Money Basics: The Ultimate Beginner’s Guide to Mutual Funds

Inside: This beginner’s guide to mutual funds will explain the basics for those newer to investing.

Do you ever wonder how in the world people learn about investing, and how to save for retirement? I mean, sure, there are classes in college. And maybe even one in high school.

Maybe.

But who really does that? It’s something that people just seem to “know” how to do.

Pssst! ( a lot of them don’t know what they are doing, they only act like they do )

But I’m here to help you actually learn a bit of something. Today, that something is about mutual funds. You’ll go away knowing what to look for when you choose options in your 401(k) or funds for your IRA.

What is a mutual fund?

A mutual fund is a pool of money provided by investors to purchase a range of stock, bonds, or other assets. We call that collection of investments a portfolio. When you buy a share of a mutual fund, you are buying into a small slice of every company in that portfolio.

A small part of the money used to buy into the mutual fund pays a fund manager or management team that oversees the investments based on the goals of the mutual fund.

So, by pooling your money with other investors, you can buy things that you wouldn’t be able to otherwise afford on your own and you are hiring an expert to make decisions for you.

Types of mutual funds

There are a lot of different types of mutual funds.

You can find mutual funds based on sector, world regions, market cap, low risk, high risk, and more.

Some of the more common types of funds are:

Money market funds

These are “safe”, low-risk, low-return funds. They invest in things like CDs, treasury bills, and government bonds. Often, if you have cash sitting in a brokerage, it will be placed into a money market fund.

Fixed income funds

Fixed income funds are lower risk and also known as “bond funds” because they invest in bonds (surprise!). Bonds are a debt a company or government owes to a shareholder at a fixed interest rate – like a loan. Generally, fixed income funds get a slightly better return than money market funds, but do carry some risk.

Equity funds

Equity funds are your basic stock fund. These funds are often categorized by what stocks they hold, such as U.S. equity or international funds, which invest in stocks outside of the U.S., but often also include American equities.

And then you will also see categorizations such as large-cap, mid-cap, and small-cap, which indicates the size of the companies.

Balanced funds

Balanced funds hold both stock and bonds so are sometimes called “hybrid” funds. Such a fund might hold 60% stock, 38% bonds, and 2% cash. The ratios vary depending on the manager and the market.

Specialty funds

Specialty funds tend to, well…specialize. You will often see sector funds here such as a health care fund, precious metals fund, technology fund, etc.

That means the investments in these funds are all related somehow. For example, in a health care fund, you will find various companies that are all related to health care.

Index funds

Index funds are ones that try to match a stock market index such as the S&P 500 for blue-chip* stocks or Russell 2000 for small-cap stocks. They do this by basically buying the stocks in the index, minus a small management fee. Because they just mimic an index, it is less work for management and is classified as a passively managed fund.

*Blue-chip stocks are stocks from large, well-established companies that have been around for a long time.

Closed-end vs. open-end funds

Ok, now on to a brief mention on closed-end and open-end funds.

Closed-end

A closed-end fund has a set number of shares available and new shares are not created to meet demand.

Like stocks, these fund shares trade on the open market and are priced throughout the day. Price will fluctuate based on supply and demand, so a closed-end fund may trade at either a premium or discount to its net asset value.

Open-end

The majority of mutual funds on the market are open-end funds. Unlike a closed-end fund, an open-end one does not have restrictions on the number of shares it can issue.

These funds do not trade on the open market like stocks or closed-end funds. They are priced once per day to reflect its assets value after the markets close.

Most funds are open-end funds. Closed-end funds are less popular because the price you pay may be more than its true value.

Another note: sometimes you will find an open-end fund that is “closed.” That sounds confusing, but it means it is closed to new investors and does not mean it is now a closed-end fund.

What about fees?

When you start looking at mutual funds, you may notices fees listed. What kinds might you run into?

Load fees

Basically, a load is a sales commission charged to the investor.

If you have a front-end load, you pay a commission when you buy the fund. A back-end load is a fee you pay when you sell shares. Watch out because you could get stuck with both (yikes!). And worse still? The fee could be upwards of 7-8%!

Confused? Let’s say you want to invest $1000 in a mutual fund that has a 6% front-end load. That means you would be paying $60 in fees and then actually investing only $940 in the fund.

Well, that sucks.

A no-load fund usually has lower expenses (partly because you aren’t paying that sales commission).

Which one of those sounds better, load or no-load?

Buying a fund with load fees is a load of BS. Look for “no-load” funds.

Redemption fees

To discourage market timing and short holding periods, funds may charge a redemption fee. What happens is, if you sell shares of your mutual fund within the fund’s stated period (usually anywhere from 6 months to a year or even 5 years), then they assess a redemption fee that goes back into the fund, rather than into the management team’s pockets.

