An Introduction To Mutual Funds: A Good Choice For
by Dave Mason, PhD, CPA; Ann McCarthy, MBA, CPA;
and Mark McCarthy, PhD, CPA
Congratulations! You did it! With your diploma in hand, you are officially
a college graduate. Now you are eager to start your first "real"
job. As you embark on your new career, consider the following scenario
that is played out in offices everywhere.
Monday, 8:00 a.m.---With great anticipation, you arrive at the office
of your new employer. Not knowing what the day holds, you are relieved
to discover that Chris, another new employee, is also starting work today.
8:10 a.m.---You and Chris are shown around the office. You are introduced
to the rest of the staff, learn where the coffee is, and get supplies
for your desk.
8:30 a.m.---Joan, the benefits coordinator, calls you and Chris to her
office to discuss your employment benefits and retirement options. After
handing you some pamphlets, Joan begins, "So how do you want to invest
your retirement funds? Do you want to invest in stocks, bonds, mutual
funds, the money market, and/or annuities? We have many different plans
from which to choose. Take a few minutes to look over the brochures."
8:40 a.m.---Your mind is racing! Stocks? Bonds? Mutual funds? Money market?
Annuities? A retirement plan? Yikes! You were daydreaming about your Spring
Break trip when investment options were covered in your Finance class.
"Oh, if only I had paid attention in class that day," you lament
to yourself, "I would know what to do now."
8:41 a.m.---Suddenly, you remember Chris. Turning to him, you ask, "So,
what are you going to do?"
Chris? You asked Chris? You just made Chris your financial advisor! You
need to be educated enough about investing to make wise and informed retirement
choices. In our article in a previous issue of New Accountant, "Retirement
Planning for New Graduates: It is More Important than You Think,"
we stressed the importance of starting early when contributing to a retirement
plan. We also suggested investing retirement funds in the stock market.
Over the long run, the trend of the stock market is upward, and stocks
outperform bonds by a substantial margin. Investing in individual stocks,
however, can be risky. So how can you invest in the stock market and minimize
your risk? Mutual funds might be the answer for you.
Definition Of A Mutual Fund
You probably have heard the term "mutual fund" but may not have
known what it meant. A mutual fund is a pool of money contributed by many
investors that is used to buy a large portfolio of securities. A professional
advisor manages the mutual fund. Currently, there are more than 6,700
mutual funds, and this number continues to grow. The professional manager
running the mutual fund makes decisions on where funds are to be invested,
how much to invest, and when to sell. With a mutual fund, an individual
is investing in all of the different companies in which the mutual fund
owns shares. As with individual stocks, shares of the mutual fund can
be purchased and sold.
Advantages And Disadvantages Of Investing In A Mutual Fund
Before you invest your hard-earned money, you must first consider the
advantages and disadvantages of any investment. Mutual funds, like all
investments, have advantages and disadvantages.
The most important advantage of investing in a mutual fund is that it
provides individuals with broad diversification. Diversification reduces
part of the risk associated with investing in the stock market. By pooling
their money, mutual fund shareholders are able to spread their assets
among many different securities, thereby dramatically reducing the risk
associated with investing in the stock market.
A mutual fund also provides professional management. When deciding how
to invest funds, mutual fund managers have the expertise and insight to
choose excellent companies with bright futures. The mutual fund managers
are in constant contact with individual company managers. They have access
to the floor of the stock market where the most pertinent company information
There are other advantages of investing in a mutual fund. Mutual funds
can be very cost efficient, so more of your money is put to work for you.
Marketability allows you to buy and sell your shares at any time. Convenience
allows you to purchase a mutual fund over the telephone.
One disadvantage of investing in mutual funds is that there are no guarantees.
Unlike bank deposits, mutual funds are not insured or guaranteed by the
Federal Deposit Insurance Corporation (FDIC) or any other agency of the
A second disadvantage is the potentially high costs. A combination of
sales commissions and high operating expenses may offset the efficiencies
that can be gained through owning mutual funds. Costs associated with
mutual funds will be discussed later in the article.
