Mutual Funds Chetan
Mutual Funds Chetan
Mutual Funds Chetan
KEY TAKEAWAYS
The average mutual fund holds over a hundred different securities, which
means mutual fund shareholders gain important diversification at a low price.
Consider an investor who buys only Google stock before the company has a
bad quarter. They stand to lose a great deal of value because all of their
dollars are tied to one company. On the other hand, a different investor may
buy shares of a mutual fund that happens to own some Google stock. When
Google has a bad quarter, they lose significantly less because Google is just
a small part of the fund's portfolio.
Most mutual funds are part of a much larger investment company; the biggest
have hundreds of separate mutual funds. Some of these fund companies are
names familiar to the general public, such as Fidelity Investments, The
Vanguard Group, T. Rowe Price, and Oppenheimer.
Equity Funds
The largest category is that of equity or stock funds. As the name implies, this
sort of fund invests principally in stocks. Within this group are various
subcategories. Some equity funds are named for the size of the companies
they invest in: small-, mid-, or large-cap. Others are named by their
investment approach: aggressive growth, income-oriented, value, and others.
Equity funds are also categorized by whether they invest in domestic (U.S.)
stocks or foreign equities. There are so many different types of equity funds
because there are many different types of equities. A great way to
understand the universe of equity funds is to use a style box, an example of
which is below.5
The idea here is to classify funds based on both the size of the companies
invested in (their market caps) and the growth prospects of the invested
stocks. The term value fund refers to a style of investing that looks for high-
quality, low-growth companies that are out of favor with the market. These
companies are characterized by low price-to-earnings (P/E) ratios, low price-
to-book (P/B) ratios, and high dividend yields. Conversely, spectrums
are growth funds, which look to companies that have had (and are expected
to have) strong growth in earnings, sales, and cash flows. These companies
typically have high P/E ratios and do not pay dividends. A compromise
between strict value and growth investment is a "blend," which simply refers
to companies that are neither value nor growth stocks and are classified as
being somewhere in the middle.
Image by Julie Bang © Investopedia 2019
The other dimension of the style box has to do with the size of the companies
that a mutual fund invests in. Large-cap companies have high market
capitalizations, with values over $10 billion. Market cap is derived by
multiplying the share price by the number of shares outstanding. Large-cap
stocks are typically blue chip firms that are often recognizable by
name. Small-cap stocks refer to those stocks with a market cap ranging from
$250 million to $2 billion. These smaller companies tend to be newer, riskier
investments. Mid-cap stocks fill in the gap between small- and large-cap. 6
A mutual fund may blend its strategy between investment style and company
size. For example, a large-cap value fund would look to large-cap companies
that are in strong financial shape but have recently seen their share prices fall
and would be placed in the upper left quadrant of the style box (large and
value). The opposite of this would be a fund that invests in startup technology
companies with excellent growth prospects: small-cap growth. Such a mutual
fund would reside in the bottom right quadrant (small and growth).
Fixed-Income Funds
Index Funds
Another group, which has become extremely popular in the last few years,
falls under the moniker "index funds." Their investment strategy is based on
the belief that it is very hard, and often expensive, to try to beat the market
consistently. So, the index fund manager buys stocks that correspond with a
major market index such as the S&P 500 or the Dow Jones Industrial
Average (DJIA). This strategy requires less research from analysts and
advisors, so there are fewer expenses to eat up returns before they are
passed on to shareholders. These funds are often designed with cost-
sensitive investors in mind.
Balanced Funds
Some funds are defined with a specific allocation strategy that is fixed, so the
investor can have a predictable exposure to various asset classes. Other
funds follow a strategy for dynamic allocation percentages to meet various
investor objectives. This may include responding to market conditions,
business cycle changes, or the changing phases of the investor's own life.
Income Funds
Income funds are named for their purpose: to provide current income on a
steady basis. These funds invest primarily in government and high-quality
corporate debt, holding these bonds until maturity in order to provide interest
streams. While fund holdings may appreciate in value, the primary objective
of these funds is to provide steady cash flow to investors. As such, the
audience for these funds consists of conservative investors and retirees.
Because they produce regular income, tax-conscious investors may want to
avoid these funds.
International/Global Funds
Specialty Funds
A twist on the mutual fund is the exchange traded fund (ETF) . These ever
more popular investment vehicles pool investments and employ strategies
consistent with mutual funds, but they are structured as investment trusts that
are traded on stock exchanges and have the added benefits of the features of
stocks. For example, ETFs can be bought and sold at any point throughout
the trading day. ETFs can also be sold short or purchased on margin. ETFs
also typically carry lower fees than the equivalent mutual fund. Many ETFs
also benefit from active options markets, where investors
can hedge or leverage their positions. ETFs also enjoy tax advantages from
mutual funds. Compared to mutual funds, ETFs tend to be more cost
effective and more liquid. The popularity of ETFs speaks to their versatility
and convenience.7
Some funds also charge fees and penalties for early withdrawals or selling
the holding before a specific time has elapsed. Also, the rise of exchange-
traded funds, which have much lower fees thanks to their passive
management structure, have been giving mutual funds considerable
competition for investors' dollars. Articles from financial media outlets
regarding how fund expense ratios and loads can eat into rates of return have
also stirred negative feelings about mutual funds. 8
Funds that charge management and other fees when an investor sell their
holdings are classified as Class B shares.9
Diversification
Easy Access
Trading on the major stock exchanges, mutual funds can be bought and sold
with relative ease, making them highly liquid investments. Also, when it
comes to certain types of assets, like foreign equities or exotic commodities,
mutual funds are often the most feasible way—in fact, sometimes the only
way—for individual investors to participate.
