Mutual Funds: Should I Invest in These Things?

Over the years, I have spent many hours explaining investments to people. Most of these conversations start with the understandable question, “What should I invest in?” In most cases, what people want to know is what stocks they should pick in order to make the highest return possible for the least amount of risk. Unfortunately, stock picking is hard. It takes a huge amount of time, effort, and is rarely efficient. Timing the markets, that is knowing when to buy and sell to maximize profits, is simply not an effective strategy for most investors over the long term. Furthermore, having the financial resources to invest in a large number of different companies in different industries is difficult. In come the investment products. These are investments which do the heavy lifting for the retail investor; pulling resources from many individuals to purchase a wide range of investments and deciding what to buy and sell. The most popular types of investment products are Mutual Funds, ETFs, and UITs. This blog will focus on Mutual Funds. Keep an eye out for future blogs on ETFs and UITs.

It is important to keep in mind that these financial products are NOT the stock market. These products invest in the financial markets (stocks, bond, and others), and their value is derived from the underlying investments. Another important thing to keep in mind is that, while you may own shares in Mutual Funds, ETFs, or UITs, you do NOT own the underlying investments. If you own shares in a Mutual Fund which holds XYZ stock, you do not own XYZ stock personally. The Mutual Fund does.

So How do these things work? Mutual Funds, ETFs, and UITs are very different in the way they manage underlying investments, and the fees involved to purchase and own the funds. Fees are important to keep in mind when purchasing any investment because they reduce the overall return on the investment. Fees in and of themselves are not bad. There is overhead involved with managing a stock portfolio. The people who do it, from the head asset manager, to the person who opens the mail in the mailroom, are real people who expect to be paid for the work they do. Investment products exist because they provide a service, and one should expect to pay for these services. That isn’t to say you should be paying for services that you don’t want or need though.

Mutual Funds

Mutual Funds are hugely popular, and many people own them within their retirement accounts, especially 401(k)s. It helps to think of a Mutual Fund like a company. Say like a plumbing company. Like any company, it has people who run it. It has people who make decisions on how to market, how much to charge, and how to keep things running. It has someone to answer the phone, and open mail, and all do the actual plumbing. It has overhead to account for, taxes to manage, and a service to provide. It has a specific objective. A plumbing company’s objective is to provide plumbing services, and sometimes specialized objectives, like a plumbing company which focuses on the installation and maintenance of septic systems. Mutual Funds are investment companies. It has people who keep things running and various employees from the asset managers who pick what to buy and sell in the investment portfolio, to accountants, and even (gasp) lawyers to give legal advice. They have expenses, such as ticket charges, and brokerage and clearing fees. They have objectives such as: invest in large cap stocks, and provide better returns than the overall large cap stock indexes.

Mutual Funds have been around for a long time, and so they have evolved in the market quite a bit. Many mutual funds try to find an investment niche and fill it. Many try to invest in a specific type of asset class. That is, they try to invest in similar types of companies based on the size and nature of the companies. For instance, a Mutual Fund which tries to invest in medium sized, established companies which the manager thinks are undervalued would be investing in a Mid Cap Value portfolio. Often, much can be gleaned simply from the name of the fund, i.e. ABC company Mid Cap Value Fund. Some Mutual Funds try to solve specific problems, like investing for someone who wants to retire in twenty years, and needs to become less aggressive with assets over time. A fund set up this way may be called ABC Target 2040 fund, meaning the intention is to get less aggressive over time, and start withdrawing from the fund to provide income in the year 2040. The asset manager will keep this objective in mind when deciding how to invest the assets in the fund. Some funds focus on only investing in socially responsible companies, while others try to minimize tax implications for the investor. It is important to understand what the fund objectives are, and not just look at historical data to see which one has had the highest return.

Mutual Funds work by pooling investor money together and using that money to buy an investment portfolio based on the fund’s objectives. The fund manager, usually and individual or a committee, decide what stocks, bonds, commercial paper, short term notes, and cash accounts etc. to invest in, and in what amounts. The Mutual Fund owns the investment portfolio, and the investor owns shares in the Mutual Fund. When the investment portfolio’s value goes up, the value of the Mutual Fund “company” goes up, and so the investor’s share of the company is worth more. When the investor needs to use the money invested, the investor sells back the shares to the Mutual Fund, also known as redeeming the shares, for cash. The basic idea of investing in a Mutual Fund is to get more leverage to invest in a wider and more diversified portfolio, while outsourcing the management and other day to day operations, with relatively small amounts of capital.

Investors make money from Mutual Funds in a couple of different ways. One is capital appreciation (redeeming the shares at a higher value then when they were bought). Another is interest and dividends (the underlying stocks may pay out dividends, or bonds will pay out interest, to the Mutual Fund which will then distribute the funds to the shareholders). Another is through short and long term capital gains (the mutual fund makes a profit when selling underlying investments, and distributes those to the shareholders). Instead of distributing these gains, the fund company may reinvest them, increasing the value per share in the fund.

