Mutual Funds and their cousins, the Exchange Traded Fund (ETF) are very common, but also commonly misunderstood. Let’s take a closer look.
We’ll start with mutual funds. Most of what we talk about here applies to ETFs as well. We’ll talk about the differences later in the post.
Think of a mutual fund as a basket of securities. Investors choose a mutual fund because it allows them to participate in the market without having to pick and choose individual securities (stocks and bonds) themselves.
Open End Funds & Net Asset Value (NAV)
Most mutual funds are open end funds. In open end funds, there are not a fixed number of shares. Investors enter buy and sell orders throughout the day. After the market closes, the fund calculates its Fund Net Asset Value (NAV) by valuing all of its securities at that day’s closing price and subtracting out any liabilities. Any mutual fund share trades are then processed using that day’s NAV per share. This is a bit confusing. The term NAV is often used for both the fund’s total net asset value (i.e. total worth) and for its share price which is the total net asset value of the fund divided by all outstanding shares. In the context it’s usually clear which is meant, but it can cause confusion.
Based on the buys and sells, the mutual fund will either have cash available to buy securities (if there are more buys than sells) or may have to sell securities if there are more sells than buys. I use the word may because the fund will typically maintain a cash position to cover expenses as well as redemptions. The fund only sells securities if the amount of redemptions is above what is anticipated.
The next day, after all this accounting is complete, the fund manager knows his net cash position and will buy and sell securities. At the same time, investors are entering mutual fund buy and sell orders. After market close, this whole process begins again.
That’s a lot. Let’s clarify
The mutual fund investors – the individuals who are buying or selling shares of the mutual fund are putting in orders throughout the day, and are receiving a price (and # shares) after the market closes and the fund values its portfolio. The fund is buying and selling securities (shares of Walmart, Ford, Amazon, etc.) during the trading day. At the end of the trading day, the mutual fund determines the value of all of its holdings (based on the day’s closing price), divides that value by the current shares outstanding to set the new fund NAV per share, and processes the investor orders based on that NAV.
How About an Example
Here’s a hugely simplified example of how this works. Our mutual fund has $100 in Fund Net Asset Value. This is the total of all securities owned, minus any liabilities. There are 10 shares outstanding so the NAV per share is $10.
Today, there is only 1 order. One investor is investing $10 in our fund.
At market close, our fund values all of its securities and liabilities and its fund net asset value remains at $100, so our NAV per share remains at $10.
The investor gets 1 share for the $10 invested.
Now the Net Asset Value of the fund is $110 (the original $100 + the $10 invested) and the number of shares outstanding is 11 (we had 10, but the investor just bought one. The fund creates a new share for this investor). The NAV per share is still $10 (Fund Net Asset Value of $110 / 11 shares outstanding).
The fund took in 10 new dollars, created 1 new share and the existing shareholders were not impacted. The NAV per share remains $10.
Closed End Funds
Some mutual funds, and most ETFs are considered closed end funds. Closed end funds have a fixed number of shares and trade on an exchange.
In these types of funds, the fund manager creates a basket of securities, similar to the way an open end fund does, but it does not create new shares with every buy or destroy shares with every sell. The number of shares available to trade is fixed. If you want to buy shares, you put in an order and it is matched with a seller and the trade takes place during market hours. Same for sell orders. The price is determined by the market and not directly by the value of the underlying securities. Closed end funds trade at a discount or premium to market value. You may get a bargain or pay a premium for shares based on the market’s view of the value of that basket of securities.
Recap
That’s a lot….don’t let it scare you. Mutual Funds and ETFs are a great way for an investor to get instant diversification – they can own shares of a fund that does the hard work of choosing individual securities to buy and sell. If you are a long-term investor, how it trades or values its portfolio probably should not be your deciding factor. Composition, Cost and Performance should take precedence.
My retirement plan’s investments are a series of mutual funds. How do I choose?
Composition
The first thing to look at is the asset class of the fund. The fund could be an equity fund, which largely holds stocks. Stocks are shares of publicly traded companies like Amazon, Netflix, Coca Cola, or Walmart. Stocks tend to be a more volatile asset. Their value (stock price) can change dramatically.
The fund may be a fixed income fund which largely holds bonds. Bonds tend to be less volatile than stocks, but they can still see major fluctuations (as your friends at the former Silicon Valley Bank will tell you).
The fund may be a blend that has equity and fixed income. We’ll talk a lot more about equity and fixed income in upcoming posts. For now, it’s enough to know that over the past 100 years or so, equities have outperformed fixed income in the long-term, but have had more periods of extreme volatility than fixed income. Both play an important role in your portfolio.
Great info, but how do I choose?
A common piece of investing advice is to take 100 – your age to determine the % of your portfolio that should be in equity. So, if you’re 60, 100-60=40, you should be 40% in equity and 60% in cash and fixed income. If you’re 20, 100-20=80, you should be 80% in equity. As you get more experienced, you’ll tweak this, but it is not a bad place to start.
Investment Objective
Now that you know the asset class of a fund, you want to get a general understanding of the types of securities it holds. There are thousands of funds and almost as many investment objectives. The investment objective is a good place to start. It’s a short paragraph that generally describes how the fund will invest. This will tell you if it is buying large cap US stocks, small cap emerging market stocks, European bonds, long duration bonds or short term treasuries. Most investor websites, as well as finance.yahoo.com and other sites will have a holdings tab that will give you more details of the fund’s asset allocation, the sectors it is invested in, the countries it invests in and the top 10 holdings.
Active v. Passive Management
Next, you should consider whether the fund is actively managed or passively managed. Active management is when there is a fund manager, or team of fund managers who choose securities. Passive management is an automated approach. Under passive management, the fund tracks an index.
