Contents
Mutual Fund Basics
Why Invest in Mutual Funds?
Mutual Fund Returns
Types of Mutual Funds
Mutual Fund Investment Holdings
Funds vs. ETFs, Stocks, and Bonds
How to Plan a Mutual Fund Portfolio
How to Research Mutual Funds
How to Buy Mutual Funds
|
 |
 |
 |
|
Types of Mutual Funds
There are currently about 10,000 mutual funds in which you can invest. To make it easier to navigate this broad universe of funds, it’s helpful to categorize them into groups. There are four main ways to classify mutual funds:
- Active vs. passive (index) funds
- Load vs. no-load
- Open-end vs. closed-end
- By type of investment holding
This section will explain the first three classifications, while the next section will explain the fourth. Note that a single fund can fit into more than one of these classifications. For instance, the Vanguard 500 Fund is a no-load index fund.
Active Funds vs. Passive (Index) Funds
The difference between actively- and passively-managed funds lies in the role of the fund manager.
- Actively-managed funds: Managers of actively-managed funds use their expertise and research to hand-pick the fund’s investments on an ongoing, “active“ basis in order to maximize returns.
- Passively-managed funds: Passively-managed funds, or index funds, attempt to mimic the performance of a particular market index, a group of investments that serves as a benchmark for the performance of other investments. For instance, an index fund that mirrors the S&P 500® index will hold most of the stocks included in the S&P 500 index in the same proportion in which they compose the actual index. An index fund manager’s role is to ensure that the holdings and performance of the fund mirror those of the index.
Because managers of actively managed funds trade more frequently and earn higher salaries than index-fund managers, actively managed funds have higher turnover rates and expense ratios than index funds do. The average expense ratio for an actively managed fund is 1.50%, while most index funds have expense ratios below 0.25%.
Why Most Actively-Managed Funds Aren’t Worth It
Investors who buy actively managed funds expect that the expertise of the fund managers will offset the lower costs of the index funds. However, not only do most actively managed funds fail to beat the performance of related index funds by such a margin, a significant number fail even to match the index fund at all. A number of studies have shown that during periods of at least five years, only 33% of actively managed funds that invest in securities like those in the S&P 500 actually beat the performance of the S&P 500 index. This makes index funds the best bet for most individual mutual fund investors.
If you’re still determined to look for an actively managed fund that will try to beat the index, look for funds whose managers have:
- Led the fund for at least ten years
- Beaten the index for the past five consecutive years
For more on how to choose funds, see How to Plan a Mutual Fund Portfolio.
Load Funds vs. No-Load Funds
Loads are sales fees that some mutual funds charge investors in addition to standard fund fees, such as expense ratios. No-load funds impose no sales charges at all beyond standard fees, such as expense ratios. Load funds are usually offered by brokers or financial advisors who receive a commission for selling the funds to their clients. There are three different types of loads that load funds charge:
- Front-end load: You pay a portion of your total initial investment as a one-time commission.
- Back-end load: You pay a declining percentage of your final fund balance each year following the year in which you sell your shares.
- Level load: You pay an ongoing sales charge on a regular basis as long as you own shares.
Why You Should Never Buy Load Funds
Investors often make the mistake of assuming that load funds must make up for the prices they charge with stellar performance. This is not so. Instead, load-fund managers have the formidable challenge of not only beating the fund’s index, but beating it after all the load expenses are taken into account. Since very few load-fund managers can pull this off, load funds end up lagging ordinary no-load funds in performance and cost investors more in fees along the way. With thousands of inexpensive no-load funds available, there’s just no good reason to buy load funds.
Open-End Funds vs. Closed-End Funds
Open-end funds are funds that can issue as many shares as necessary to meet investor demand. The price of each share is determined by the fund’s net asset value (NAV), rather than by the supply and demand for the fund’s shares in the marketplace. For instance, the price of an open-end fund that consists of large-cap stocks would fluctuate as the share prices of the stocks that it contains fluctuate, not as more investors line up to buy or sell the fund.
Closed-end funds issue a fixed number of shares. The value of closed-end funds is determined by the demand for the shares based on their supply, rather than by the fund’s NAV. Closed-end funds trade on stock markets, so their value changes constantly as demand fluctuates throughout the trading day.
Why Buy Closed-End Funds?
The vast majority of mutual funds—about 98%—are open-end funds. Some investors favor closed-end funds because it’s sometimes possible, when demand for the shares wanes, to buy shares at a discount to their NAV, pushing the price down below what the shares should be worth. This strategy doesn’t always work: as with stocks, how the market values closed-end fund shares always matters more than what they should be worth based on their fundamental value. The best reason to buy closed-end funds is the same reason you should buy open-end funds—you believe the value of the fund’s assets will grow over time.
| Acknowledgments & Disclaimer |