Types Of Mutual Funds
There are essentially three categories of mutual funds: money market,
fixed income, and stock. Within each category, there are a variety of
types of funds.
Money market funds have relatively low risk as compared to other mutual
funds. These funds invest in short-term IOUs issued by governments, corporations,
banks, and other institutions. Two examples are U.S. Treasury bills and
bank certificates of deposit (CDs).
Bond funds (also called fixed income funds) have higher risks than money
market funds but seek to pay higher yields. There are many different types
of bonds, such as taxable, tax-free, long-term, short-term, government,
corporate, and junk. Bond funds can vary dramatically in their risks and
Stock mutual funds (also called equity funds) are a third type. These
funds generally involve more risk than money market or bond funds; however,
with more risk, they can offer the highest returns. Stock mutual funds
should be considered for retirement accounts. These funds are a great
way to invest in the stock market, but minimize the risk associated with
holding individual stocks. Stock mutual funds are categorized based on
the types of companies included in their portfolio. Listed below are some
of the different types of investment objectives of stock mutual funds:
Size---a manager invests primarily in companies of a certain size:
Small capitalization ($150 million to $500 million)
Mid capitalization ($500 million to $5 billion)
Large capitalization (greater than $5 billion)
Growth---companies with above average growth potential and lower than
average dividend yields
Value---companies that are currently out of favor with investors and offer
higher than average dividend yields
Sector---companies that are in a certain type of business such as health
care, financial institutions, technology, and pharmaceutical
Index---invest only in companies that make up a specific index like the
Standard & Poor's (S&P) 500. Index funds do not require a professional
manager since the companies to be included in the portfolio are already
determined by the composition of the index
How A Mutual Fund Makes Money
An investor in a mutual fund makes money in two different ways: current
income and/or capital gains. It is important for an investor to understand
the difference between these two sources of income.
Current income is produced when a mutual fund invests in interest-paying
bonds or money market instruments or dividend-paying stocks. This income
is paid out to the shareholders of the mutual fund in the form of dividend
income. Normally, shareholders can choose to receive the dividend income
in cash or to have the dividends reinvested in more shares of the fund.
In a retirement fund, the dividends are normally reinvested in more shares
of the fund.
Capital gains occur when a security held by the mutual fund appreciates
or rises in value. As long as the fund holds the security, there is an
unrealized gain. These gains remain in the fund, which raises the market
value of the mutual fund shares. If the security is sold, then the capital
gain becomes realized. Realized capital gains are paid out periodically
to shareholders. When the mutual fund pays out its realized capital gains,
the fund's share price is reduced by the amount of the distribution. As
with current income, these realized gains can automatically be reinvested
in more shares of the fund.
Mutual Fund Fees
As with any type of investment, there are fees and costs associated when
investing in mutual funds. Any fee or cost in a mutual fund reduces the
overall return and earnings of the investment. Research on the performance
of mutual funds has shown that, on average, funds having the lowest expenses
yield the highest returns. If expenses are lower, then more of the investors'
money is being put to work for the investors. Mutual fund costs fall into
two categories: sales charges or "loads" and operating expenses.
A load is a commission that the mutual fund deducts from the amount invested
before buying shares of the mutual fund. This commission goes to the salesperson
and the company. By law, the percentage cannot be higher than 8.5%. For
example, if you invest $2,000 and a mutual fund has a 5% load, the mutual
fund takes $100 ($2,000 x 5%) off the top. The remaining $1,900 is used
to buy shares of the mutual fund. There are some funds that do not charge
a front-end load but charge a back-end load. With this type of mutual
fund, a percentage is deducted when you sell the mutual fund. The charge
usually starts out at 5 or 6% for the first year and decreases each year
thereafter until it reaches zero.
Operating expenses represent the basic costs that all mutual funds incur.
