I have brought up mutual funds a few times and now it is time to give them their due. When buying a mutual fund you are buying an ownership stake in a corporation. That corporation sells shares to investors to raise capital that is used to purchase securities. This activity is overseen by a board of directors that make sure the fund in managed in the best interests of the investors. The board hires a fund manager and various ancillary service providers to perform the day to day operation of the fund. If everything goes as planned the securities purchased by the fund appreciate in value while paying dividend and interest payments and the investors make a profit. The fund charges management fees to the shareholders for performing this service and in turn earns a profit.
Mutual funds can be divided into two major types based on when and how the shares can be redeemed open ended funds and close ended funds. With a close ended fund there are a set number of shares created at the time of the initial public offering. After the IPO should an investor wish to sell their shares they need to find another investor willing to purchase the shares from them. With an open ended fund the fund allows investors to both purchase and sell shares to the fund at the end of each day at the net asset value (NAV) price. Open ended funds are currently the most widely available type.
Funds also differ in whether they are actively or passively managed. In an actively managed fund the fund manager is generally charged with attempting to beat the return of a benchmark. Most commonly this benchmark will be an index. In a passively managed fund the goal is generally to match the performance of an index. These funds will often be called index funds since they track an index. Aren’t financial service folks just an imaginative lot? Actively managed funds generally charge a premium for the service they provide and very few actually beat their benchmark. Passively managed funds on the other hand that only have to match their benchmark less fees have a far easier target to hit and generally charge lower fees than actively managed funds for the service.
Mutual Funds are required to publish a few documents detailing how the fund is organized, who is running it, what it invests in, along with how well it has been doing. These documents are the prospectus, the statement of additional information, and the annual report. Since all mutual funds are required to publish these documents it makes it relatively easy to compare funds. Morningstar makes a business out of aggregating and reporting on mutual funds making the job of comparison even easier.
The prospectus is the high level overview of a fund. In the prospectus you will find the investment objective of the fund. Which is what it is trying to do for its shareholders. Is it looking for capital appreciation or trying to pay out a steady stream of income? These are the sorts of questions that will be answered by reading the investment objective. In addition the prospectus also lists the strategy the fund will follow that guides the mix of stocks, bonds, currency, and other securities a fund may purchase while trying to achieve the investment objective. The risks inherent in the investments should also be detailed in the prospectus as well. There will also be a section on the expenses the fund charges its shareholders. This one is always an eye opener. I am constantly amazed that funds exist that charge their shareholders a sales commission to buy the fund along with a 12-1b fee to market the fund to new investors along with a back end load when you go to sell the share in addition to regular management fees. When other funds exist that only charge a low management fee. I have trouble comprehending how funds so laden with fees can still be in business when their competition beats them so soundly. There will also be a section on who the fund manager is that is busy putting all these things to work for the shareholders. Last, but not least there should also be a section detailing past performance. The phrase: “Past performance does not guarantee future results” is often nestled in this section somewhere and is one of the most overlooked phrases in all of investing.
The statement of additional information (SAI) is often considered a second tier document by mutual fund companies. While they will mail out the prospectus and annual report (or at least send you a link in e-mail to go retrieve them) the SAI is a document that generally has to be asked for or you have to go digging on the fund’s website. This document goes into the gritty details of how that 12-1b fee was spent and how much the fund paid in brokerage fees.
Funds are also required to release a shareholder report at least twice a year. Some funds go above and beyond and report quarterly. Generally in this document you will find a letter from the president of the board and maybe a letter from the portfolio manager talking about the fund recapping what has happened and laying out an idea of where things are heading. There will also be an accounting of the fund performance and holding.
Why own a mutual fund instead of buying the underlying securities directly? Over in the bond article I mentioned that bonds are generally issued in 10k face value increments. With an initial investment that high to just buy one bond it takes some serious capital to make a diversified bond portfolio on your own. Buying into a mutual fund that pools many investors money together to purchase securities makes it easier to achieve a more diverse portfolio than an individual investor can manage on their own. Another advantage of an open ended fund is the daily liquidity. An investor can sell the shares back to the fund company for the net asset value calculated at the end of each day. Some securities can take a while to find a buyer for. On the disadvantages side of things for why one may not want to own a mutual fund is the fees charged by the fund. Also funds manage the buying and selling of their holdings which takes the control of the timing of recognition of gains away from the investor. Which can lead to an unpleasantly high tax bill.
I generally own low cost index funds. This avoids some of the disadvantage of mutual funds charging fees since passively managed index funds generally have lower fees than the actively managed alternatives while taking advantage of diversification that mutual funds can provide. I also generally keep the mutual funds tucked away in tax advantaged accounts such as a 401k or an IRA. This mitigates the disadvantage of the timing of capital gains since the piper doesn’t have to be paid on tax advantaged accounts until you actually start taking distributions from them. Even though having to pay taxes on capital gains is a good problem to have I prefer defer the tax liability as long as possible. Owning mutual funds in this way allows me to benefit from the advantage that mutual funds offer while avoiding some of the disadvantages.