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Mutual Fund Investing 101 – Intermediate Level Mutual Fund Investing

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Introduction

 

 

In the previous lesson, we discussed the very basics of mutual funds, how they work, and what they can offer you as the investor. In this lesson we will be kicking it up a notch as we will divulge much further and introducing more terms and topics in this lesson dubbed Mutual Fund investing 101.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Mutual Funds 101

 

 

A mutual fund pools together money from many investors, including individuals like you – and institutions like university endowments and employer sponsored retirement plans.

A professional money manager administers these pooled funds and invest in securities such as stocks, bonds, and money market instruments, among others.

Every mutual fund has a unique prospectus, which is a document detailing the securities a mutual fund invests in, the funds overall strategy, fees associated, and other operating details.

The goal of a mutual fund is to make its investors money through capital gains in income from the underlying securities, which are again stocks, bonds, money market accounts, and other assets that make up a fund.

Underlying securities in a mutual fund can number in the hundreds. This is one of the main benefits, because it allows investors to easily diversify their portfolio by investing in a single mutual fund.

 

 

At the end of every business day, the gains and losses of underlying securities are totaled to calculate a single price per unit, or share, of the mutual fund. This price per share is known as the net asset value, or NAV.

The NAV is the price you pay per share when investing or receive when redeeming the fund.

Some funds charge a sales load at purchase or redemption, which may be included in the NAV.

In addition to letting you know the price per share, the NAV also helps you monitor a mutual fund’s performance day-to-day or over longer periods of time.

However, it’s important to remember that a mutual funds’ performance figures are based on past performance and don’t indicate future performance. Too often, new investors only look at past performance when deciding which mutual fund to invest in.

This can be a costly mistake, because last year’s highest performer could be this year’s lowest performer.

Instead of focusing on past performance, consider how a mutual fund fits within your risk tolerance and time horizon – as well as its fees.

For instance, an investor with a high risk tolerance and a 10-year time horizon, might look for a broadly diversified stock mutual fund.

Conversely, an investor with a low risk tolerance and a short time horizon might be more interested in a bond mutual fund.

Its also important to consider the fees involved with mutual funds. Some funds charge sales loads, or commissions, that you must pay when investing or redeeming shares.

All mutual funds charge an expense ratio, which represents the costs associated with a fund. The expense ratio is deducted from the NAV on a daily basis.

Expense ratios vary widely across mutual funds, particularly between actively managed and passively managed funds.

Actively managed mutual funds are run by a professional money manager who picks and chooses securities that they think best meet the fund’s stated investment objectives. In an attempt to accomplish this, they try to time the market and frequently adjust asset allocations.

They also have a team of analysts and traders who help select securities and manage the portfolio.

The money manager and team receive a salary for their work, which increases the expense ratio and makes actively manages funds more expensive.

Passively manged mutual funds are much different. These mutual funds still have a portfolio manager, but track an index and use asset allocations that simply match an underlying index.

 

 

Passively managed mutual funds are usually referred to as Index Funds.

An example of an index is the S&P 500, which tracks the 500 largest stocks in the US. An index that tracks the S&P 500, for example, simply matches the securities in the S&P 500.

And because the fund automatically changes to match the index without active management, the expense ratios are much lower.

 

 

The average expense ratio of an actively managed stock mutual fund is about 1.5%. In contrast, the average expense ratio of a stock index fund is around 0.25%.

The difference in average expenses might seem small, but it can add up over time. Let’s look at an example.

Suppose an investor buys $10,000 of an actively managed fund with an expense ratio of 1.5%. The investor also buys $10,000 of an index fund with an expense ratio of 0.25%. Both funds earn 8% per year for the next 30 years.

After 30 years, the investment in the actively managed fund would have grown to $66,144 – which is not bad.

But the investment in the index fund with a 0.25% expense ratio would have grown to $93,868 – that’s almost $30,000 more, thanks to the lower expense ratio.

To clarify any confusion as to how I received these calculations – you would have to use the compound interest formula – as this is how most investors predict the theoretical value of their investment over a set time period.

