Almost 9 out of every 10 investors participate in a mutual fund. At its most basic interpretation, a mutual fund is simply a company, and like any business, a mutual fund exists to make a profit by investing money on behalf of its investors. A mutual fund will typically put together a prospectus for potential investors that states the goals and objective of the fund. Some mutual funds invest exclusively in stocks or bonds, while others delve into other opportunities for profit. Investors like mutual funds for two big reasons: relatively low risk thanks to diversification and investment minimums as little as $1,000 for some funds. But before any decisions are made, it is important for investors to choose their mutual funds carefully. There are thousands of mutual funds to choose from and a lot of options to consider.
The Bottom Line-Fees, Expenses, and Loads
Mutual funds have a wide assortment of potential fees that can be charged to investors. While some funds may charge higher fees, higher fees, they may also yield higher returns- on average. Therefore,fees alone are not the most important criteria to consider when buying a mutual fund, but investors need to understand how they may affect the bottom line of their investment, and factor them into the purchase decision.
Loads are basically sales commissions, and can be charged when investors first purchase the mutual fund, or when they sell it. Many mutual funds may carry a maximum load of up to 8.5% or a minimum of only 1%. If the sales commission is charged when an investor buys into the mutual fund, it is know as a front-end load. Investors need to carefully consider this option, since front-end load, then only $4800 would be invested.
A back-end load, on the other hand, charges the sales commission when investors choose to sell their shares of the mutual fund. If the mutual fund has done well, these back-end loads can be pretty steep. But while the front-end loads can loads can sap into the initial investment and ultimately lower profits, back-end loads can add up to incredibly steep fees. For investors with a smaller initial investment, the back-end loads would probably be the wiser way to go to ensure the largest possible initial investment. Front-end loads would be preferred by those with larger investments. Of course, there are no-load mutual funds (no sales commission at all) but they may also have other fees to consider.
Management fees are assessed by mutual funds for the time and expenses related to overseeing the investments. These management fees do not generally exceed 1% of the total value of the mutual fund and its investments, but they can significantly cut into profits- this is especially true the longer the fund is held. For instance, if a mutual fund averaged a 10% return for 20 years with a 2% management fee, then an initial investment of $20,000 would add up to $20,700 in fees by the time it was redeemed. However, if the same investment only had a 0.5% management fee, then it would only add up to $7600 by the time the mutual fund was redeemed- nearly one third of the total fees charged by a mutual fund with a 2% fee! Therefore, it is critical for investors to consider management fees when making a mutual fund purchase, as they can seriously diminish returns. Those mutual funds with management fees in excess of 1% need to be viewed with caution- maybe their returns justify such fees, but past performance is no assurance of future returns.
Other potential expenses to consider are custodian and 12b-1 fees. Custodian fees are charged by the caretaker accountable for the assets in the fund. Banks and trust companies are often responsible for the assets in a mutual fund. The 12b-1 fees relate to any advertising costs the mutual fund incurs while trying to find investors. Be way of mutual funds with no-loads as they often will have larger 12b-1 and management fees.
Size Does Matter
Not only size, but the age of a mutual fund is very important for investors to consider. Initially, when a mutual fund begins. it is usually small and only contains a few investments in the portfolio. Therefore, one homerun in the portfolio can make the mutual look absolutely golden with solid double-digit returns. However, as the fund matures, it naturally diversifies. Even one solid home run in the portfolio of a large and well-established mutual fund will not have the same impact upon returns as one in a smaller, newer fund. It is very important to check the prospectus of a mutual fund to see how old it is, how diversified the assets are, and the annual returns since establishment. Newer funds tend to have truly great returns the first year or so, and then begin to diminish with time. But, while they may be more profitable, they are also more risky, as they are not diversified as well as older funds. For a solid, more stable investment, an older mutual fund with larger assets and more diversification is the way to go. But, for investors hoping to see higher-than- average returns, a newer mutual fund is the better bet- but again, it’s riskier.
Mutual fund investors need to understand how their tax liability may be affected by potential capital gains. Mutual funds are required to make capital gains distributions any time a security is sold that cannot be offset by selling another one for loss. For this reason, investors should pay attention to when the mutual fund makes distributions. If the mutual fund is purchased before a distribution, the investor may have to pay capital gains on the money received. This will be an especially important point to consider for those investors making large investments in a mutual fund, while those investors spending a $1,000 or so should not have to worry about potential tax liability issues.