For young investors, I believe that exchange-traded funds — or ETFs — offer the cheapest and simplest way to make money in the stock market. It’s so easy to get burned buying a single stock, bond, or piece of gold.
But a single ETF invests in hundreds of stocks, which spreads the risk out among all the shares. We call this “diversification.” Winners compensate for the losers. The highs smooth out the lows. In other words, you’re spreading your bets.
That said, have you ever heard of mutual funds? They’ve been around for well over 100 years in the U.S. Your grandparents and parents probably know them well. Most pension and retirement accounts are comprised of mutual funds. It’s a legacy issue. Think of the current move from gas-powered vehicles to all-electric.
In a previous column, I referred to mutual funds as the crazy uncle of ETFs. But they're crazy in a good way. Millions of people have gotten rich off them or used them to raise money to buy a home, get a college education, or start a new business.
Today, the mutual fund universe represents a trillion dollar enterprise.
While I believe that ETFs are the best way to go because of cost and simplicity, you may still want to consider buying a mutual fund.
What is a Mutual Fund Investment?
A mutual fund is a collection of investments — such as stocks and bonds — based on a well-planned investment objective or strategy. When you buy a mutual fund, you’re pooling your money along with other investors who have purchased shares of the fund.
A portfolio manager oversees the fund on a day-to-day basis, buying and selling stocks. The mutual fund’s price is called its net asset value (NAV) and is calculated at the end of each business day. This price is determined by the value of the stocks or bonds in the fund, divided by the number of the shares the fund holds.
What do Mutual Funds Offer to Investors?
The world, so to speak. As with ETFs, there are thousands of mutual funds, and each is designed with its own investment objective. You can buy funds that invest in companies making tons of cash, or you can buy a fund that invests in struggling companies on the verge of a big comeback. You can bet on sectors like health care, banks, and energy. Or how about cows and soybeans?
You can even bet on geographical regions like Europe or Africa.
Want nothing to do with companies that may violate your values? You can easily find a fund that invests in profitable companies committed to being good global citizens.
The Benefits of Using a Mutual Fund
Every mutual fund comes with an expert money manager whose duty it is to ensure that the fund sticks to its investment objective.
The fund also minimizes risk by being invested in thousands of companies. In other words, it diversifies your stocks. Winning stocks will compensate for losing ones. And another benefit?
A mutual fund allows smaller investors access to stocks typically reserved for very rich people.
Plus, it regularly pays out earnings called capital gains and dividends. You can deposit these earnings in your checking account or have them reinvested in the fund. But don’t forget, you’ll have to pay taxes on those distributions.
Some mutual funds even look a lot like ETFs. They’re called index funds (more on this in my next column).
The Downsides of Using a Mutual Fund
Many funds carry high expense ratios. The industry average is 0.70 percent. That’s $7 for every $1,000 invested. It may not seem like a lot at first, but that parasitic expense ratio will eat away at your returns over time.
Mutual funds also often come with minimum investment requirements. In other words, when you open a brokerage account to buy your first fund, some may want a down payment – typically between $500 and $1,000. Some funds require $100,000 upfront.
Some brokers will also charge you an annual service fee if you have a small account (below $10,000, for example). Others will impose a penalty if you withdraw your money to soon. (Remember: you should invest for the long haul).
In addition, some funds will charge one-time fees called “loads,” and those can be hefty. Avoid these funds.
The Bottom Line on Mutual Funds
Now you know the skinny on mutual funds. They can best ETFs a simple reason: Investors gain access to unique investment strategies and special share classes that they’ll never get with an ETF. But it may cost you!