Mutual Funds: Worth The Investment?

Investing in mutual funds is a popular option for those looking to diversify their portfolios and gain exposure to different markets. Mutual funds are a type of investment product where the funds of many investors are pooled and used to invest in a group of assets, providing instant diversification. They are considered safer than picking stocks and are a good option for those who don't want to choose individual investments but still want to benefit from the stock market's high average annual returns. However, it's important to remember that mutual funds are subject to market risk and there are no guaranteed returns. When deciding whether to continue investing in mutual funds, it's crucial to consider factors such as your investment goals, risk tolerance, time horizon, and the fees associated with the funds.

Active vs passive funds

When deciding whether to keep investing in mutual funds, it's important to understand the differences between active and passive funds.

Active funds are managed by professionals who research the market and buy with an eye toward beating the market. Active fund managers are buying and selling daily based on their research, trying to ferret out stocks that can beat the market averages. Active investing requires a hands-on approach and a deeper analysis of the market, and it can be useful for certain portions of a portfolio, such as those invested in illiquid or little-known securities. It offers advantages such as flexibility, hedging, and tax management advantages. However, active funds tend to be more expensive due to the higher fees associated with the extensive research and analysis required.

On the other hand, passive funds, often called index funds, seek to track and duplicate the performance of a benchmark index. They are bought and held over a long period, and fund managers ensure the investments held in the funds are performing well. Passive investing involves less buying and selling and is, therefore, more cost-effective. It offers advantages such as ultra-low fees, transparency, and tax efficiency. However, passive funds are limited to a specific index or predetermined set of investments, and investors rely on fund managers to make decisions.

While both active and passive investing have their benefits, passive investing has become more prevalent among retail investors. Historically, passive investments have earned more money than active investments, and passive funds still dominate overall due to their lower fees. However, some investors are willing to pay higher fees for the expertise of active fund managers, especially during market upheavals.

In conclusion, the choice between active and passive mutual funds depends on your investment goals, risk tolerance, and time horizon. Passive funds are generally more suitable for those seeking a long-term, cost-effective, and hands-off investment strategy, while active funds may appeal to those willing to take on more risk and pay higher fees for the potential of higher returns.

Risk and return

Mutual funds are considered a safer investment than purchasing individual stocks. Since they hold many company stocks within one investment, they offer more diversification than owning one or two individual stocks. However, as with all investments, it is possible to lose money in mutual funds.

Mutual funds are typically categorized as bond funds, equity funds, target-date funds, and money market funds, each with different investment profiles, risk levels, performance results, and fees.

Bond Mutual Funds

Bond mutual funds, as the name suggests, invest in a range of bonds and provide a more stable rate of return than stock funds. As a result, potential average returns are lower. Bond funds often have a low or negative correlation with the stock market, so they can be used to diversify a stock portfolio. However, bond funds carry risks such as interest rate risk, credit risk, default risk, and prepayment risk.

Stock Mutual Funds

Stock mutual funds, or equity mutual funds, carry higher potential returns but also higher inherent risk. The performance of large-cap, high-growth funds, for example, is typically more volatile than stock index funds.

Money Market Mutual Funds

Money market mutual funds are fixed-income mutual funds that invest in top-quality, short-term debt. They are considered one of the safest investments but have the lowest returns.

When deciding whether to invest in mutual funds, it's important to consider your goals, risk tolerance, and investment horizon. If you need money in the short term, mutual funds may not be suitable due to the potential for market volatility. However, if you have a long-term investment horizon and can tolerate some risk, mutual funds can provide diversification and the potential for returns.

Mutual fund fees

Annual fund operating expenses

Annual fund operating expenses are fees that are charged to cover the cost of paying managers, accountants, legal fees, marketing, and other administrative costs. These fees are typically between 0.25% and 1% of your investment in the fund per year, but they can be higher. Actively managed funds, which aim to beat average stock market returns, tend to have higher operating expenses than passively managed funds, such as index funds, which only aim to mirror the returns of a benchmark index.

The total annual fund operating expenses are usually expressed as a percentage of the fund's net average assets and can be found in the fund's prospectus, a legal document that each mutual fund is required to file with the SEC.