Mutual Funds cost money to run, and the investors pay for it. There has been a lot of bad press about fees and costs associated with investing. Some of this bad press is warranted. Some of it is not. In the end, a Mutual Fund company has expenses like any other company. Over time, the financial services industry has come up with some basic structures on how fees are paid. The ones the average retail investor will run into are Loaded Funds, No-Load Funds, and Institutional Funds. Loaded Funds are usually sold by investment professionals such as financial advisors and brokers. Mutual Funds are seldom sold directly to investors. Instead, like many types of products, they are distributed by a distributor. Loads are how the distributors (broker/dealers) and sales people (representatives such as financial advisors) get paid by the Mutual Fund. Of course, it would not make sense for the Mutual Fund company to eat this expense, so the charge is something the investor pays. More on this soon. No-Load Funds are different in that they do not charge investors to pay the distributors. Often the distributors will offer these funds to investors and charge a transaction fee for doing so. Furthermore, since there is no load, financial advisors usually do not get paid for recommending these types of funds. Some firms will only sell these funds to investors if they ask for them specifically. Sometimes financial advisors and financial companies are vilified for this. In the end though, most people work to make a living, and that includes advisors. A financial advisor who never gets paid is not a financial advisor for long. Institutional Funds are a special fee structure reserved for very large investors such as pension funds, large endowment funds, and retirement plan providers, and not available to the general public except perhaps inside retirement plans like 401(k)s.

More on Load Funds. The most common fee structures for Mutual Funds are front-end load funds called A shares. Back-end load funds called B shares, and “pay as you go” load funds called C shares. There are other load structures out there, but these are the ones retail investors will most often run across. The different fee structures are called share classes. The loads on all these funds are a percentage of the total assets invested. It is important to note that the same mutual fund, with the exact same investment portfolio, has different share classes. The investments are not different, only the way the investor pays the load on the fund is different.

A shares have a front-end load. That is to say, when an investor buys shares of a mutual fund, a percentage, say 5%, comes off the top right away. If an investor buys $1000.00 of ABC Large Cap Growth Fund, class A, then $50.00 goes to the financial company and advisor as a commission. $950.00 is invested in the Mutual Fund. There are also internal operating expenses going forward, as well as a relatively small marketing and sales charge annually, say 0.75%. A shares also offer volume discounts called Breakpoints. Breakpoints are a way a mutual fund company will reward the investor for investing more money within that company. For example, if an investor buys $25,000.00 in ABC Large Cap Growth Fund, class A and $25,000.00 in ABC Mid Cap Value Fund, class A for a total of $50,000.00, then ABC may lower the load from 5% down to 4%. If the total amount invested were $100,000.00 ABC may charge even less, say 3%. BE CAREFUL if your advisor is recommending you purchase Mutual Funds from more than one or two fund companies. You may be paying more by missing breakpoints while your advisor is getting paid more in commissions. It is wrong and illegal for advisors to structure sales in such a way that you don’t get the sales discounts you are entitled to so they get higher commissions!

B shares have a back-end load sales charge. That is to say, when in investor buys shares of a mutual fund, the investor pays nothing up-front. When the investor sells the fund, a percent of the proceeds are retained by the fund company. The size of the load depends on the amount of time the investor holds the fund. The load is on a sliding scale down based on time called a Contingent Deferred Sales Charge, or CDSC. For example, the scale may be 5%, 5%, 4%, 4%, 3%, 3%, 2%, 1%, 0%. So if the investor sells a fund after holding it for three years, the load would be 4%. If the investor sells $1000.00, 4% would be $40.00, and the investor would get $960.00. Like A shares, there are also internal expenses, which are the same as A shares, but there are also ongoing marketing and sales charges. These are almost always higher than the same type charges for A shares. B shares convert to A shares at the end of the CDSC period. At that point there is no back-end charge and the ongoing sales fee reduces to the same amount as the class A share for the fund. B shares are typically more expensive in the long run for investors because the fee is being paid after appreciation of the fund, and because the ongoing charges are higher. Also, B shares to not qualify for the breakpoints that A shares do. BE CAREFUL if your advisor is recommending B shares for large, long term purchases. You are likely paying more than you would for A shares so your advisor can make more on commissions!

C shares have no front end or back end loads. Instead the ongoing fees are higher. Perhaps instead of paying 0.75% like on an A share, or 2% like on a B share, the investor may be paying 2.75% ongoing. This amount never deceases. C shares will also often have a CDSC. This is a charge for selling the fund too soon, usually within a year, such as 1%. If the investor holds the C share longer than a year, then the CDSC does not apply. Due to the higher ongoing fees and lack of breakpoint discounts, the longer and investor holds onto C shares the more likely they will cost more than if the investor had bought A shares. BE CAREFUL if your advisor is recommending C shares for very large, long term purchases. You are likely paying more than you would for A shares so your advisor can make more on commissions!

Also be careful if your advisor is recommending mixing share classes within the same fund company. While it is sometimes appropriate based on your holding period, it may also be costing you more than it should, and only to your advisor’s benefit.

The information contained in this blog is general in nature and should not be viewed, and is not intended by the author to be viewed, as legal advice. For specific legal advice, please discuss your situation with a qualified attorney.