Mutual Funds

Mutual Funds hire investment professionals to do fundamental company research and then hire portfolio managers or fund managers to assemble a group of good companies together. Some funds are broadly diversified and some are sector funds that invest in a single part of the economy. When an investor buys a mutual fund, their money is co-mingled with other investor’s funds and is used to buy more of the stocks of the companies the fund manager has decided to buy. At the end of each day, the value of all of the stocks the fund owns are added up and the sum is divided by the number of shares that the investors have purchased. The resulting number is called the Net Asset Value (NAV). All investors who buy or sell mutual funds do so at this end of day NAV. The fund manager charges some fees against the value of the fund each quarter to pay for the investment service they are providing.

There are many broad categories of mutual funds. There are no-load and load funds. There are open ended funds and closed end funds. There are index funds, index replication funds and non-index funds.

Load funds are Mutual Funds where the fund manager charges you a fee up front (or sometimes when you sell) to participate in the fund. For a three percent load, that would mean that only 97% of your money would be invested. The rationale is that the fund has such significant performance that it will make up the fact that you are starting 3% or whatever the load is in the hole. A no-load fund does not charge these fees. Most investment advisors would recommend buying the no-load fund. It is rare for load funds to consistently outperform no-load funds with the same investment objective.

Closed end funds stop accepting investments when the fund reaches a certain pre-announced size. The fund usually is investing in something where they believe there is a limited size to the amount that can be invested without eliminating the advantage the fund manager has identified. Because there is not a constant flow of new investors, closed end funds are generally less liquid than open-ended funds. Closed end funds may also have a lock up period where investors cannot get their money out of the fund. Consequently, after the fund closes, the fund trades at a slight discount to the end of day NAV for buyers and sellers. Open-ended funds remain open to investors and continue to grow in size if they have acceptable performance. Unless you are sure you will not need to access your funds until the fund maturity, you should not buy closed end funds.

Index funds and index replication funds try to match the performance of a given index. The most popular may be the S&P 500 index. This index measures the performance of the 500 largest companies in the US by market capitalization. Market capitalization is the price the stock sells for multiplied by the total number of shares. Other indexes are the Dow Jones Industrial Average (30 industrial companies), the Russell 1000, the NASDAQ 100 (the 100 largest companies on the NASDAQ). Index funds can be thought of as buying a pure Beta investment. You get the return of the market, without any active management or Alpha. Because you are not paying for Alpha, index funds tend to be much cheaper than non-index funds.

The good news is that index funds outperform the average mutual fund. Remember that Alpha returns are slightly negative overall because they are zero-sum and have transaction fees. This gives index funds an advantage on average. I have seen different studies that show the S&P 500 outperforming 60% to 80% of all actively managed funds depending on the length of time measured. This is one of the great secrets of investing. You can outperform most investors the majority of the time by buying an index fund.

Index funds are also tax efficient. They do not have high turnover (that is buying and selling of securities) because they only need to change the securities in the portfolio when a company enters or leaves the index, which does not happen too frequently.

Certain fund families offer a wide variety of no-load, low expense, index funds. John Bogle was one of the first to come up with this concept and he founded a company, Vanguard to offer low cost index funds. There are many competitors today.

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