Everything you should know about mutual funds

A brief introduction to mutual funds and why you should invest in them, the risks, who should invest, their performance and the alternatives. Every year, Warren Buffet writes a letter to investors in Berkshire Hathaway. His are the most important and highly-anticipated letters in the financial industry. In the letters, he talks greatly about his portfolio and shares the lessons he has learnt in his decades in the industry. In the 2017 letter, he said the following:

If a statue is ever erected to honour the person who has done the most for American investors, the hands-down choice should be Jack Bogle.

Jack Bogle founded Vanguard, an asset manager with more than $5.1 trillion. This makes it the second biggest asset manager in the world after Blackrock which has more than $6.6 in assets under management. Larry Fink, who founded Blackrock has a net worth of more than $1 billion while Steve Schwarzman who founded Blackstone has a net worth of more than $12 billion. Blackstone has assets of $430 billion. In contrast, Jack Bogle has a net worth of $80 million.

The reason why Bogle is worth less than the other asset managers is that of the industry he founded. In the 70s, he started the mutual fund industry. Instead of charging clients an administration fee and an incentive fee, he came up with a model where customers pay a small incentive fee. A mutual fund is an investment vehicle that is made up of a pool of money from investors who hand it to a professional manager. The manager then invests in different assets that are created for the fund. There are many assets that the fund manager can invest in. However, the manager must always invest in the asset classes defined by the mutual fund agreement. Some of these assets are:

• Stocks: these are shares of publicly-listed companies. The gains are generated from the appreciation of the stock price and the dividends from the companies.
• Bonds: these are debts issued by the government, government entities, municipalities, and corporations. Mutual funds can lend the money and hold it to maturity. They can also buy and sell the bonds at a profit in the open market. Examples of these funds are Mortgage-Backed Securities Index Admiral Shares and Short-Term Treasury Index Admiral Shares.
• Currencies: a number of mutual fund providers have created mutual funds built on currency products. An example of such funds is PIMCO Emerging Markets Currency Fund.
• Money markets: these are funds created to invest in short-term instruments which are primarily treasury bills and commercial papers. Examples of this are California Municipal Money Market and Pennsylvania Municipal Money Market.
• ETF funds: these are mutual funds which invest in Exchange Traded Funds.

Types of mutual funds

There are eight primary types of mutual funds. These are:

Domestic stocks

These are mutual funds which invest primarily in stocks from a given country. These stocks are further divided into other categories which include: large value, large blend, large growth, mid-cap value, mid-cap blend, mid-cap growth, small cap value, and small-cap blend. For example, the large growth index invests primarily in large companies that are seeing increased growth rates. Examples of such companies are Microsoft and Apple.

Small-cap stocks, on the other hand, invest in small companies that have a market valuation of less than $1 billion.

International stocks

This is a mutual fund that invests in international stocks. For example, a Latin America mutual fund will invest in Latin American public companies while a Europe fund will invest in companies from Europe. The most common types of international funds are those from North America, Emerging Markets, Japan, Pacific, and world stocks.

Specialty stocks

These are mutual funds that invest in stocks that are in a certain industry. The goal is to have access to these industries through their stocks. For example, if you want to have exposure in the crude oil market, you can invest in crude oil mutual funds like Vanguard Energy Fund. Similarly, if you want exposure in the gold market, you can invest in mutual funds that invest in gold mining companies. Other sectors are: financial, technology, communications, real estate, health, utilities, and natural resources.

Specialty bonds

Bonds are not equal. There are a number of categories that you can invest in. These are high-yield bonds, multisector bonds, international bonds, and emerging market bonds.

Hybrid funds

These are bonds that allocate funds to stocks and bonds in ratios selected by the money manager. The most common type of allocation is 60% stocks and 40% bonds. Different managers allocate in their own ratios.

Municipal bonds

These are bonds issued by municipals. These too have a number of types which include Muni National Long, Muni high yield bonds, Muni short term, and Muni Single State.

Government bonds

These are funds created by investing in government bonds. These are known to be safer than corporate bonds because of the difficulty of a government to default. For example, if the United States was unable to pay its obligations, it can decide to increase taxes. Alternatively, it can decide to print dollars to pay the obligations which will lead to higher inflation.

Why invest in mutual funds

With so many financial products you can invest in, why should you choose mutual funds?

Diversified portfolio: a mutual fund allows you to invest in a diversified portfolio of the financial securities mentioned above. This diversification helps you reduce the risks that come with being invested in an individual stock. Low cost: if costs matter to you – and they should – mutual funds are less expensive than other types of investments. This is because the only fees you pay goes to administration. Further, many mutual funds invest in their own funds. This is contrary to the hedge funds which charge you a 2% administrative fee and another 20% incentive fee. This is the main reason why Bogle did not get very rich.

Professional management: Mutual funds are managed by professional money managers. For most firms, the experience and expertise of a fund manager are very important. Therefore, if you don’t have any experience in investment, a mutual fund helps you to participate in the market.

A wide set of products to choose from: As shown above, there are many types of mutual funds you can select from. Access to international markets: If you want to access international markets, international mutual funds allow you to gain this access.

Who should invest in Mutual Funds?

Since mutual funds are highly diversified products, they are not known to have the highest yields. For example, in 2017, the S&P 500 delivered more than 27% in gains. In the same year, the average mutual fund returned less than 17%. In the last 20 years, investors have earned a return of 4.6% on mutual funds which is less than 8% from the S&P 500. Therefore, you should invest in mutual funds for the following reasons.

Retirement: mutual funds are ideal for your retirement account. This is because as mentioned above, the returns are not very high for the short term. Access to international markets: If you believe that certain geographies will do well, you should consider investing in mutual funds. It is a less risky strategy than investing in these markets yourself.

No experience in markets: If you don’t have any experience in the market, you should consider investing in them. This is because they are managed by professional money managers.

Risks of mutual funds

There is no financial product that does not come without risk. Mutual funds too have a number of risks which include:

• Country risk: this is a risk that comes especially when you have invested in a fund that invests in country bonds. If a country defaults, it can expose your investment to risk.
• Credit risk: if an issuer of a bond goes bankrupt, then you will hold worthless bonds. A good example of this is Sears, which recently announced that it will declare bankruptcy.
• Currency risk: this is where a currency of a country loses value. This affects both bonds and equities. An example of this happened in Venezuela, whose currency lost 95% its value in August 2018.
• Interest rate risks: this is a problem mostly in fixed income securities. In this situation, the value of fixed asset securities goes down when interest rates rise.
• Liquidity risk: this is a risk where there are no participants in the market to buy the held securities.
• Market risk: this happens when the securities market is in a bear market.

Alternatives to mutual funds

Since mutual funds are usually ideal for long-term investments, it is also important for you to have exposure to shorter-term securities. A good way to do this is to trade - the buying and selling of financial securities like currencies, stocks, commodities and indices for the short term. The benefit of this is that you can buy those you believe will go up and short what you believe will go down. With mutual funds, there is no short selling. Trading will also allow you to use leverage which helps you buy more than the capital amount you have available for trading. By combining short-term trading with longer-term mutual funds, you get a varied and healthy portfolio that can improve your overall financial position.