Do you really understand your mutual funds?
December 8, 2014
by Brian Wolf

So what the heck is a mutual fund anyway? Most people will own them at some time in their lives. Most people will get them right from their employer's retirement plan. But, what really are they, and how do they work?

Since their inception in 1924, open-end mutual funds have been a fast growing, profitable industry. At the time of the Great Crash in 1929, 19 mutual funds existed. At year- end 2011, there were more than 8,600, which is approximately three times the number of companies that trade on the New York Stock Exchange. Most of this growth has occurred over the past 20 years. Almost one-half of all US households (52 million) have investments in mutual funds.

A mutual fund is a professionally managed collective investment that gathers money from many individual investors to purchase securities. Theoretically, by having access to a larger pool of money, the company is able to create a diversified basket of investments that can be accessed by many small, unrelated investors.

Investments in a mutual fund may not be limited to just stocks. Some mutual funds invest in bonds, commodities, real estate, currencies, art, precious metals, and more. An investor can find a mutual fund company that will specialize in just about any asset class or mix imaginable.

Mutual fund structures are unique in that they provide; easy access to lots of different securities. Instead of having to research, and possibly buy hundreds of stocks, and pay commissions on each, an investor can buy shares of this pooled company. It's relatively easy access for small investors. As long as an investor has enough money to buy a minimum number of shares, they can be an owner. Shares can be bought and sold at the end of each business day, and they typically hire experienced people to manage these mutual funds.

Three groups of people will generally profit from mutual funds.

1. The companies who create these funds. For the most part, the investment firms that create mutual funds make money from the fees they charge to manage and administer them.

2. The brokers that sell shares of mutual funds to their clients and generate commissions and fees.

3. The investors that buy shares; provided the investments actually make money.

Companies and brokers most always make money from mutual funds; which isn't always the case for the investors.

Here are a few thoughts to consider about investing in mutual funds.

Expenses can be higher than you think. There are two types of expenses that work against the investor's goals: stated and unstated.

Combined, they produce a formidable obstacle for growing your wealth.

Think of any iceberg. The stated expenses are what you see, and the unstated expenses are what you don't see under the water.

Stated expenses are listed in a mutual fund's prospectus. Most investors know to check the expense ratio of a mutual fund to determine the stated costs.

According to the Investment Company Institute, the average expense ratio in an equity mutual fund is 1.4 percent per year.

Unstated expenses are more difficult to quantify and not required by law to be disclosed. Like the iceberg, the unstated costs below the waterline may dwarf the stated costs that are easily visible above.

The unstated expenses will come from areas like trading costs, transaction commissions, market impact costs and taxes, just to name a few.

It's estimated by Stephan Horan of the CFA Institute that trading costs alone will increase your costs of ownership ranging from 1 to 3 percent annually for equity funds.

This isn't to say that an investor shouldn't invest in mutual funds, but like most things that you purchase in life, you want to be sure you have all the information and a good mentor or advisor who can navigate you through all the details.

Stay tuned; I'll be sure to continue this mutual fund discussion in future columns.

Sources: A Brief History of the Mutual Fund, Investopedia.com

2012 Investment Company fact book, statistical Abstract of the United States 2012, U.S. Census Bureau, Global Financial Private Capital, The Hidden Costs of Mutual Funds, Wall Street Journal.

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