If you are a new investor, you may be thinking about investing in a mutual fund. According to Pete Briger, the first step is to identify your goals and desires for the money you want to invest. Are you looking for long-term capital gains or for current income? Once you identify your goal, it’s not difficult to choose the right mutual fund.
What is a Mutual Fund?
According to Investopedia, a mutual fund is an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities (stocks, bonds, etc).
Mutual funds are operated by money managers who invest the fund’s capital to attempt to produce capital gains and/or income for the fund’s investors.
They can be very useful for individuals who wish to actively invest their money, but do not want to fall foul of the investing mistakes that are all too easily made as an individual investing in stocks.
Related Article: Why You Shouldn’t Listen To Stock Tips
What Is Risk Tolerance?
Risk tolerance is the amount of variability in your investment returns that you are willing to withstand. Your investment may rise in value or go down in value, and you need to be able to withstand these swings and not panic and sell at the wrong time. If your risk tolerance is low, you may constantly worry about your investment and not sleep at night. This is not considered good risk tolerance.
You also need to decide how long you are willing to tie up your money. Can you afford to invest and forget for years, or will you need that cash soon? If you are thinking about a mutual fund, you would ideally be willing to invest for at least five to eight years, and perhaps even longer.
Different Styles of Mutual Funds
If you have decided to invest for the long-term and are willing to assume some volatility and risk, then you may like a capital appreciation fund. This type of mutual fund contains a high percentage of their assets in common stocks, which is why they are considered volatile. However, they could give a large reward over time.
If you need current income you may like an income fund. The two most common holdings in income funds are government and corporate debt.
If you require a long-term investment but cannot sustain substantial risk, you may consider a balanced fund that invests in both bonds and stocks.
Related Article: What Should I Invest In?
What Are the Fees?
There are several different types of fees charged by mutual funds, and they play such a massive role in eventual returns. This is the way the fund managers make their money and is something to be very wary of. It can also be a fairly complex affair (despite regulators trying their best to make fund managers show a single fee for comparative purposes).
The sales fee is called a load fee and it charged on your initial investment, a front-end load fee, or at the time of the sale of the investment, a back-end load fee. Both of these fees are about three to six percent of the total amount you invest, but it is legal for funds to charge as much as 8.5 percent. Clearly, if you are investing over a short time frame, this can be a significant chunk of your investment.
There are also no-load funds that don’t charge either fee, but they have other fees including administration fees and the management expense ratio. Again, these ongoing management fees can be up to 2% per annum depending on the fund.
Imagine that you placed £10,000 in two funds for 30 years. Both funds earn 10% per year. One charges ongoing management fees of 2% and the other only 0.3%.
After the end of the 30 years, the higher fee fund will be worth £100,627. In comparison, the lower fee fund (which earns the same gross return) will be worth £160,768. Therefore this fee, due to the effect of compound interest, can have a huge impact on you overall returns.
Another fee is 12b-1 fees. You may not be aware of this fee because it is taken off the reported share price at a particular time. According to law, this fee may be 0.75 percent of the fund’s average assets per year.
When studying mutual funds, you should look for the management expense ratio. This covers fund expenses. It is the total percentage of fund assets that are being charged to cover the expenses. The higher the percentage, the lower your return will be each year.
Some other points to consider when looking for a mutual fund are:
- No sales charges
- An expense ratio below one percent
- A low turnover less than 50 percent per year
- No cash reserves because all the money is invested
- Don’t forget about tax wrappers when investing in mutual funds
Related Article: Investing My ISA Allowance
What else to consider?
However, you may not choose a mutual fund at all. As we have previously reported in a previous article, passive investing (low-fee index funds & market tracking ETFs) is historically a better investment than the majority of mutual funds.
Related article: Why Passive Investing is better than Active Investing
Choosing the right mutual fund is not an easy endeavour, and may not be the right choice for everyone. However, with these tips, there is a possibility that you could get a good return on your money if you are willing to take the time to do the research.
Jayson @ Monster Piggy Bank says
I believe those people who have got an MF account yet, they are missing a lot. The funds that they should be investing will become millions in the long run. I have started some investments already. Hope it will. For those who have not enough knowledge, Mutual Fund in Equity is one of your best option. Because there is no safe investment, I rely on other investment wheels like Mutual Funds and Trust Funds since these investments are already performing well and are managed by financial gurus and professionals. Whether you have a short-term or long-term investment, they will still give you higher earnings. Well-guaranteed, I believe.
Mr Zombie says
Interesting article. 🙂 With all the research indicating that passive investing out performs active where do you stand? History doesn’t necessarily repeat itself, despite what singers tell us. Does an active fund have a place along side a passive strategy? Does it provide any further diversification?
Like you say, with the complexity around these funds, they deserve a substantial amount of your own time to review them properly to make sure what they are actually invested in ties up with the rest of your portfolio and to ensure you are not being ripped off with charges.
I am leaning towards passive funds for the moment, and once I have more invested to start investing a small portion into active funds. (Having said that my pension is actively managed haha).
Thanks for your comments Mr Z!
I personally lean towards passive investing (as I’m more than happy to match the market and no hand my money over the greedy fund managers). However, investing is a very personal thing and people should educate themselves on all the options and decide carefully which they think is most suitable for them.
Paul @ The Frugal Toad says
I have most of my funds with Vanguard and have been very happy. They have some of the lowest fees in the industry and a wide range of choices.