It may not be the sexiest subject in the world, but the
mutual fund
is one of those few
financial instruments well within the reach of
almost everybody, so it's about time for a (mostly) serious writeup.
The Basics
Let's say our friends Joe and Bob want to invest in the
stock market. Joe ponies up $5000, Bob matches him, and they use
the total fund of $10000 to buy stocks. If any profits from
the fund are mutually shared out to both Joe and Bob, they now
have a simple mutual fund. That's really all there is to it...
except that in real life Joe and Bob are probably too busy to
micromanage their fund, so they'll hire their buddy Chuck
to do the dirty work, perhaps paying him a commission of 10%
on the profits.
Note, however, that the profits of a mutual fund are only
theoretical until the money is actually withdrawn. If Joe & Bob's
stocks go up by 10% during a year, they have to sell them all to
realize their $1000 profit.
Why Mutual Funds Are Good
There are three major advantages to using a mutual fund instead of
just buying stocks on your own:
- Diversification. If you only have $5000, you can't really
buy shares in very many companies, so if even one of those companies
tanks your profits may be wiped out. Mutual funds have big pots of
money and can buy lots of shares, reducing the total risk of
your investment.
- Economies of scale. If you buy one share of Acme, the
commission will be a pretty hefty percentage of the value of
that share. When a mutual fund buys one million shares of Acme,
they pay a lot less per share.
- Last but not least, the non-financial advantage of
mental health: maintaining your own stock portfolio can involve a
lot of stress and work, as you have to constantly worry about
what to sell, what to keep and what to buy. Why not sit back,
let the money roll in, and let someone else get the ulcers?
Why Mutual Funds Are Bad
Now, your investment bank would love to tell you that they are
also far more experienced than you at picking out shares that
will perform well, and will throw statistics at you to prove it.
Not so -- the issue has been studied a lot, and
the long and short of it that the performance of mutual funds
fits right on the same bell curve as picking stocks at random
(ie. letting monkeys throw darts at the stock pages).
In fact, the mean of the bell curve underperforms the
DJIA, because three factors are playing against you:
- Commissions. Fees vary widely by company and risk, but
usually you'll pay a percent or two whenever you put money in
the fund or take money out, and also once per year as a management charge.
- Soft money. The mutual fund's stock broker makes a
hefty chunk of change whenever those 1,000,000 shares of Acme
change hands, so the stock broker loves it when the mutual fund
churns a lot, buying and selling stocks all the time.
How to best encourage this? Why, by giving a kickback. Actual
bribery is of course illegal, but trips to Hawaii, letting
their buddies rent a swanky Wall Street office for $1/month and similar
types of soft money aren't. The only loser in this is
the investor, especially in those funds where the small print
says that the investor pays the broker's fees as well.
- Dividends. Stock owners get dividends when the company has a good year, but the dividends paid to the mutual fund go to the fund operators, not you.
So how can all investment banks claim that 95% of
their funds
outperform the average? Simple -- those
that don't get rolled into other funds, and thus
cease to exist. This is why investors tend to distrust
funds that haven't been around for at least a few years.
How to Pick a Mutual Fund
Just the same, I think that the advantages outweigh the disadvantages,
as long as you choose your fund wisely. Alas, choosing one is
every bit as complex as picking out a stock in which to invest,
so all I can do is offer some rules of thumb.
A few words about the investment bank you choose: be sure to
read the small print about the commissions. The fees can be
pretty hefty, especially for small investors, which for banks
means less than $100,000. Some funds now market
themselves as no-load funds, meaning that they
charge no commissions except for a percentage of profits.
This can be a saving grace
in a slow economy and has the additional advantage of
discouraging spurious churn, but is not so hot during a boom.
Also remember
that in nearly all countries money earned with a mutual fund is
taxable income. Shop around and try out the
comparison calculators you can find on many financial websites
these days.
The central equation in investment is that rewards require risk.
If you want to double your money in a year, you'll have to pick
a fund that invests only in Bulgarian Internet companies,
and risk losing all your money when Plonsky Internyet's CTO
Vladimir heads for the Bahamas with the company's IPO proceeds
in a suitcase. On the other hand, if you're
happy with a return on investment a percent or two higher
than the bank interest rate and have ten years to spare, you can
be satisfied with a more conservative fund.
Stocks vs. Bonds
The two big financial instruments bought by mutual funds are
stocks and bonds. Funds usually spell out their investment
policy and most invest only in a certain type of stock or bond,
although there are some multimarket funds that can invest in
pretty much anything.
A stock is a share in a company, so its value fluctuates with
the company's value. Stocks are risky, stocks in emerging markets
are very risky, and stocks in small companies are extremely risky.
(Investing in Bulgarian Internet companies is thus suicidally risky.)
However, in the long run -- meaning over 10 years -- stocks on
the Dow Jones have gained about 12% a year. A special type of
mutual fund called
an index fund buys stocks that match the weighting of a
major index like the DJIA, which means that -- again, in the
long run -- the index fund will go up by 12% a year, minus any
commissions. In my humble opinion, these are a pretty good
bet for the long-term investor who can afford to ride out any
recessions.
A bond is a promise by a company or a government to repay a loan
with interest. Unlike stocks, which are unpredictable, the
interest on a bond is fixed and the only risk comes from the
possibility that the issuer may default (read: go bankrupt).
If you buy U.S. Treasury bonds, this risk is pretty minimal,
but this is also why bonds earn little -- 10% in a good year, 0% in
a bad one, long-term average around 6%.
Bonds are a good bet if you cannot afford to lose
the money, are afraid that you may need to withdraw it suddenly,
or the stock market is tanking or showing irrational exuberance.
The third category of mutual funds is the hedge fund, which
involve complicated financial jiggery-pokery and
promise absolute returns, ie. the gains of stocks with the
security of bonds. If this sounds like too good to be true, it
probably is. The entire concept is a relatively new, untested
and above all unregulated one, and most hedge funds also have pretty
prohibitive minimum investments, so if all this is new to you
you'll probably want to steer clear.
Open-End vs. Closed-End
There is also one more division based on how
the fund is structured. In an open-end fund
anybody can join or leave the fund at any time,
and the value of a share in the fund
depends only on the fund itself. (This value is known
as the Net Asset Value or NAV, and you can find
listings for popular funds in financial newspapers.)
The down side is
that the size of the fund fluctuates
constantly, and the manager has to buy and sell shares
constantly to compensate.
A closed-end fund, on the other hand, is set up
with a fixed amount of money
and accepts no new investors, reducing churn.
The only way to join a closed-end fund is to get
someone to sell your their part of the fund,
so the value of the fund depends on supply and demand.
The down side is that timing matters -- it's not enough
to want to sell, you need to find a buyer at your
price too. (Yes, this sounds like a stock, and
that's why many closed-end funds are exchanged like
stocks on the NYSE.)
How to Invest
Most funds will require a minimum investment on the
order of $1000, and some have much higher requirements.
You can usually arrange to have a fixed amount of
money placed in the fund every month, making the
process of building up your fund more painless.
Invest wisely and follow this regimen long enough,
and when your children graduate or it's time to retire
you'll have a handy sum on hand.
You can (and probably should) diversify your
investment by buying
several funds, placing some
money in bonds for security and stocks for growth.
Figure out what your needs are and how much you can
spare; just remember that once you get into mutual
funds, there's little point to keeping cash around
on low-interest bank accounts.
Obligatory Disclaimer
Past performance is not a guarantee of future profits. It's your
money, you do what you want with it, and don't come
crying to me if the
Osmium Bulgarian Internet Growth and Security Fund goes tits up.