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Mutual Funds: Basics

A Grand, Comprehensive Overview to Mutual Fund Investing

Mutual Funds

By Bill Barker

Buy an index fund.

Details

If you've finished reading our thorough overview, you now know about 95% of everything you need to know to succeed in the zany world of mutual fund investing. We are, by the way, perfectly serious about that. Almost everything that you will ever read about mutual funds beyond "Buy an index fund" is superfluous to your long-term success in investing in mutual funds.

The rest of this brief little tour of mutual fund investing will simply seek to tell you in broad strokes why you are probably best off buying an index fund, and even why you might want to avoid some companies' index funds. [Hint: It's because some mutual fund families, having heard about the success of low-cost index funds, are trying to sell index funds with sales loads and annual expenses that destroy the advantage of index funds. These fees and expenses are the antithesis of what index funds are all about.] But, if you're getting bored already, realize that if you can remember our four-word overview, you already know a lot more than most mutual fund owners seem to know.

The Boring Technical Stuff

Mutual funds are financial intermediaries. They are companies set up to receive your money, and then having received it, to make investments with the money. When you buy mutual fund shares, you are a shareholder -- an owner -- of that mutual fund, with voting rights in proportion to your ownership of the fund.

Every mutual fund issues a prospectus, which is written in the driest, most confusing, boring, tedious language possible, but which somewhere describes the fund's investment policies and objectives, risks, costs (very important -- that's why we put it in bold), historical performance data, and various other legalese-encrusted tidbits. The prospectus, in essence, will describe the investment style of the fund. Nowadays, you can also find the essential information about mutual funds on various Internet sites. You can begin your research (once you've finished reading our little section) at Morningstar's site, where you'll find data and analysis on over 8500 mutual funds.

Good Things About Mutual Funds
It's a pretty short list. Keep your eyes open while it sails past you, or you might miss it:

  • Diversification. Buying a mutual fund provides instant holdings in several different companies, giving a level of stability to your investment.
  • Liquidity. Like individual stocks, a mutual fund investment can be converted into cash upon your request.

The Things About Mutual Funds That Really Bug Us

  • The Wisdom of Professional Management. That's right, this is not an advantage. The average mutual fund manager provides stock picks no better than the average non-professional, dart board, or stock-picking hamster, as far as we can tell. Annual fees charged by the well-dressed mutual fund manager, however, are significantly more than what it costs to feed a hamster.
  • No Control. Unlike picking your own individual stocks, buying a mutual fund puts you in the passenger seat of somebody else's car.
  • Dilution. The downside of diversification. The Mergon Stanlynch 2000 Best Ideas Fund holds so many different stocks that insanely great performance by a fund's top holdings still won't make much of a difference in the fund's total performance.
  • Buried and Confusing Costs. Mutual funds specialize in burying their costs.

Fund Classifications

Mutual funds come in every possible size, shape, and color. Here are some of the general categories of mutual funds.

  • Bond Funds: Bond mutual funds are pooled amounts of money invested in bonds. Bonds are IOUs, or debt, issued by companies or governments. A purchaser of a bond is lending money to the issuer, and will usually collect some regular interest payments until the money is returned. Usually, the amount of interest paid (the coupon) is fixed at a set percentage of the amount invested, thus, bonds are called "fixed-income" investments.
  • General Equity (Stock) Funds: Stocks represent part ownership, or equity, in corporations, and the goal of stock ownership is to see the value of the companies increase over time. Stocks are often categorized by their capitalization (or market cap), and like many other things come in three basic sizes: small, medium, and large. Many mutual funds invest primarily in one of these sizes and are thus classified as large-cap, mid-cap, or small-cap funds. Additionally, mutual funds are often categorized by the type of stock that is bought. Mutual fund types are generally "growth," "value," or a combination of the two, called "blend."
  • Balanced Funds: Balanced funds mix some stocks and some bonds. A typical balanced fund might contain about 50-65% stocks, and hold the rest of the shareholder's money in bonds and cash. It is important to know the distribution of stocks to bonds in a specific balanced fund to understand the risks and rewards inherent in that fund.
  • Global/International Funds: Global and international funds invest in companies whose homes are beyond the fair shores of this great nation. (There are, of course, many other great nations.) In general, international funds are much more volatile than domestic funds. International funds generally invest only in foreign companies, while global funds may invest in some U.S.-based companies in addition to foreign companies.
  • Sector Funds: Sector funds invest in one particular sector of the economy: technology, banking, computers, the Internet, llamas. Just kidding about the llamas. No one has yet started the Llama Fund, though it's only a matter of time given that there is a mutual fund called the Couch Potato Fund, which invests in, as far as we know, the "remote control" sector. Sector funds can be extremely volatile because the broad market will find certain sectors very attractive and very unattractive often in rapid succession (much like couch potatoes may find certain programs very attractive and very unattractive in rapid succession -- annoying the heck out of their significant others).
  • Index Funds: Finally, our favorite -- the index mutual fund owns a full participation in some portion of the stock market. An index fund matches the shareholdings of a target index, such as the Standard & Poor's 500 Composite Stock Price Index (S&P 500). Index funds are distinct from actively managed mutual funds in that they do not involve any stock picking by supposedly skilled professionals -- they simply seek to replicate the returns of the specific index. The Motley Fool Index Center offers a complete description of some of the major indexes you may have heard of.

Okay, so now you know what mutual funds are, where to find out a little information about them, and the different types of mutual funds you're likely to run across. Lately, mutual funds have been getting a lot of good press for providing handsome rewards to their shareholders. But is that true? Are the double-digit growth rates of equity mutual funds during the past couple of years really impressive?

No -- definitely not. Definitely, absolutely, without question, mutual funds should be embarrassed by their performance over the past couple of years.

Next: How to Choose a Mutual Fund »

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