Getting a Grip on Funds
A mutual fund is a collection of investment money pooled from many investors to be invested for a specific objective. When you invest in a fund, you buy shares and become a shareholder of the fund. The fund manager and a team of assistants determine which specific securities (for example, types of stocks or bonds) they should invest the shareholders’ money in to accomplish the objectives of the fund and keep shareholders happy.
A misconception some investors hold regarding mutual funds is that they all invest in stocks and, therefore, are too risky. They don’t, and they’re not. By using funds, you can invest in a whole array of securities, ranging from money market funds to bonds, stocks, and even real estate. And even within a specific class of investments such as stocks, which have greater short-term volatility, there’s a range of different types of stocks and therefore risk.
All funds aren’t created equal. Some funds, such as money market funds, carry virtually zero risk that your investment will decline in absolute value (but the purchasing power could indeed be eroded by inflation). Bond funds that invest in shorter-term bonds don’t generally budge by more than several percentage points per year. And you may be surprised to find out in Chapter 13 that some conservative stock funds aren’t that risky if you can plan on holding them for a decade or more.
They allow you to diversify your investments — that is, invest in many different industries and companies instead of in just one or two; and funds let you achieve this diversification with small dollar amounts — something that wouldn’t be possible otherwise. By spreading the risk over a number of different securities representing different industries and companies, funds lessen your portfolio’s instability and the chances of a large permanent loss.
They enable you to hire the best money management firms and managers in the country to manage your money.
They are the ultimate couch potato investment! However, unlike staying home and binge watching your favorite series or playing video games, investing in funds can pay you big financial rewards.
What’s really cool about funds is that when you understand them, you realize they can help you meet many different financial goals. Maybe you’re building up an emergency savings stash of three to six months’ living expenses (a prudent idea, by the way). Perhaps you’re saving for a home purchase, retirement, or future educational costs. You may know what you need the money for, but you may not know how to protect the money you have and make it grow.
Don’t feel badly if you haven’t figured out a long-term financial plan or don’t have a goal in mind for the money you’re saving. Many people don’t have their finances organized, which is why I write books like this one! I talk more specifically in Chapter 3 about the kinds of goals funds can help you accomplish.
Financial intermediaries
A mutual fund company is a type of financial intermediary. (Now that’s a mouthful!) Why should you care? Because if you understand what a financial intermediary is and how fund companies stack up to other financial intermediaries, you’ll better understand when funds are appropriate for your investments and when they probably aren’t. A financial intermediary is nothing more than an organization that takes money from people who want to invest and then directs the money to those who need investment capital (another term for money).
Suppose you want to borrow money to invest in your own business. You go to a bank that examines your financial records and agrees to loan you $20,000 at 6 percent interest for five years. The money that the banker is lending you has to come from somewhere, right? Well, the banker got that money from a bunch of people who deposited money with the bank at, say, 2 percent interest. Therefore, the banker acts as a financial intermediary, or middleman — one who receives money from depositors and lends it to borrowers who can use it productively.
Insurance companies do similar things with money. They sell investments, such as annuities (see Chapter 1) and then turn around and lend the money — by investing in bonds, for example — to businesses that need to borrow. (Remember, a bond is nothing more than a company’s promise to repay borrowed money over a specified period of time at a specified interest rate.)
The best mutual fund companies are often the best financial intermediaries for you to invest through because they skim off less (that is, they charge lower management fees) to manage your money and allow you more choice and control over how you invest your money. In this book, I highlight fund companies with excellent funds with the lowest costs.
Open-end versus closed-end funds
Open end and closed end are general terms that refer to whether a mutual fund company issues an unlimited or a set amount of shares in a particular fund:
Open-end funds: Open end simply means the fund issues as many (or as few) shares as investors demand. Open-end funds theoretically have no limit to the number of investors or the amount of money that they hold. You buy and sell shares in such a fund from the fund company.
Closed-end funds: Closed-end funds are those where the mutual fund companies decide upfront, before they take on any investors, exactly how many shares they’ll issue. After they issue these shares, the only way you can purchase shares (or more shares) is to buy them from an existing investor through a broker. (This process happens with buying and selling stock and exchange-traded funds, too.)
Open-end funds are usually preferable to closed-end funds for the following reasons:
Management talent: The better open-end funds attract more investors over time. Therefore, they can afford to pay the necessary money to hire leading managers. I’m not saying that closed-end funds don’t have good managers, too, but generally, open-end funds attract better talent.
Expenses: Because they can attract more investors, and therefore more money to manage, the better open-end funds charge lower annual operating expenses. Closed-end funds tend to be much smaller and, therefore, more costly to operate. Remember, operating expenses are deducted out of shareholder returns before a fund pays its investors their returns; therefore, relatively higher annual expenses depress the returns for closed-end funds. Brokers who receive a hefty commission generally handle the initial sale of a closed-end fund. Brokers’ commissions usually siphon from 5 to 8 percent out of your investment dollars up front, which they generally don’t disclose to you. (Even if you wait until after the initial offering to buy closed-end fund shares on the stock exchange, you still pay a brokerage commission,