What is a Mutual Fund

 

A mutual fund is simply a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. The mutual fund will have a fund manager who is responsible for investing the pooled money into specific securities (usually stocks or bonds). When you invest in a mutual fund, you are buying shares (or portions) of the mutual fund and become a shareholder of the fund.

Mutual funds are one of the best investments ever created because they are very cost efficient and very easy to invest in (you don't have to figure out which stocks or bonds to buy).

By pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. But the biggest advantage to mutual funds is diversification.

The Major Advantage - Diversification

Diversification is the idea of spreading out your money across many different types of investments. When one investment is down another might be up. Choosing to diversify your investment holdings reduces your risk tremendously.

The most basic level of diversification is to buy multiple stocks rather than just one stock. Mutual funds are set up to buy many stocks (even hundreds or thousands). Beyond that, you can diversify even more by purchasing different kinds of stocks, then adding bonds, then international, and so on. It could take you weeks to buy all these investments, but if you purchased a few mutual funds you could be done in a few hours because mutual funds automatically diversify in a predetermined category of investments (i.e. - growth companies, low-grade corporate bonds, international small companies). On the next page, I clearly explain how diversification works using a "Wheel of Fortune" concept.

Spin the Mutual Fund Wheel

Imagine you have two wheels in front of you, each with different possible outcomes - kind of like the Wheel of Fortune Game show, only each pie piece represents a different return on your money.

Your task is to choose which wheel you would like to spin and you will have to live with the randomly produced result listed on the wheel.

The first wheel represents purchasing a single stock. If you choose to spin it, there is basically a 50-50 chance that you will either make money or lose money. It is like flipping a coin. And among the winning and losing wheel pieces there is a great range of possible outcomes - from a loss of 50% to a gain of 50%.

The second wheel represents purchasing a mutual fund that holds many stocks. This time there is a better chance that you will make money because there are only two pieces that represent a loss. The range is a bit smaller - from a loss of 11% to a gain of 35%.

 

Take a close look at the wheels and think about which wheel you would rather spin. And remember, this is not a game. This is your hard earned cash that you are investing!

Choose between:

·        Wheel 1: One Stock- No Diversification

·        Wheel 2: Many Stocks (Mutual Fund)- Diversification

The second wheel should be the obvious choice. By purchasing many stocks you have reduced your risk and increased your chance of a winning spin. As I mentioned earlier, you can go beyond this level of diversification by purchasing other mutual funds with different objectives. 

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Mutual funds – There’s one for you

Different Strokes for Different Folks

Being a collection of many stocks, you may have thought that picking a mutual fund might be easy. Not necessarily... there are over 10,000 mutual funds to choose from. It is easier to think of mutual funds in categories.

I won't discuss every category because this article is designed for the beginning investor (read other articles on this site for more in-depth information on funds).

Money Market Funds

These funds are a great place to park your money. Whether you're storing money for emergencies, saving for the short-term, or looking for a place to store cash from the sale of an investment, money market funds are a safe place to invest. These funds invest in short-term debt instruments and typically produce interest rates that double what a bank can offer in a checking account or savings account and rival the returns of a CD (Certificate of Deposit).

 

The beauty of money market funds is that you can often write checks out of your account and they provide a high amount of liquidity (ability to cash out quickly) not found in CD's. These funds are not FDIC insured, but in the history of money market funds no money market fund has ever folded, yet many banks have failed and many investors with over $100,000 lost out.

 

Bond Funds

Bond funds carry more risk than money market funds are often used to produce income (useful in retirement) or to help stabilize a portfolio (diversification). The primary types of bond funds are:

• Municipal Bond Funds -uses tax-exempt bonds issued by state and local governments (these funds are non-taxable).
• Corporate Bond Funds -uses the debt obligations of U.S. corporations.
• Mortgage-Backed Securities Funds - uses securities representing residential mortgages.
• U.S. Government Bond Funds -uses U.S. treasury or government securities.

Another way bond funds are often classified is by maturity, or the date the borrower (whether it be the bank, the government, a corporation or an individual) must pay back the money borrowed. Using this classification bonds are often called short-term bonds, intermediate-term bonds, or long-term bonds.

 

Stock Funds

Stocks funds are considered riskier than bond funds (although certain bond funds can be very risky) and are used for growing your money. Money market funds and bond funds typically provide returns just a percentage or two above inflation, but stock funds should do much better over long periods of time.

There are many types of stock funds (also referred to as equity funds). As you can imagine, stock funds are more popular than bond funds and money market funds, especially for younger investors. Here's a break down of the most common types of stock funds:

Strategy Types

• Growth Funds - These funds invest in stocks believed to be the fastest growing companies in the market. Growth funds rarely provide dividend income and are considered risky investments.
• Value Funds - These funds invest in large and mid-sized companies that appear to be overlooked or out of favor. These undervalued stocks tend to pay dividends.
• Blend Funds - These funds are a "blend" of both growth and value stocks.

By Size

• Large-Cap Funds - These funds invest in companies whose market value (# shares outstanding X current market price) is large. By large, I mean greater than $9 billion. These "blue-chip" funds tend to be well-established corporations and tend to pay dividends.
• Mid-Cap Funds - These funds invest in mid-sized companies whose market value is more in the range of $1 billion to $9 billion.
• Small-Cap Funds - These funds invest in emerging companies whose market value is less than $1 billion. These companies tend to use profits to grow rather than pay dividends.

