Mutual Fund Investment: A Smart Ss Strategy?

Social Security trust funds are accounts managed by the US Department of the Treasury. They invest in special-issue US government securities, which can be redeemed as needed. These funds are made up of payroll taxes from workers and their employers and are used to pay out benefits to Social Security recipients. Mutual funds, on the other hand, are investment vehicles that pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are managed by professional money managers and provide individual investors with access to a wide range of assets. While Social Security trust funds are limited to investing in US government debt securities, mutual funds offer exposure to a variety of assets, including stocks, bonds, derivatives, and real estate.

Mutual funds: pros and cons

Mutual funds are a popular investment option, allowing investors to pool their money into a variety of securities. They are a good way to diversify your portfolio and save for the long term. Here are some of the pros and cons of investing in mutual funds:

Pros

• Diversification: Mutual funds allow you to invest in a variety of different types of stocks and bonds from a number of industries, exposing you to less risk than purchasing individual securities.
• Small investment amounts: Mutual funds allow investors to make smaller contributions that can grow over time.
• Professional money management: Mutual funds provide professional management, ongoing supervision of your holdings, and automatic diversification.
• Liquidity: Shares can be redeemed on any business day, and because they are priced daily, investors always know the value of their investment.
• Accessible: Mutual funds are highly liquid and can be bought and sold relatively easily, making them accessible to investors.
• Economies of scale: Mutual funds enable investors to take advantage of dollar-cost averaging and benefit from economies of scale.

Cons

• Fees: Mutual funds often have high fees, including sales charges, operating expense ratios, and 12b-1 fees for sales and marketing. These fees can eat into your gains.
• Taxes: Dividends and interest payments are generally considered taxable income by the IRS, even if you reinvest the money.
• Potential for loss: Mutual funds are not FDIC insured and may lose principal and fluctuate in value.
• Too hands-off: Some investors prefer to be involved in trades and investment decisions, which is not possible with a mutual fund.
• No guaranteed returns: There is no guarantee that a mutual fund will generate returns, and growth can be slower when compared to aggressive, higher-risk investments.

Social Security Trust Funds

The OASI Trust Fund is used to pay benefits to retired workers and their families, as well as to the families of deceased workers. The DI Trust Fund covers benefits for disabled workers and their families.

The OASI trust fund receives 10.6% of employee earnings covered by Social Security payroll taxes, and the DI trust fund receives the other 1.8%. The two funds work similarly. When workers and employers pay more into the system than is needed to pay benefits to current beneficiaries, those "excess" contributions are invested in special US government securities. This allows the federal government to borrow money from the trust funds for purposes other than Social Security, while the trust funds earn investment income with minimal risk.

The Social Security Trust Funds are limited by law to investing their reserves in US government debt. The funds have held marketable securities in the past but currently only hold special US debt issued expressly for their use. In contrast to the Treasury securities sold to the public, which are only guaranteed to return face value when redeemed at maturity, the special issue debt held by the trust funds may be redeemed at face value at any time if needed to meet current obligations.

The special government securities are of two types: short-term certificates of indebtedness, which mature on the following 30 June, and bonds with a term of one to 15 years. The short-term certificates and bonds issued to the Social Security trust funds are not traded in the bond market or available to the public. However, like other Treasury securities, they are backed by the full faith and credit of the US government.

The interest rate on the special issues is set by a formula established in 1960 through amendments to the Social Security Act. For special issue debt issued to the trust funds in a given month, the interest rate is the average market yield on the last day of the prior month for marketable US government debt securities not due or callable for more than four years, rounded to the nearest one-eighth of a percentage point.

In 2023, the trust funds earned an effective interest rate of 2.4%, while the average of the 12 monthly rates for the debt they purchased that year was 4.1%. In May 2024, the interest rate for new special issue debt bought by the Social Security trust funds was 4.750%.

Private securities

Private equity is an alternative investment class that involves investment partnerships that buy and manage companies before selling them. Private equity funds are managed by private equity firms, which act as advisers. These funds are not registered with the SEC and are therefore not subject to regular public disclosure requirements.

