Concerning Mutual Funds

Introduction

In our last post, we compared mutual funds to ETFs, and we weighed the advantages and disadvantages of each. By nature, mutual funds and ETFs have a lot of similarities in that they’re both pooled funds used to buy baskets of different stocks or bonds sold as one unit. But when you get down to it, there are some very critical differences in their costs and who makes the decisions with your money. Because of these differences, at NEST we invest in ETFs.But we realize that for DIY investors, or even professional ones without access to or expertise in analyzing good, unbiased data, it can be more difficult to navigate ETF investment successfully. After all, unlike mutual funds, they aren’t usually professionally managed. That means managing them is up to the investor, which for us is a great thing. It means our clients don’t have to pay the extra fees for a professional fund manager’s services, and we can be confident that our portfolios reflect the best data. For others, this lack of professional management can be a hindrance. So, in the spirit of education, we’re taking a deeper dive into mutual funds — the different types, the difference between load and no-load, and what you should consider before investing in mutual funds. 

What are Mutual Funds?

A mutual fund is a professionally managed investment fund that trades in diversified holdings. The investment companies that manage them raise money from shareholders to invest in stocks, bonds, futures, currencies, options, or money market securities. Each mutual fund is a diversified portfolio of stocks and/or bonds. Because the number of different stocks or bonds is usually 100 or more, the mutual fund shareholders hedge against the risk associated with non-diversified investments. For example, if the price of some of the stocks in the fund drop, others may rise or hold steady. This mitigates the overall risk by spreading it out across the fund. This also lessens the impact of a specific stock or bond’s devaluation on the mutual fund’s net asset value (NAV). Mutual fund shareholders share in the fund’s gains and losses equally, according to the number of shares they own.  

Types of Mutual Funds

There are four basic types of mutual funds: 

1. Equity funds – buys stocks of publicly traded companies 
2. Bond funds –  invest in government and corporate debt, and investors are paid back a fixed amount on their initial investment
3. Money market funds – fixed-income funds that invest in short-term, high-quality government, bank, or corporate debt
4. Balanced funds – a blend of different assets, such as stocks and bonds

There are also mutual funds that specialize in certain industries like tech, health care, or energy. These are called sector funds. Mutual funds that purchase assets from foreign governments or companies are called global funds. Additionally, there are index funds which mirror indices like the S&P 500, and there are hedge funds, managed futures, and commodities.  

Diversification in Mutual Funds

Mutual funds not only increase diversification by allowing you to invest in many different stocks and/or bonds, they also simplify the diversification process. Instead of seeking out and researching all these different investments on your own and buying stocks in each of them, which could be prohibitively expensive, a professional manager curates the fund’s holdings. And boom — instant diversification. Investing in a number of different mutual funds with different objectives and in different niches in another way you can further your portfolio’s diversification.  

Investment Objectives of Mutual Funds

There are three basic objectives for mutual funds:

1. Growth: capital appreciation – offers highest risk and greatest potential return
2. Income: the goal is to provide regular income payments – often select bonds and preferred stock
3. Safety: focus on capital preservation – often hold very short-term cash equivalent assets

While all mutual funds’ goal is to ultimately grow and increase value, they go about it in different ways at different times. 

Load vs. No-Load Mutual Funds

Okay, so this is where you can really start to get into the weeds. So, we’re going to simplify as much as possible.In the context of mutual funds, the word “load” basically means sales charge or commission. All mutual funds either fall into the category of load or no-load. 

No-Load Mutual Funds

No-load mutual funds’ shares are sold without a commission or sales charge, either at the time of purchase or sale. This is possible because the investment company distributes the shares directly, rather than going through a secondary party.  But just because there’s no commission or sales charge, that doesn’t mean there aren’t fees. All mutual funds carry fees and expenses. The difference is in how and when investors are charged. In the case of no-load funds, the fees are part of the average expense ratios. 