 

 

The actively managed has a principal (P) of $10k, a rate of return (r) of 6.5% after taxes, commissions, and fees, compounded annually (n=1), and you want to find the growth of the account after 30 years (t). Simply plug it into the formula and this will give you the theoretical value of the fund – approximately $66,144.

The index fund, on the other hand, has a rate of return (r) of 7.75% after taxes, commissions, and fees – which is far greater than that of the first fund. Using the previous data as constant variables, you will receive a theoretical value of $93,868 – allowing you to achieve a greater return.

As you can see, a small difference in expense ratios can make a very big difference in returns over long periods of time.

Expense ratios, along with risk tolerance and time horizon, are much more important to consider when selecting a mutual fund rather than chasing last year’s performance.

 

 

Quick Recap

In Review……

 

Mutual Fund 101

  • A mutual fund pools together money from many investors, including individuals like you – and institutions like university endowments and employer sponsored retirement plans
  • A professional money manager administers these pooled funds and invest in securities such as stocks, bonds, and money market instruments, among others
  • Every mutual fund has a unique prospectus, which is a document detailing the securities a mutual fund invests in, the funds overall strategy, fees associated, and other operating details
  • The goal of a mutual fund is to make its investors money through capital gains in income from the underlying securities, which are again stocks, bonds, money market accounts, and other assets that make up a fund
  • Underlying securities in a mutual fund can number in the hundreds. This is one of the main benefits, because it allows investors to easily diversify their portfolio by investing in a single mutual fund
  • At the end of every business day, the gains and losses of underlying securities are totaled to calculate a single price per unit, or share, of the mutual fund. This price per share is known as the net asset value, or NAV
  • The NAV is the price you pay per share when investing or receive when redeeming the fund.
    Some funds charge a sales load at purchase or redemption, which may be included in the NAV
  • In addition to letting you know the price per share, the NAV also helps you monitor a mutual fund’s performance day-to-day or over longer periods of time
  • However, it’s important to remember that a mutual funds’ performance figures are based on past performance and don’t indicate future performance. Too often, new investors only look at past performance when deciding which mutual fund to invest in
  • Its also important to consider the fees involved with mutual funds. Some funds charge sales loads, or commissions, that you must pay when investing or redeeming shares
  • All mutual funds charge an expense ratio, which represents the costs associated with a fund. The expense ratio is deducted from the NAV on a daily basis
  • Actively managed mutual funds are run by a professional money manager who picks and chooses securities that they think best meet the fund’s stated investment objectives. In an attempt to accomplish this, they try to time the market and frequently adjust asset allocations – these tend to be more expensive via the expense ratio
  • Passively managed mutual funds are usually referred to as Index Funds. These mutual funds still have a portfolio manager, but track an index and use asset allocations that simply match an underlying index.
  • Passively managed portfolios tend to have a much lower expense ratio than that of actively managed portfolios

 

 

This is a more through lesson for our intermediate level learners – this takes the knowledge that you have gained in the previous lesson, as a stepping stone toward the more advanced topics that will be covered in this module.
As you can already tell, mutual funds group asset classes together and reduce risk through the power of diversification – as a single purchase of a fund allows you access to multiple stocks, bonds, CDs, ect. – all at your finger tips. They are also considered to be attractive to some investors due to their convenience and due to the fact that they can depend on professionals to handle, manage, and adjust their funds for them.

The price per share of mutual funds are updated at the close of the stock market (4pm Mon. – Fri.) – and is known as the Net Asset Value (NAV).

There are primarily two types of mutual funds – that being active and passive mutual funds. Active mutual funds….like the name implies, are manged actively, which means that it has higher maintenance fees – and is represented using the expense ratio (represents the management fees of your mutual fund – and is not included in the calculation of the NAV). Your portfolio manager may implement several trading strategies to grow the value of your portfolio – but this does not necessarily mean that you will be promised the results you desire.

Passive mutual funds (aka index funds) are still managed by a pro, but they more so mimic the performance of an index. Since passive funds have a more hands-off approach, they generally have a lower expense ratio.

Keep in mind that there are other costs in addition to the expense ratio, that are commonly associated with mutual funds, such as the sales loads (commissions) and additional taxes.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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