You can think of it as a penalty for holding the fund short-term. If you hold it longer, you won’t be charged the fee when selling shares. The prospectus should list any redemption fees and their conditions.

Advisory fees

Tired of hearing about fees yet? Well, here’s another one, the advisory fee.

The advisory fee is one the fund manager charges for the decisions the team makes for the fund. Rather than being charged directly, an advisory fee is deducted from your fund’s returns.

The fee fee

Yup, there is a fee for charging the fees.

Not really.

You want to avoid fees. No load, avoid advisory if you can, and if there is a redemption fee, plan on holding the fund until the redemption penalty period has passed.

Expense ratio

What is an expense ratio? The expense ratio is a fee all funds charge their shareholders every year. You’ll see the number given as a percentage, and that is a percentage of your account value. Typical expense ratios vary from .25% to 2%, but you’ll find some outside of that range.

This is a number you want to pay attention to. Ideally, you want your expense ratio to be under 0.50%, and in many cases you can find expense ratios under 0.25%.

What does the expense ratio include? Well, it includes 12b-1 fees, management fees, administrative fees, and operating costs.

You aren’t billed for these fees directly. Rather, the fund takes the fees from the income of the fund’s assets. This means they take it out of the return, thereby reducing the amount you get.

Things like sales charges and brokerage fees are NOT included in the expense ratio.

Effects of expenses

Of course, the higher the fees (and expense ratio), the greater the dampening effect on your returns. It is the age-old tale of compound interest.

Check out this graph comparing the return you would get investing in funds averaging 7% annual return per year. Note the difference after 20 years if you choose a low-fee fund at 0.05% vs a fund that charged 2.5%. And it is easy to find examples of funds charging either of these rates.

See why you want your fees to be low?

There is a tool available at the FINRA site to help evaluate funds and their fees. Do be aware that different types of funds have different ranges of expense ratios and fees, so compare apples to apples.

For instance, a small-cap fund will have higher expenses than an S&P 500 index fund. A good comparison would be two funds that are trying to mimic the same index or two funds in the same sector.

Management

Active

When you have a fund that is actively managed, the management team actively decides on stocks or bonds to buy or sell, seeking the best return for the investor while staying within parameters detailed in the prospectus of the fund. Because of this extra work, they charge extra fees.

Passive

With a passive fund (which is what index funds are), investments reflect the general index the fund is attempting to mimic.

Which is better?

There is a lot of debate amongst the financial crowd. Me? I’m with team Passive.

Why? Well,

1) It is hard for an actively traded fund to consistently beat the market.

2) Passive funds often have expense ratios of about 0.20% or lower, making them much less expensive than their actively managed counterparts.

What is the best type of mutual fund to invest in?

My personal preference is to primarily seek out index funds. Why?

• Passive management? Check
• Low fee options? Check
• Can find low expense ratio? Check

What do professional investors say?

“Both large and small investors should stick with low-cost index funds.” – Warren Buffett (2016)

“Even fans of actively managed funds often concede that most other investors would be better off in index funds.” – Paul Samuelson, Ph.D., Nobel Laureate in Economics (2007)

“Most investors would be better off in an index fund.” – Peter Lynch (1990)

“Buy index funds. It might not seem like much action, but it’s the smartest thing to do.” – Charles Schwab, Money magazine, Jan. 2007

Well, ok then.

How do I get a mutual fund?

Are you ready to invest in a mutual fund? Here is how you can do it. Just remember, investments are a long game. Some years the market loses money, but more often than not the market goes up.

401(k)

If your company offers a 401(k) plan, talk to HR about enrolling. From there, you’ll be given investment options which often includes mutual funds and at least one index fund. An S&P 500 or total market index fund is a great place to start.

Check the expense ratio and fees!

IRA or standard brokerage account

You will want to set up an IRA through a brokerage. Banks and credit unions may also offer this service, but a good brokerage is what I prefer.

A few suggestions for brokerages that offer low-cost index funds:

Charles Schwab

Fidelity

Vanguard

If you have any questions about funds available or trading, give your brokerage (or prospective brokerage) a call and they can assist you.

The same goes with your 401(k) plan administrator. She should be able to provide you with information on funds available to you through your company retirement plan.

Mutual fund basics (tl;dr)

Phew! That is a lot to take in.

What it boils down to is that a mutual fund is a pool of money from investors that gives them more bang for their buck when buying securities. A share in a mutual fund means you are buying a little piece of possibly hundreds or thousands of companies.

When you are comparing mutual funds, it is generally to your advantage to look for an open-end, no-load, passively managed fund with an expense ratio below 0.25% or at least below 0.5%. Index funds are a good place to start.

If you found this guide to mutual funds helpful, let me know! You can subscribe to the weekly newsletter to keep on top of future posts as well.