Load Mutual Funds

Load mutual funds essentially come with a sales charge or commission. This is in order to pay the second party sales intermediary, like a financial advisor, for selecting the fund and brokering the purchase of shares for the investor.Simple, right?Well, things get a little complicated from here.There are 3 types of load mutual funds — Class A, Class B, and Class C Shares 

Class A Shares

Class A Shares charge an upfront sales fee, otherwise known as a “front-end load.” This fee is deducted from your initial investment. If you have a lot of money to invest, you’ll more quickly reach a breakpoint. A breakpoint is a dollar amount your investments in a mutual fund which, once reached, qualifies you for a reduced sales charge. Great news for those investors with larger amounts of money to invest over a long period of time. These can actually be the lowest cost option in the long run. If you have investment capital beneath the breakpoint or are looking to hold shares for a shorter period of time, they might not be the best option.  

Class B Shares

Class B Shares tend to work best for investors whose capital isn’t high enough for Class A Shares and who have a long time to hold the investment.Rather than charge a front-end sales charge, Class B Shares have a “back-end” or Contingent Deferred Sales Charge (CDSC). Basically, you pay the fee when you sell your shares within a specified period of time. This charge is usually carried over a five to ten year holding period, with the CDSC decreasing over time. After a certain amount of time, the fee is eliminated and the shares convert to a type of A Share. Because of this, if an investor buys and holds Class B Shares for the entirety of the specified amount of time, they could avoid the fees altogether. Unfortunately, on average investors hold their mutual fund shares for fewer than five years, negating the key benefit of this class of mutual fund investment. For those who can’t hold their shares long enough for them to convert to Class A Shares, Class B Shares can actually have higher expense ratios than both Class A and Class C Shares.  

Class C Shares

Like Class B Shares, Class C shares aren’t front-end loaded. But rather than converting to Class A Shares after the holding period, investors pay up to 1% in annual charges for fund marketing, distribution, and servicing for the life of the investment. These charges are officially known as 12b-1 fees.This setup can work really well for investors who want to hold on to their shares for a shorter amount of time and/or have less capital to invest. But because of the power of compounding interest, if you keep Class C Shares for a longer period of time, they can end up costing more than Class A or B Shares. They also have the added disadvantage of not offering discounts once your account reaches a breakpoint threshold.  

What’s Concerning About Mutual Funds?

We’re ready to admit that mutual funds have their uses. They are a good option for people who want to take the DIY route and diversify their investments on their own. They can also be a good choice for financial advisors to recommend to clients who don’t meet their usual minimum requirements. But at NEST, we don’t use them, and that’s because there are a few things we find concerning about the practice.

1. Clients end up paying more. They have to pay the mutual fund’s manager fees in addition to fees that their financial advisor or investment manager charges. At NEST, we charge 1%, and for that, we put in the work instead of selling products to clients or passing the buck to someone else. 
2. Liquidity. Due to holding periods and the fact that mutual funds are traded at NAV which is calculated at the end of the day, it can be much more difficult and costly to liquidate your shares. At NEST, the ability to be responsive to both the market and whatever life throws at you is very important. 
3. When someone else is actively managing an aspect of a client’s portfolio like a mutual fund manager would, we don’t control it. And at NEST, we’re very particular about where we get our data and what type of moves and adjustments, we make according to the macro view we take of the economy. There’s no guarantee that the fund manager’s information or philosophy will match our own. 
4. We think that for financial advisors and investment managers, crutching on mutual funds is another form of laziness. Yeah, we said it. 

What Questions Should You Ask About Mutual Funds?

If you’re considering investing in a mutual fund, don’t go into it without doing due diligence. Here are some questions to ask:

• What type of mutual fund is it?
• How long has the fund been around?
• How has the fund performed over the past year, three years, and since its inception?
• Are the fees front-end loaded, back-end loaded, or annual?
• What is the fund manager’s background? (This information can be tricky to find.)
• What is the fund’s investment objective: growth, income or safety?

 If you’d like to learn more about mutual funds, or better yet, the alternative that NEST uses, why not schedule a no-obligation call with us? We have the skills and experience needed to analyze and interpret data so we can make the best investment decisions for our clients. We serve the Austin and Hill Country area, and our raison d’etre is helping individuals, families and entrepreneurs reach their financial goals. Pardon our French.  Find us on:LinkedIn  Facebook  Yelp  TwitterDISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net.11