Examples of such costs are fees paid to the fund manager, legal and accounting
services, postage, printing, telephone service, and other costs of running
the funds. The management fee usually ranges from 0.5% to 1% of the fund's
total asset value. Some funds also charge a 12b-1 fee, named for the Securities
and Exchange Commission rule that originated it. A 12b-1 fee permits a
fund to pay commissions to brokers and other salespersons, and occasionally
to pay for advertising and other costs of promoting the fund to investors.
The 12b-1 fee for a "no-load" fund cannot exceed 0.25% of the
All of these costs, except the load, added together produce an expense
ratio---the ratio of total expenses to net assets of the fund. The average
stock mutual fund expense ratio is approximately 1.5%. For every $1,000
invested in a mutual fund, $15 a year goes toward covering the cost of
running the fund. This also means that a mutual fund having a return of
12% before deducting expenses ends up returning 10.5% to the investors.
Watch out for fees! Remember...lower expenses means that more of your
money is put to work for you.
Selecting The Right Mutual Fund
An employer offering a retirement plan may arrange for employees to have
retirement accounts with different mutual fund companies. For example,
Merck & Co. employees can choose from 10 different mutual fund families
such as Fidelity Investments, Vanguard Group, T. Rowe Price Associates,
and Franklin Templeton Group. Each of these families has a number of individual
mutual funds from which to choose. If you are on your own in establishing
and funding your retirement account, then you will have to choose a mutual
fund (or funds) for your retirement savings. Today, over 6,700 mutual
funds are available, and this number continues to grow. In either case,
choose the mutual fund that meets your objectives and will give you the
highest return in the years to come. So how do you select the mutual fund
that is right for you? Research, research, research!
Information about mutual funds is easily accessible. One source is a prospectus
that is obtained by calling the mutual fund company. A prospectus, often
available on the Internet, contains much of the relevant information needed
to make a wise decision. Morningstar is another good source. Morningstar
is a service that not only provides information about different mutual
funds, but it also rates the performance of the funds over one-, three-,
and five-year periods. Each mutual fund is assigned a rating of 1 to 5
stars, with five being the highest. Only 10% of the funds followed by
Morningstar receive a 5-star rating. Morningstar, however, does not follow
every mutual fund available. Other sources include monthly periodicals,
such as Money and Mutual Fund Magazine, that provide information and recommendations
about mutual funds. There is also a wealth of information on the Internet
about mutual funds. An abundance of information is available to help you
choose a mutual fund that is right for you.
When investing, select a mutual fund that will yield a good return. What
constitutes a good return? To address this question, a benchmark for good
returns must be established. Certainly, you want to put your money into
a mutual fund that will provide returns which are better than average.
The S&P 500 is a stock market index that many stock mutual fund managers
use as a benchmark for comparing their return performance. This index
is made up of the 500 largest companies in the United States, known as
the Fortune 500. Of the 262 stock mutual funds tracked by Morningstar,
only 21% have exceeded the S&P 500 over the last ten years. Why are
so many stock mutual funds performing below the S&P 500? Two of the
most important reasons for underperformance are advisory fees and management
1. Advisory Fees---mutual funds charge customers an average of 1.5% of
their assets invested in the fund. Therefore, managers must beat the market
average by 1.5% each year just to equal the market average. Studies have
shown that funds charging lower expenses perform better than those charging
higher expenses. These findings are true for the past one-, three-, five-,
and ten-year periods.
2. Management---with so many new mutual funds being established, many
of the funds are being managed by individuals with little or no track
record. When choosing a mutual fund, examine the manager's track record.
Managers with solid track records tend to perform better than those with
little or no track records.
How should you go about finding a mutual fund that is going to perform
better than the benchmark S&P 500? Since advisory fees and management
are two of the main reasons why mutual funds fail to beat the S&P
500, they are two criteria that should be used when selecting a mutual
First, look at management tenure and performance. How long has the current
manager been running the mutual fund? It takes time to build a track record.
A manager that beats the S&P 500 for the first couple of years of
his or her tenure probably does not have a long enough track record. In
addition, a mutual fund may boast a great track record, but those returns
may be the result of a manager that is no longer running the fund. A mutual
fund is only as good as its current manager. One rule of thumb is to look
at funds where the manager has been in place for at least six years.