Shareholder fees

Shareholder fees are sales commissions and other one-time costs incurred when buying or selling mutual fund shares. These fees are also outlined in the fund's prospectus and may include:

• Sales loads: commissions paid to third-party brokers when buying or selling fund shares. Sales loads can be front-end loads, paid at the time of purchase, or back-end loads, paid when selling shares back to the fund.
• Redemption fee: charged if an investor sells shares within a short period of purchasing them.
• Exchange fee: charged by some funds when shareholders transfer their shares to another fund offered by the same investment company.
• Account fee: a fee charged for maintaining an investor's account, often applied if the balance falls below a specified minimum investment amount.
• Purchase fee: charged by some funds when shareholders purchase shares, used to cover the fund's costs associated with the purchase.

Load funds vs no-load funds

Funds that impose sales loads are known as load funds, while those that don't are called no-load funds. Load funds typically charge a front-end or back-end load, which is a commission paid to brokers when buying or selling shares. The commission is calculated as a percentage of the amount invested or sold and can be as high as 5.75%. Back-end loads may also be structured as a contingent deferred sales load, which decreases the longer an investor holds their shares.

No-load funds do not charge sales loads but may still charge other fees such as purchase, redemption, exchange, and account fees.

Expense ratios

In addition to the fees outlined above, funds may also charge expense ratios, which are annual costs paid to the people who manage and promote the fund. Expense ratios are typically expressed as a ratio of the total investment and can be found in the fund's prospectus. The average mutual fund expense ratio is between 1.3-1.5%, but some funds have lower or higher ratios.

Impact of fees on returns

Even small differences in fees can have a significant impact on investment returns over time. For example, an investment of $10,000 with a 5% annual return and annual operating expenses of 1.5% would result in roughly $19,612 after 20 years. However, if the annual operating expenses were only 0.5%, the final amount would be $24,002—a 23% difference.

Therefore, it is essential to carefully consider the fees associated with a mutual fund before investing.

Instant diversification

Investing in mutual funds is a great way to instantly diversify your portfolio. By investing in mutual funds, you gain exposure to dozens or even hundreds of stocks, bonds, or other securities. This diversification helps to spread out your risk and reduce the impact of any one stock or security on your overall investment performance.

When you invest in a mutual fund, you are investing in a large group of stocks, which tend to ride out market volatility better than individual stocks. This means that if one stock in the fund performs poorly, it can be balanced out by the other stocks in the fund that are performing well. This can help to reduce the risk to your overall portfolio when compared to investing in only one stock.

Mutual funds also provide access to different markets and asset classes, which can help to further diversify your investments. For example, you can invest in large or small companies, growth-focused or dividend-paying companies, and companies located in different countries or emerging markets. Mutual funds also give you access to different classes of bonds, including corporate bonds, government bonds, and international bonds.

Equity mutual funds, in particular, offer instant diversification by investing in shares from a diverse range of industries. At any given time, an equity mutual fund may be invested in anywhere from 50 to 100 shares, meaning that you are indirectly owning shares in multiple companies across various industries. This diversification helps to protect your investment, as even if one industry performs poorly, the rest of your investment will likely remain safe.

Overall, investing in mutual funds is a great way to instantly diversify your portfolio and reduce your risk. By investing across a wide range of stocks, bonds, and other securities, you can benefit from the historical high average annual returns of the stock market while minimising the impact of any individual stock or security on your investment performance.

Access to different markets

Investing in mutual funds can provide access to different markets, even within the broad asset classes of stocks and bonds. This means that investors can gain exposure to various segments of the market that they are interested in.

Within stocks, mutual funds can provide access to large or small companies, those focused on growth or paying out dividends, and companies located in large, developed, or emerging market countries. Different classes of bonds include corporate bonds, government bonds, international bonds, and bonds that protect against inflation.

For example, if an investor is particularly interested in investing in large U.S. companies, they can choose to invest in a mutual fund that focuses on this segment of the market. This way, they can gain exposure to a diversified portfolio of large U.S. companies with a single investment.

Mutual funds also allow investors to access different asset classes, which can provide another level of diversification since their prices generally don't move in lockstep. By investing in different parts of the market, investors can reduce the risk of their portfolio being negatively impacted by bad news or performance in a specific sector or industry.

Additionally, mutual funds can serve specific roles in an investor's portfolio, such as generating income or adding stability during periods of market volatility. For example, an investor may choose to invest in a mutual fund that focuses on dividend-paying stocks if they are seeking regular income from their investments.

Overall, mutual funds provide a convenient and low-cost way to access different markets and asset classes, making them a popular choice for investors seeking diversification and exposure to a wide range of investment opportunities.

Frequently asked questions