Private equity funds are typically open only to accredited investors and qualified clients, including institutional investors such as insurance companies, university endowments, and pension funds, as well as high-income and high-net-worth individuals. The initial investment amount is often very high, with a minimum investment requirement typically starting at $250,000 and going up to $25 million.

Private equity funds may acquire private or public companies in their entirety or invest in buyouts as part of a consortium. They usually do not hold stakes in companies listed on a stock exchange. The funds raised are used for developing new products and technologies, expanding working capital, making acquisitions, or strengthening a company's balance sheet.

Private equity firms tend to focus on long-term investment opportunities, with an investment time horizon of 10 or more years. They often take a controlling interest in an operating company and actively engage in its management and direction to increase its value.

There are a few non-direct ways to invest in private equity, such as funds of funds, exchange-traded funds (ETFs), and special purpose acquisition companies (SPACs). Mutual funds, however, have restrictions on buying private equity directly due to SEC rules regarding illiquid securities holdings. According to SEC guidelines, mutual funds can allocate up to 15% to illiquid securities, and they typically have their own rules restricting investment in illiquid equity and debt securities. Therefore, mutual funds that invest in private equity are usually structured as funds of funds.

The private equity industry has grown rapidly, particularly during periods of high stock prices and low-interest rates. In 2022, private equity buyouts totalled $654 billion, the second-best performance in history.

Mutual fund shares

Mutual funds are a type of investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are a popular choice for retirement savings, offering investors a professionally managed, diversified portfolio with relatively low investment risk.

When an individual buys shares in a mutual fund, they gain part-ownership of the underlying assets, and the fund's performance is reflected in the value of its shares. Mutual funds are subject to fees and expenses, such as annual fees, expense ratios, and commissions, which impact the overall investment returns.

There are various types of mutual funds, including stock, bond, money market, index, and target-date funds, each with its own investment strategy and focus. The returns on these funds come from distributions of income, such as dividends or interest, and the profit made from selling fund securities.

While mutual funds offer diversification and professional management, there are also some drawbacks. Mutual funds are subject to market risk, interest rate risk, and management risk, and there is always the possibility of depreciation in value. Additionally, mutual funds typically hold a significant portion of their portfolios in cash to accommodate redemptions, which can result in a "cash drag" that earns no return.

In the context of Social Security Trust Funds, investing in mutual funds could provide higher returns compared to the current investment strategy of solely holding special-issue U.S. government securities. However, it is important to consider the potential risks and safeguards needed to protect investment decisions from political pressures.

Mutual fund fees

Mutual funds charge fees and expenses that vary from fund to fund. These fees can be divided into two main categories: annual fund operating expenses and shareholder fees.

Annual Fund Operating Expenses

These are ongoing fees that cover the cost of paying fund managers, accountants, legal fees, marketing, and other administrative costs. They are typically between 0.25% and 1% of your investment in the fund per year and are paid out of the fund's assets. These fees are often referred to as mutual fund expense ratios or advisory fees.

Shareholder Fees

These are sales commissions and other one-time costs incurred when buying or selling mutual fund shares. They include:

• Sales loads: commissions paid to third-party brokers when buying or selling shares, typically between 2% and 5% of the total investment.
• Redemption fee: charged when you sell shares within a short period of purchasing them.
• Exchange fee: charged by some funds when shareholders transfer their shares to another fund within the same fund group.
• Account fee: charged for maintaining your account, often applied if your balance falls below a specified minimum.
• Purchase fee: charged when you buy shares, distinct from a front-end sales load which is paid to the broker.

It's important to note that even "no-load" funds, which don't charge sales loads, may still charge redemption, exchange, account, and purchase fees.

Additionally, funds may compensate brokers who sell their shares by imposing a "sales load" or "sales charge" on investors, similar to a commission. This is typically between 2% and 5% of the investment and is paid when purchasing (front-end load) or redeeming (back-end load) shares.

When investing in mutual funds, it's crucial to understand the fees involved as they will significantly impact your overall investment returns over time.

Frequently asked questions