QUARTERLY STOCK MUTUAL FUND REVIEW : Q & A : Red Hot Mutuals: A Primer on Fund Investing
After languishing for two years after the 1987 stock market crash, mutual funds became one of the hottest success stories of the 1990s, as investors started pouring money into the funds as never before.
Investors now have $2.14 trillion in mutual funds, up from $1.9 trillion at year-end 1993. And despite recent market volatility, mutual funds--which specialize in everything from fixed-rate investments to highly volatile international stocks--are expected to remain popular.
But for many investors, mutual funds are still a mystery. What are they and what do they do? Here’s a look.
Question: What is a mutual fund?
Answer: A mutual fund is a company that pools the funds of many people and invests the money following stated guidelines. Each investor owns a piece of the investment pool that corresponds to the amount of money he or she invested. For instance, if you invested $1,000 in a fund that has total assets of $100,000, you would have a 1% stake in the fund. If the fund’s value rose to $120,000, your 1% stake would be worth $1,200.
*
Q: Where can I buy a mutual fund?
A: You can buy mutual funds from brokers, banks or financial planners or directly from the funds. You may also be investing in mutual funds through a 401(k) plan at work.
*
Q: Does it matter where I buy fund shares?
A: Somewhat. When you buy shares from brokers, financial planners and banks you will generally pay a “load.” A load is a sales charge, usually between 3% and 8.5% of the amount you invested. If you buy shares from a mutual fund company directly, you generally don’t have to pay a load. In other words, if you buy an 8% load fund from a broker, only $920 of your $1,000 investment goes to work for you. When you buy a no-load fund, the entire $1,000 is invested.
*
Q: If I buy a load fund from a banker, do I get the protection of federal deposit insurance?
A: No. Mutual funds are not federally insured, no matter where you buy them.
*
Q: Then why would anyone pay a load?
A: Advice. When you buy through a broker, banker or financial planner you should expect to get sage advice about dividing up your assets among different types of investments and advice about which funds are best for you. If you don’t need the advice, however, there’s no reason to choose a load fund.
*
Q: So if they are not federally insured, how safe are mutual funds?
A: The overall risk depends on what the fund buys. A fund that buys government bonds is essentially as safe as government bonds. A fund that buys stocks of major companies is, on average, safer than one that buys stock of small companies. But to shelter the funds from outright fraud, unparalleled federal structural safeguards have been built into the industry. Extensive, regular reports are required. And most importantly, the invested funds are held separately from the mutual fund company. The “custodian” is usually an independent bank. If the mutual fund company is in trouble, it cannot just help itself to the customer’s money. Although plenty of funds are not invested wisely, the risk of theft or abuse is very small.
*
Q: Is the load the only cost of investing in a mutual fund?
A: No. You also pay annual management fees, which usually amount to about 1% of your investment each year. And some fund companies charge an annual marketing fee called a 12(b)1 fee, as well. A mutual fund discloses these fees in a prospectus--legal documents that spell out the risks and rewards of that particular fund--that is usually given to investors before they invest. These fees are used to calculate a fund’s “expense ratio.”
*
Q: Should you always look for the lowest-cost funds? The ones with the lowest expense ratios, for instance?
A: No. Expense ratios are important because the expenses reduce your overall return. However, the main thing is what you’re getting for your money. If the fund with higher expenses consistently returns more than the lower-cost fund, it’s worth the cost.
For instance, say you were trying to choose between the Berger One Hundred fund and the Vanguard/Morgan Growth fund. Vanguard charges just a .49% annual management fee. The Berger fund charges a lofty 1.63%. But the Berger fund returned 21.2% in 1993 versus the Vanguard fund’s 7.32% return, according to the Investor’s Guide to Low-Cost Mutual Funds. Chances are, those who invested in the Berger fund last year didn’t get too uptight about the fee.
*
Q: My employer gives us a choice of funds in our 401(k) retirement plan but won’t give us financial advice. Why not?
A: Because making suggestions would expose the employer to liability if you made the wrong choices and were left with insufficient savings for retirement. However, some employers are trying to educate their workers about the risks and rewards of their various choices through clearly written employee newsletters and magazines.
*
Q: Why are stock funds so often suggested over bond or money market funds? Aren’t they more risky?
A: They are more risky. However, if history is a guide, they also perform better over long periods. And for someone who has a long time before they’ll need their money, that extra return can be pivotal.
Can you rely on this to happen in future? Many financial advisers would argue that anything so serious as to prevent companies listed in the stock markets from increasing in value--an end to innovation, environmental disaster, political rejection of the free market system or world nuclear war--could equally damage bond and money market funds.
The key point to remember is that stocks offer protection against inflation in the long run, while fixed-rate investments do not.
*
Q: Given the recent market drop, should I be revamping my asset mix--pulling money out of stocks and bonds and putting it into cash, for instance?
A: If your asset allocation strategy is fairly up-to-date--in other words, in the past year, you’ve reviewed your goals and put specific amounts into stocks, bonds, cash and other investments to suit your goals--you shouldn’t let this slide bother you.
However, if it’s been a while since you’ve looked at your investment plan or if you’ve never really considered the best way to break up your assets, this would be a good time to think about your goals and review your investments.
*
Q: I was thinking about investing in equity mutual funds, but last week’s drop in the stock market is giving me pause. Would it still make sense?
A: Yes, although you might want to get in more slowly than normal, using a popular program called “dollar-cost-averaging.” Dollar-cost-averaging simply means that you invest the same amount regularly. When the stock market is high, your investment gets you relatively fewer shares. When it’s low, it buys more. When the market direction looks uncertain, this is a particularly attractive way to go because, over time, dollar-cost-averaging tends to even out the effect of market swings on your portfolio.
Mutual funds make using this strategy exceptionally simple by allowing you to set up automatic investment plans, where the fund company automatically and regularly withdraws even small amounts from your checking account.