Economies of Scale
Because a mutual fund buys and sells large amounts of securities at a time,
its transaction costs are lower than what an individual would pay for securities
transactions. Moreover, a mutual fund, since it pools money from many
smaller investors, can invest in certain assets or take larger positions than a
smaller investor could. For example, the fund may have access to IPO
placements or certain structured products only available to institutional
investors.
Professional Management
A primary advantage of mutual funds is not having to pick stocks and manage
investments. Instead, a professional investment manager takes care of all of
this using careful research and skillful trading. Investors purchase funds
because they often do not have the time or the expertise to manage their own
portfolios, or they don't have access to the same kind of information that a
professional fund has. A mutual fund is a relatively inexpensive way for a
small investor to get a full-time manager to make and monitor investments.
Most private, non-institutional money managers deal only with high-net-worth
individuals—people with at least six figures to invest. However, mutual funds,
as noted above, require much lower investment minimums. So, these funds
provide a low-cost way for individual investors to experience and hopefully
benefit from professional money management.
Investors have the freedom to research and select from managers with a
variety of styles and management goals. For instance, a fund manager may
focus on value investing, growth investing, developed markets, emerging
markets, income, or macroeconomic investing, among many other styles.
One manager may also oversee funds that employ several different
styles. This variety allows investors to gain exposure to not only stocks and
bonds but also commodities, foreign assets, and real estate through
specialized mutual funds. Some mutual funds are even structured to profit
from a falling market (known as bear funds). Mutual funds provide
opportunities for foreign and domestic investment that may not otherwise be
directly accessible to ordinary investors.
Transparency
Pros
Liquidity
Diversification
Minimal investment requirements
Professional management
Variety of offerings
Cons
High fees, commissions, and other expenses
Large cash presence in portfolios
No FDIC coverage
Difficulty in comparing funds
Lack of transparency in holdings
Fluctuating Returns
Like many other investments without a guaranteed return, there is always the
possibility that the value of your mutual fund will depreciate. Equity mutual
funds experience price fluctuations, along with the stocks that make up the
fund. The Federal Deposit Insurance Corporation (FDIC) does not back up
mutual fund investments, and there is no guarantee of performance with any
fund. Of course, almost every investment carries risk. It is especially
important for investors in money market funds to know that, unlike their bank
counterparts, these will not be insured by the FDIC. 1 0
Cash Drag
Mutual funds pool money from thousands of investors, so every day people
are putting money into the fund as well as withdrawing it. To maintain the
capacity to accommodate withdrawals, funds typically have to keep a large
portion of their portfolios in cash. Having ample cash is excellent for liquidity,
but money that is sitting around as cash and not working for you is not very
advantageous. Mutual funds require a significant amount of their portfolios to
be held in cash in order to satisfy share redemptions each day. To
maintain liquidity and the capacity to accommodate withdrawals, funds
typically have to keep a larger portion of their portfolio as cash than a typical
investor might. Because cash earns no return, it is often referred to as a
"cash drag."
High Costs
In other words, it's possible to have poor returns due to too much
diversification. Because mutual funds can have small holdings in many
different companies, high returns from a few investments often don't make
much difference on the overall return. Dilution is also the result of a
successful fund growing too big. When new money pours into funds that have
had strong track records, the manager often has trouble finding suitable
investments for all the new capital to be put to good use.
One thing that can lead to diworsification is the fact that a fund's purpose or
makeup isn't always clear. Fund advertisements can guide investors down
the wrong path. The Securities and Exchange Commission (SEC) requires
that funds have at least 80% of assets in the particular type of investment
implied in their names. How the remaining assets are invested is up to the
fund manager.1 1 However, the different categories that qualify for the required
80% of the assets may be vague and wide-ranging. A fund can, therefore,
manipulate prospective investors via its title. A fund that focuses narrowly on
Congolese stocks, for example, could be sold with a far-ranging title like
"International High-Tech Fund."
Many investors debate whether or not the professionals are any better than
you or I at picking stocks. Management is by no means infallible, and even if
the fund loses money, the manager still gets paid. Actively managed funds
incur higher fees, but increasingly passive index funds have gained
popularity. These funds track an index such as the S&P 500 and are much
less costly to hold. Actively managed funds over several time periods have
failed to outperform their benchmark indices, especially after accounting for
taxes and fees.1 2
Lack of Liquidity
A mutual fund allows you to request that your shares be converted into cash
at any time, however, unlike stock that trades throughout the day, many
mutual fund redemptions take place only at the end of each trading day.
Taxes
Evaluating Funds
Even after Lynch left, Fidelity's performance continued strong, and assets
under management (AUM) grew to nearly $110 billion in 2000. By 1997, the
fund had become so large that Fidelity closed it to new investors and would
not reopen it until 2008.1 6
As of March 2022, Fidelity Magellan has nearly $28 billion in assets and has
been managed by Sammy Simnegar since Feb. 2019. 1 4 The fund's
performance has pretty much tracked or slightly surpassed that of the S&P
500.