Mutual funds are one of the financial world’s most popular investment vehicles, and for good reason.
For a relatively small investment, these funds give individual investors the ability to buy a diverse portfolio of stocks and / or other financial instruments – all in one transaction.
If you have just two or more mutual funds, chances are that you’re more than adequately diversified. This means that you don’t have to worry about one bad apple (i.e. Enron) destroying your entire investment account.
How Mutual Funds Work
So how do these funds work? Each fund is actively managed by a mutual funds professional. This is someone who has several years of experience analyzing and trading stocks or other securities, probably has an advanced degree, and has worked his or her way up the ladder to what is essentially the top of the money management profession.
The fund manager chooses the securities that the mutual fund owns. These funds can be composed of stocks, bonds, and / or other financial instruments.
The types and balance of securities (i.e. 60 percent stocks, 35 percent bonds, 5 percent cash / money market), and the investment objectives and strategies (i.e. aggressive growth or equity income) are listed in the mutual fund’s prospectus.
This way investors know what they are getting into each time they buy new mutual funds.
Mutual funds are split into shares, just like stocks. For example, a fund may own 5,000 shares of Microsoft (MSFT); 10,000 shares of General Motors (GM); 20,000 shares of Alcoa (AA), etc., and be split into 100 million shares itself.
If the net asset value (NAV) of the shares is $1 billion, then each share of the fund would be worth $10. The fund manager buys and sells shares of stock that the fund owns – you, in turn, can buy or sell your shares of the fund, but only at the end of each trading day.
No Load Mutual Funds vs. Load Mutual Funds
So what’s the catch? Well, mutual fund managers have to be compensated for their services, so they charge you a fee which is sometimes called a “load.”
Essentially, you are paying them to have the heartburn and ulcers associated with watching the stock market eight hours a day, 52 weeks a year, so that you don’t have to. Whether or not the fund managers earn their keep depends on how skillful they are, and how the fund’s fees are structured.
Load mutual funds charge either front-end loads or back-end loads. Front-end loads charge you a percentage of your initial investment.
For example, if you invest $10,000 each into a pair of front-end load funds with loads of 3 percent and 5 percent, you will only be investing $9,700 and $9,500, respectively. How long will it take your funds to make up the $800 you’ve lost right off the bat?
Instead of charging you up front, back-end load funds don’t charge you a load until you withdraw your money.
These funds are usually a better deal, because the size of the loads usually decreases the longer you leave your money in the fund.
For example, a back-end load fund might have a load of 7 percent if you withdraw your money the first year, with the load going down by 1 percentage point each year, and reaching 0 percent by the eighth year.
Mutual Funds – Just Say No To Your Broker; Buy Direct Instead
Typically, full-service brokers with offices on Main Street only sell front-end load funds. This is because they receive an up-front commission on the sale of these products.
Mutual funds are designed for average investors – you don’t need a broker to recommend these funds for you, and you don’t need to pay the extra sales charges.
There are hundreds of good, no-load funds that charge only a small annual management fee (which load mutual funds charge in addition to their loads) available directly from fund companies.
Most funds have a minimum investment of $2,500, but this can usually be waved if you commit to regular monthly investments of as little as $50.