Let’s look at an example. The Fidelity 500 Index Fund is a passively managed mutual fund that tracks the S&P 500 index. The S&P 500 index is a list of the 500 largest US companies and the weight of each company in the index. Weight is determined by the size of the company. Larger companies make up a greater % of the index.
There is no active management team that makes buy and sell decisions for this fund. Instead, on a periodic basis, the fund’s holdings are rebalanced to realign with the index. For example, if a company went through a rough patch and decreased significantly in value. It may no longer be one of the 500 largest companies so it would drop out of the index to be replaced by another company. At the next rebalancing, the fund (and every other S&P 500 Index fund) would sell the first company and buy the 2nd to realign with the index.
Cost
A passive fund has much lower expenses because its portfolio management is automated. It doesn’t have to pay fund managers and research analysts who are picking stocks. For this reason, the expense ratio (the fund management costs that are passed on to the investor) are much lower. It is very important to know the expense ratio of your fund. For example, the Fidelity 500 Index Fund, a passive fund, has an expense ratio of 0.015%. That means for every $10,000 you have in the fund, you pay $1.50 per year. You don’t get a bill, this is taken out of the fund automatically.
An active fund will typically have a higher expense ratio. The Fidelity Contrafund is a popular actively managed equity fund. Its expense ratio is 0.55%. That means for every $10,000 in the fund, you pay $55 per year. This is over 30 times more than the passive fund costs.
Cost can have a big impact on returns
Online there are lots of investment expense calculators. Here is the one I used. I ran a quick compare and assuming you invested $10,000 in each of these funds for 30 years, the index fund would cost you $243 in fees, while the Contrafund would cost you over $8,000 in fees. This example assumes an investment return of 6% per year for each investment. Note that because the value of your investment grows every year, the fee grows in proportion. For example, if your $10,000 invested in the Contrafund grew to $11,000 in one year, in year 2, you would pay $60.50 ($11,000 x 0.55%). The expense ratio remains the same but it is applied to the higher balance.
OK, so this is how expense ratios work. You will pay more for active management. This does not however mean that the passive fund is always the better choice. Do you expect more growth from the active fund manager? There may be reasons why it’s worth paying for active management.
Performance
“Past performance is no guarantee of future results.” This is a standard disclaimer on investment materials. It’s meant to protect you. Just because a security gained 20% this year, doesn’t mean it will next year. That said, we’re all looking for an investment that is going to perform well. One of the factors will be whether it has outperformed in the past. Assuming the fund manager or management team hasn’t changed, it is fairly reasonable to assume that a fund that has beaten it’s peers over the last 1, 3, 5, and 10 year periods will continue to perform well more often than not. One of my personal observations is that the hot fund one year is often not the hot fund the next year. Consider performance over 3, 5 and even 10 years.
Recap (2)
Composition, Cost and Performance are 3 key factors in evaluating whether a mutual fund is right for you. As you begin to invest, and read more, you’ll get more comfortable.
Here’s my 2 cents….If you are a beginning investor, choose a nice passive fund with a low expense ratio. Choose something that follows an index that is familiar like the S&P 500 index – the 500 largest US companies. Maybe stay away from a passive index that follows the emerging markets equity index. What do you really know about emerging markets? What are they and what are they emerging from? Stick with the familiar when you are starting out.
How do I get my money out?
Here’s an important question. We talk a lot about which funds to choose and how to invest, but what if you need your money back? One of the great things about mutual funds is that they are very liquid. Be sure to read a fund’s prospectus (ok…it’s really boring with lots of fine print. You don’t have to read every word, but search for the section on redemptions). For most US mutual funds, if you put in a sell order during trading hours today (before 4pm eastern) your redemption will process overnight and be in your account in cash tomorrow. Depending on the type of account, there may be rules about how you can get the cash out and what taxes you will pay.
Other fees
The expense ratio is the only fee you should pay. That fee is taken out of the fund directly so you don’t write a check for it.
In rare cases, you may see funds that have a sales charge. This is also called a load and can be a front-end load or a back-end load, or a deferred sales charge.
If a fund has a front-end load, you will pay a higher price for the shares than they are actually worth. That fund will have a public offer price (POP), which is higher than the fund’s net asset value per share (NAV).
For a back-end load, you will pay a percentage when you redeem the shares.
A deferred sales charge is like a back end load but the % declines over time.
These other fees typically only show up when you are buying shares through an intermediary. If you are buying directly from the fund company (Fidelity, Vanguard, ishares) you will not pay a load.
You may also see some funds that have a 12b-1 fee. This is a charge that is applied to your investment to support the firm’s marketing expenses for the fund. You should never pay a 12b-1 fee. The Securities and Exchange Commission (SEC) is working to eliminate them.
ETFs
ETFs are almost identical to mutual funds. Like mutual funds, they are a basket of securities. The big difference is that they trade on an exchange during market hours, while an open-end mutual fund takes orders during the trade day and processes those orders after hours. There are opinions that ETFs are more cost-efficient, or more tax-advantaged because they don’t trade as frequently, but I like to avoid generalizations like this. Read the prospectus, or at least the summary prospectus to see how the investment operates to determine if it is right for you.
Final Recap
Congratulations! You got through quite a bit of information. Hopefully it made sense. I think it is important for anyone who invests in mutual funds to understand a little bit about how they work so that they can feel confident in their investment. We’ll talk a lot more about the stocks and bonds that are in your mutual funds and how they behave. When you understand this, it is much easier to be a confident investor and stick to your game plan, even in times when the market is working against you.
As always, please post comments and questions. I’d love to hear your thoughts.