Mutual Fund Investing
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Mutual fund investing is one of the most common ways people try to make money in the markets.
In fact, most households in the United States have a lot of their money invested in mutual funds (~25%).
The reason is simple; most people do not have the time or patience to research every company and find out which ones are the best.
And even if they did have time, trying to be an expert in every industry is impossible.
It makes more sense to rely on professionals, whose job it is to research and select good quality companies for investing.
The Key to Mutual Fund Investing
Usually, mutual fund investing comes with restrictions on how often you can buy or sell. This means that they need to be used as part of a longer-term strategy (meaning that you won't trade them very often). In this case, you need to focus more on some of the attributes that will make you successful long term; fees and expenses
Investors pay the fund's expenses. These expenses come in the form of distribution charges (sales loads and 12b-1 fees), management fees, "other" expenses, and transaction fees. Some of these expenses are taken directly out of your account (such as loads); others are paid by the fund and reduce the funds value.
Distribution charges basically pay for administrative activities related to the fund; marketing, distribution of the fund's shares, and "services" for investors. Distribution charges are paid by the fund and reduce net asset value.
In addition to the distribution charge, funds can charge another fee in order to compensate the distributor of fund's shares for providing ongoing services to fund shareholders. The 12b-1 fee is paid by the fund and reduce net asset value.
There are two types of loads that can be applied to mutual funds. A front-end load
(often called a sales charge) is a commission that you pay to a broker when you buy shares of a mutual fund. A back-end load
is a commission you pay when you sell your shares. The fee is quoted as a percentage, and is based on the the total amount of money you invest in the fund. You might be able to lower the commission percentage if you invest enough money.
Safe Investing Tip:
DO NOT BUY FUNDS THAT HAVE A FRONT END OR BACK END LOAD! A no-load fund does not charge a front-end or back-end load under any circumstances and does not charge a 12b-1 fee greater than 0.25% of fund assets.
A management fee is charged to compensate the fund manager for organizing, managing, advising, and "branding" (i.e. an aspect of marketing) the fund. The management fee is paid by the fund and is included in the expense ratio
When a mutual fund needs to buy or sell shares, it must pay brokerage commissions just like you and I do. The transaction fees incurred by the fund are not included in the expense ratio, but do impact the performance of the fund. The amount of commissions paid by a fund is usually correlated with "turnover" percentage, or the number of trades made within in the fund.
If you purchase mutual funds in a non-retirement or retail account, you'll probably pay a transaction fee to your broker for arranging the trade. There will be funds available called NTF funds, which stands for "No Transaction Fee". However, the availability of these investments is dependent upon your investment broker.
If you are labeled an "active trader", you may be forced to pay additional fees when you buy or sell shares of a mutual fund. This is especially true in retirement accounts. Or, if a broker is assisting you with your trades, you may be charged a fee for their help. Transaction fees that are incurred by you are also not part of the expense ratio.
A mutual fund may pay fees and expenses for "other" services, such as:
- Board of Directors
- Fund Administration (Communications, Operations, Customer Support, etc.)
- Professional Services (Lawyers, Accountants, Auditors, etc.)
- Shareholder Communications
How to Start Mutual Fund Investing
If you have a retirement account, you've probably started investing in mutual funds. But how do you know what to buy?
For starters, keep your options open. Mutual fund investing has it's place, but exchange traded funds (ETFs) provide a lot of benefits that mutual funds can't match.
Keep in mind that if you only buy mutual funds based on equities (stocks), all your investments will perform about the same. What I mean is that if you buy large, mid, and small cap focused mutual funds, you still have a bunch of stock-based investments. So in terms of diversification, you are diversified across many different types of stock. They will all move in the same direction at the same time.
Some of the fees and expenses are charged to you every year (specifically the 12b-1, management, and "other" expenses). The good news is that you can find out what these fee's are because they are included in a fund's "expense ratio"
. Because all funds must calculate expense ratios the same way, you can easily compare costs between different funds.