Index Funds

These funds try to mimic a chosen index. Examples of indices include the S&P 500, NASDAQ, and the Russell 2000. An index is simply a group of stocks chosen to represent a particular segment of the market. Usually this is accomplished by purchasing small amounts of each stock in a market.

Index funds are a hands-off approach to investing. The manager is not trying to find the hot stocks or great deals. Instead, the manager is simply trying to match an chosen index. The results are funds that are very cost efficient, meaning the operating costs are very low, and often beat most actively managed funds.

International Funds

• Global Funds - These funds invest in both U.S. and International stocks.
• Foreign Funds - These funds invest primarily outside the U.S.
• Country Specific Funds - These funds focus on one country or region of the world.
• Emerging Markets Funds - These funds focus on small developing country and are considered very risky.

Sector Funds

Sector funds choose to invest in a particular industry or segment of the market. Examples of sectors include automotive, technology, baking, air transportation, biotechnology, health care and utilities.

Sector funds are considered less diversified than most mutual funds, but they do offer diversification within a particular industry.

There are some variations of mutual funds that were left out (for example funds that invest in both stocks and bonds called hybrid funds), but you should now have a fair understanding of the different kinds of mutual funds.

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Origins of Mutual Fund Investing

When three Boston securities executives pooled their money together in 1924 to create the first mutual fund, they had no idea how popular mutual funds would become.

The idea of pooling money together for investing purposes started in Europe in the mid-1800s. The first pooled fund in the U.S. was created in 1893 for the faculty and staff of Harvard University.  On March 21st, 1924 the first official mutual fund was born. It was called the Massachusetts Investors Trust.

After one year, the Massachusetts Investors Trust grew from $50,000 in assets in 1924 to $392,000 in assets (with around 200 shareholders).

In contrast, there are over 10,000 mutual funds in the U.S. today totaling around $7 trillion (with approximately 83 million individual investors) according to the Investment Company Institute.

The stock market crash of 1929 slowed the growth of mutual funds. In response to the stock market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws require that a fund be registered with the SEC and provide prospective investors with a prospectus. The SEC (U.S. Securities and Exchange Commission) helped create the Investment Company Act of 1940 which provides the guidelines that all funds must comply with today.

With renewed confidence in the stock market, mutual funds began to blossom. By the end of the 1960s there were around 270 funds with $48 billion in assets.

In 1976, John C. Bogle opened the first retail index fund called the First Index Investment Trust. It is now called the Vanguard 500 Index fund and in November of 2000 it became the largest mutual fund ever with $100 billion in assets.

One of the largest contributors of mutual fund growth was Individual Retirement Account (IRA) provisions made in 1981, allowing individuals (including those already in corporate pension plans) to contribute $2,000 a year. Mutual funds are now popular in employer-sponsored defined contribution retirement plans (401k), IRAs and Roth IRAs. 

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Market Timing – Is it Worth the Risk?

What a difference time makes . . .

Market timing can be costly!

Over the past several years, investors have become aware of how volatile the stock market can be.  One unfortunate result of this awareness is an increase in market timing—jumping into and out of the market in an effort to avoid market downturns and corrections.

Market timing can be dangerous to your long-term financial health.  In fact, it can often result in lower returns than if you had simply ignored market volatility altogether. 

Missing out can cost you

In a perfect world, equity gains would be steady and even.  In the real world, however, gains often come in the form of short, sudden market spikes.  Unfortunately, there’s no real way of knowing just when those spikes will occur, and missing out on them can be very costly.

An example will illustrate this point.  Let’s assume you invested $10,000 in the Toronto stock index back on December 31st of 1993.  As of December 31st of 2003, that amount would have doubled and you would have enjoyed an average annual return of 8.6%.  If you had missed the 10-best single-day performances during that time span (that’s only 10 days out of 2,519), your return would have dropped to 4.40%.  If you had missed the 30-best performances, your return would have been -1.80%. At the same time, that $10,000 investment would have declined significantly in value.  

	annual return	growth of $10,000
fully invested (2,519 days)	8.60%	$22,745
missed 10 best days	4.40%	$15,329
missed 30 best days	-1.80%	$8,341
missed 60 best days	-8.10%	$4,314

Source:  Bloomberg. S&P/TSX Composite Total Return Index values

As the figures show, the more you try to time the market, the more chance you have of missing out on these unexpected single-day gains. 

Perfect timing doesn’t always mean perfect performance

Even if you could time the market perfectly, it wouldn’t always translate into significant gains.  In fact, there have been many times when it probably wouldn’t have made a big difference to your portfolio at all.

On “Black Monday,” October 19, 1987, the Dow Jones Industrial Average lost 22.6% in a single day (the TSE 300 Composite index lost 11.3%).  If your timing was bad and you had invested immediately preceding Black Monday and had held that investment for five years, you would have averaged 11.9% per year.  If, on the other hand, your timing was good and you had bought after the crash and had held for the same time period, you would have made 12.6% per year.  That’s a difference of only 0.7%.

Instead of worrying about short-term events, review your personal investment goals with your financial advisor, and maintain your investment discipline.  Rather than stay on the sidelines, often the best thing you can do for your portfolio is to stay in the market, no matter what direction it may be going in the short term.

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