

When investing in mutual funds, it is important to consider fees, as these will impact your overall returns. There are several types of fees associated with mutual funds, including annual fees, expense ratios, and commissions.

1. Decide between active and passive funds: Active funds are managed by professionals who aim to beat the market, while passive funds aim to mimic the market. Passive funds, such as index funds or ETFs, often have lower fees.

2. Calculate your investing budget: Consider the minimum investment amount required for mutual funds, which can range from $100 to $3,000, and decide how much you are comfortable investing.

3. Choose a brokerage account: You can buy mutual funds through an employer-sponsored retirement account, directly from the fund company, or through an online brokerage. Compare fees and fund choices when selecting a brokerage.

4. Understand mutual fund fees: Be sure to research the expense ratio, sales charges or loads, redemption fees, and other account fees associated with the mutual funds you are considering.

5. Manage your portfolio: Rebalance your portfolio periodically to maintain your desired diversification. Avoid chasing performance and focus on finding funds that align with your goals and risk tolerance.

By following these steps and comparing fees, you can invest in mutual funds while minimizing the impact of fees on your overall returns.

Understand the different types of mutual funds

There are four main types of mutual funds: stock, money market, bond, and target-date funds. Each type has a different investment focus and strategy, and it's important to understand the differences before investing. Here's a closer look at each type:

• Stock mutual funds invest principally in equity or stocks. They are the most common type of mutual fund, accounting for about 55% of the market. Stock funds offer higher potential for growth but also come with more potential volatility in value. They are generally recommended for younger investors who have more time to weather market ups and downs. Stock funds can be further categorized based on company size ("large-cap," "mid-cap," or "small-cap"), industry or sector, investment style (growth or value), and geographic focus (international, global, or emerging markets).
• Money market mutual funds are fixed-income funds that invest in high-quality, short-term debt instruments from governments, banks, or corporations. They are considered one of the safest investments, offering slightly higher returns than regular savings accounts. Money market funds make up about 15% of the mutual fund market.
• Bond mutual funds are the second most common type of fund, accounting for about one-fifth of the market. They invest in government and corporate debt, offering a fixed rate of return and lower potential for growth compared to stock funds. Bond funds are generally recommended for investors nearing retirement who want to protect their nest egg while earning interest.
• Target-date funds are a type of asset allocation fund that automatically adjusts the ratio of stocks and bonds in the portfolio as the investor gets closer to retirement. They are designed to become more conservative as the target date approaches, providing a hands-off approach to retirement savings.

In addition to these main types, there are also specialty or alternative funds, such as hedge funds, managed futures, commodities, and real estate investment trusts. Socially responsible investing (SRI) funds are another growing category, focusing on companies with strong environmental and social practices and avoiding controversial industries.

Compare fees and costs

When investing in mutual funds, it's essential to understand the fees associated with them as they will significantly affect your investment returns over time. Here are some common mutual fund fees:

Expense Ratio

An expense ratio is an annual fee that covers the fund's operating expenses, including management fees, administrative costs, and marketing expenses. It is expressed as a percentage of the fund's average net assets and is deducted from the fund's returns. For example, a fund with a 1% expense ratio will cost you $10 for every $1000 you invest. A fund's expense ratio isn't always easy to identify upfront, but it's worth the effort to understand as these fees can eat into your returns over time.

Sales Charges or Loads

Some mutual funds charge sales fees, known as "loads", when you buy or sell shares. Front-end loads are charged when you buy shares, while back-end loads (or contingent deferred sales charges) are assessed if you sell your shares before a certain date. No-load funds, on the other hand, don't have commission or sales charges.

Redemption Fees

Some mutual funds charge a redemption fee when you sell shares within a short period (usually 30 to 180 days) after purchasing them. This fee is designed to discourage short-term trading in these funds for stability.

Other Account Fees

Some funds or brokerage firms may charge extra fees for maintaining your account or transactions, especially if your balance falls below a certain minimum.

When investing in mutual funds, it's important to compare fees and costs across different funds and brokers to find the most cost-effective option. These fees can vary significantly, so it's worth shopping around to find the best deal. Additionally, some brokers may offer funds with no transaction fees, which can help reduce your overall costs.

Research the fund's performance history

Researching a mutual fund's performance history is a crucial step in deciding whether to invest. Here are some detailed instructions on how to research a mutual fund's performance:

Step 1: Determine the Fund's Investment Style

Firstly, you need to identify the investment style of the mutual fund to see if it aligns with your financial goals. For example, if you seek steady income, a mid-cap value fund, which is growth-oriented, may not be suitable. Investment styles can be categorised as growth or value, large or small companies, and passive or active investing. Financial tracking websites like Morningstar provide valuable insights into a fund's basic facts, performance data, and tools to facilitate your evaluation. Utilising a mutual fund screener tool, available on platforms like Morningstar, can aid in this process.

Step 2: Compare Performance with Peers

The next step is to delve into the historical performance data of the fund and compare it with similar funds. Morningstar, for instance, ranks funds based on their risk and historical returns within their respective universes, making it easier to assess if a fund takes on more risk than its peers. It is important to remember that the ideal balance between risk and return depends on your personal risk tolerance and investment objectives.

When comparing performance, it is crucial to examine the consistency of returns over time. For instance, a fund with impressive five-year average returns may have achieved this due to a single exceptional year, which could be attributed to luck rather than skill. Therefore, it is advisable to select a fund that consistently outperforms its benchmark and has demonstrated resilience during market downturns, as this reflects the capabilities of its managers. However, it is worth noting that even the best managers may be unable to prevent losses during a market crash.

