New Podcast Released – Read the transcript below.
The mutual fund is one of the most common investment vehicles in the United States. Almost half of all U.S. households have money invested in Mutual Funds, perhaps as part of a 401k or retirement planning.
The idea behind the creation of mutual funds over 20 years ago was to form a company which will invest the money of the investors on their behalf. If you invest in the mutual fund, you would actually be investing in the company; they would then take your money and invest it in an array of assets, stock, bonds or treasuries.
As an owner of a piece of the mutual fund, you will be able to earn money from potentially three revenue streams:
- Income earned from the dividends paid on the assets the mutual fund owns should be distributed to the shareholders.
- If the underlying assets (Net Asset Value-NAV) of the mutual fund increase this should be reflected in the worth of the fund. The NAV should be calculated every day by the fund.
- If the fund realized any gains from the sale of assets it owns, this capital gain can be passed on to the fund holder.
The advantages of mutual funds:
- Diversification in the asset base of the fund should mean less risk in terms of spreading the capital amongst differing asset types.
- Economies of scale can be achieved as a larger fund will pay less in transaction costs for the assets it deals in.
- Liquidity is another benefit as the shares in the fund can be cashed in at any point.
The disadvantages of mutual funds:
- Cost of management – The overhead of paying for star fund managers and the management hierarchy of the company can increase the costs of owning mutual funds.
- Success of the professional fund managers – The majority of Fund Managers fail to beat the market. This means that they fail to return more in returns that the underlying indices to which the assets belong.
- Complicated Cost Structures – The fees involved in owning a mutual fund can vary a lot depending on the costs of the business and the profit targets of the management team. The costs presented to the customer can be difficult to understand and if they exceed a few percentage points can often wipe out the profits gains from the underlying assets.
For example, your mutual fund made an annual return of 5% for 2012. If the S&P500 Index made a return of 8%, then you could consider that your fund managers have not been successful. Also if from the 5% you earned from the fund you had a 2% management fee, you could consider your net gain to be 3% which would have grossly underperformed the stock market.
Always compare your mutual funds performance against a standard index such as the Dow Jones Industrials (DJ-30) or the Standard & Poors 500 (S&P500), over a period of 5 years to see which performed better.
There are other types of investments that seek to minimize the drawbacks of mutual funds whilst providing many of the benefits, such as exchange traded funds and index trackers.