Evaluating the performance of the current fund manager is extremely important.
How well has the fund performed over past one, three, and five years?
Morningstar assigns 4 and 5 stars to the funds having the best performance.
When evaluating performance, consider the average returns for one-, three-,
and five-year periods and the consistency of the yearly returns. A high
one-year return may be the reason for an excellent five-year average return.
For example, if you have two different mutual funds with the same five-year
average return, one fund may have beaten the S&P 500 every year (consistency).
The other fund may have had one great year and returns less than the S&P
500 for the other years.
Second, consider the costs and fees. Funds with lower expenses outperform
funds with higher expenses. Think twice before putting your money into
a mutual fund that charges any type of front-end load, back-end load,
12b-1 fees, or unusually high management fees (>1.5%).
Consider Index Mutual Funds
What if you want to invest in stock mutual funds, but don't have the time
to research, research, research? If you feel that you won't have the time
or don't want to take the time to evaluate the different mutual funds,
consider investing in an index fund. These types of funds are gaining
in popularity. An index mutual fund is designed to match the returns of
a specific index such as the S&P 500 (large companies), Russell 2000
(small companies), and Wilshire 5000 (all companies). The fund is made
up of all the stocks that comprise the index. An S&P 500 index fund
will hold shares of the 500 companies that make up the index, no more
or less. An index fund will not beat the index it is trying to match,
but year after year it will come very close to the return of the index.
Expenses are the reason for not quite matching or beating the market index.
Remember that expenses of a mutual fund take away from the investor's
return. However, index funds tend to have the lowest expenses of any type
of mutual fund. Why?
First, an index fund does not need a highly compensated manager to decide
which companies to invest in, when to sell, and when to buy. The companies
that make up an index are the same ones in the portfolio.
Secondly, within an index fund, there is very little buying and selling
of stocks since the make up of an index will only have minor changes each
year. In contrast, when a professional manager decides to buy and sell
stocks, the commissions incurred reduce the return of the mutual fund.
The average expense ratio for actively managed mutual funds is approximately
1.5%. Index funds may have expense ratios as low as 0.2% to 0.3%. The
difference of approximately 1% in average expense ratios between actively
managed mutual funds and index funds may not sound like much. Be aware
that the additional 1% in expenses can make a staggering difference when
you are ready to retire.
Assume that you start investing $2,000 a year at age 23 and continue until
age 65. Also assume that the average stock market return, before expenses,
for those 43 years is 11.3%. If you invested your money in an actively
managed mutual fund with a return of 11.3%, after deducting expenses of
1.3% the annual return would be 10%. Therefore, you would have accumulated
$1,303,282. Now, assume the money was invested in an index fund that matched
the stock market before expenses. With an expense ratio of 0.3%, the fund
would earn an annual rate of 11% and you would have accumulated $1,773,925.
The 1% difference in return from a lower expense ratio produced $470,643
more in funds available at retirement.
Index funds are an excellent choice if you don't want to spend time researching
the many different mutual funds available and keeping up with their performance.
With an index fund, you get a winning combination! You will pay the least
amount of expenses and beat 70 to 80% percent of all the actively managed
stock mutual funds.
Early in your career, you will have to make decisions on where your retirement
funds are going to be invested. If the stock market interests you, then
mutual funds are an efficient way to invest. With so many different mutual
funds available today, where to invest may be a difficult decision. Following
the guidelines discussed in this article will help you in choosing a mutual
fund. If you want to invest in the stock market but still feel unsure
about which mutual funds to choose, then putting your money into an index
fund may be the right move for you.
Regardless of which investment plan you choose, remember that you need
to be educated enough about investing to make wise and informed retirement
choices. A thoughtful investment now can yield a big payoff later.
Dave Mason is an assistant professor; Ann McCarthy is a
lecturer; and Mark McCarthy is an associate professor. They all teach
in the School of Business at East Carolina University, Greenville, North