Step 3: Evaluate the Upside and Downside Against Comparable Funds

In addition to comparing returns, it is essential to assess the fund's upside and downside potential relative to comparable funds. This analysis will provide insights into how the fund performs during favourable and unfavourable market conditions, giving you a more comprehensive understanding of its risk-return profile.

Step 4: Analyse the Fund's Fees

The final step is to scrutinise the fund's expenses and fee structure. Tactical mutual funds, which engage in heavy trading or active management, tend to have higher annual expenses. These costs directly impact your real rate of return, so they should be carefully considered. While a fund with higher management fees is not inherently better or worse, it is important to be aware of reasonable expense ratios for the specific type of fund you are considering. Again, comparing fees with similar funds can help determine if the fund aligns with your investment strategy.

Consider the risks

As with any investment, there are risks involved with mutual funds. Here are some of the key risks to consider:

• Market Risk: Mutual funds are subject to market risk, which means they can lose value if the market declines. This risk is inherent in the nature of mutual funds, as they invest in a variety of financial instruments such as stocks, bonds, and other securities. The performance of these instruments can be affected by various factors such as natural disasters, inflation, recession, political unrest, and interest rate fluctuations. Diversification can help mitigate this risk, but it cannot eliminate it completely.
• Interest Rate Risk: Rising interest rates can cause mutual funds, especially bond funds, to decline in value. When interest rates go up, bond prices tend to fall. This is because newer bonds are issued at higher interest rates, making the existing bonds less attractive, leading to a drop in their price.
• Exchange Rate Risk: Mutual funds that invest in foreign securities are exposed to exchange rate risk. If the foreign currency depreciates against the domestic currency, it can reduce the returns for investors when they convert their gains back into the domestic currency.
• Credit Risk: Credit risk refers to the possibility that the issuer of a bond or other security may default on their payments. Mutual funds, especially debt funds, can be impacted by this risk if the fund manager includes lower-rated securities to boost returns. It is important for investors to assess the creditworthiness of the issuers before investing.
• Liquidity Risk: Liquidity risk is the risk of being unable to redeem an investment without incurring a loss. This can happen in certain types of mutual funds, such as those with lock-in periods or exchange-traded funds (ETFs) that may suffer from a lack of buyers in the market. Diversification and careful fund selection can help mitigate this risk.
• Management Risk: The performance of a mutual fund is heavily dependent on the decisions made by the fund manager. Poor investment choices by the manager can negatively impact the fund's returns. It is crucial for investors to research the fund manager's track record and investment strategy before investing.
• Dilution: Successful mutual funds may become victims of their own success if they grow too large. When a significant amount of new money pours into a fund with a solid track record, the manager may struggle to find suitable investments for all the new capital, leading to a dilution of returns.
• Tax Risk: Mutual funds can trigger capital gains taxes when they sell securities, which can pass on tax liabilities to investors. This risk can be mitigated by investing in tax-sensitive funds or holding non-tax-sensitive mutual funds in tax-deferred accounts.
• Redemption Fees: Some mutual funds charge redemption fees if shares are sold within a short period after purchase, typically within 30 to 180 days. These fees are designed to discourage short-term trading and promote stability.
• Other Account Fees: Mutual funds may also have other account-related fees, such as maintenance fees or transaction fees for balances that fall below a certain minimum. It is important to carefully review the fund's prospectus to understand all the associated fees.

It is important to remember that not all mutual funds are susceptible to the same risks. For example, equity funds are subject to market risk but can help protect against inflation risk. On the other hand, fixed-income funds are vulnerable to interest rate risk but offer some protection against market risk. Diversification across different types of mutual funds can help reduce the overall risk exposure of your portfolio.

Decide where to buy

You need a brokerage account when investing in stocks, but you have a few options with mutual funds. If you contribute to an employer-sponsored retirement account, such as a 401(k), there’s a good chance you’re already invested in mutual funds.

You could buy directly from the company that created the fund, such as Vanguard or BlackRock, but doing so will limit your choice of funds. You can also work with a traditional financial advisor to purchase funds, but it may incur some additional fees.

Most investors opt to buy mutual funds through an online brokerage, many of which offer a broad selection of funds across a range of fund companies. If you go with a broker, you'll want to consider:

• Affordability: Mutual fund investors can face two kinds of fees: from their brokerage account (transaction fees) and from the funds themselves (expense ratios and front- and back-end “sales loads”).
• Fund choices: Workplace retirement plans may carry only a dozen or so mutual funds. You may want more variety than that. Some brokers offer hundreds, even thousands, of no-transaction-fee funds to choose from, as well as other types of funds like ETFs.
• Research and educational tools: With more choice comes the need for more thinking and research. It's vital to pick a broker that helps you learn more about a fund before investing your money.
• Ease of use: A brokerage's website or app won't be helpful if you can't make heads or tails of it. You want to understand and feel comfortable with the experience.

No-load funds

Also known as “no-transaction-fee funds”, these mutual funds charge no sales commissions for the purchase or sale of a fund share. This is the best deal for investors, and online brokers often have thousands of choices for no-transaction-fee mutual funds. Most funds available to individual investors are currently no-load.

You can search for no-load mutual funds at broker sites such as Fidelity Investments and Charles Schwab.

Frequently asked questions