Mutual Fund Basics
Types of Mutual Funds
Mutual Fund
Performance
Mutual Fund Links
- Diversification
- Lower Transaction costs
- Liquidity and divisibility
- Better record keeping
- Professional management
- Marketing (reminds you to invest!)
- Markets are very tough to beat. This is the basic idea behind the Efficient Markets Hypothesis. There are many very smart people trying to beat each other and it is unlikely that anyone can consistently beat everyone.
- Mutual Funds incur transaction costs whereas market indices do not.
- Do fund managers beat the market? mmm Maybe.
- Do Fund managers hold on to losers too long?
- Cost of active management is more than you think!
- Hot hand fallacy and "Gambler's Fallacy" both are things to avoid!
- Short Term Thinking
Mutual Funds are nothing more than a group of people pooling their money for investment purposes. Everything else that we see written about with respect to mutual funds is really just details about how to decide who we should allow "manage" our money and how we should keep track and reward those that invest the money for us.
Advantages of mutual funds
Do not put all of eggs in one
basket!
Diversification is the idea of not putting all of your money in one spot. It means holding many types of assets. For example owning shares in many companies or owning some stocks and some bonds. Diversification lowers risk since when some assets are up in value, others are down in value.
Diversification, however, can drive up transaction costs for small investors. Mutual Funds are a solution to this problem. Investors pool their money and the fund then invests in many different assets. By spreading out trading costs over a larger investment, the percentage transaction costs are often lower. Additionally, each investor need not do the research which further saves expenses.
Most mutual funds (especially open ended funds) allow investors to purchase (or sell) fractional shares. This divisibility of shares allows investors to invest set dollar amounts without worrying about the cost of the shares.
Mutual funds also keep track of when people buy and sell. This makes tax reporting easier. Periodic reports are sent to investors. These lower record keeping costs.
Some investors need a "kick" to remember to invest. Mutual Funds often provide that impetus by showing the benefits of investing and also merely by keeping the fund in the mind of the investor.
While the efficiency of markets ( prices are correctly priced) draws into the question the advantages of paying a fund manager to pick stocks, there are those individuals that believe that managers can invest better than you and me.
There are many ways of classifying mutual funds. These range from how the funds are bought or sold to where the funds invest. It must be stressed that these categories are not mutually inclusive. Funds can be classified in several of these categories.
Closed-end vs Open End Mutual Funds
Open End mutual funds are ready to to redeem or issue new shares at any point. This is the more popular type of mutual fund. The number of shares is constantly changing as investors buy and sell their shares. The firm is generally willing to buy and sell at Net Asset Value (NAV).
The price of a closed end funds is set in the secondary
markets. In this type of fund the number of shares is largely fixed
and shares are bought and sold between different investors. This
is the traditional investment company. The firm raises money through
periodic security issuances (primary market transaction) but generally
all subsequent buying and selling is done without the fund's intervention.
Type of Investment
An alternative way of classifying mutual funds is by the types of assets
the fund buys. Some of the more popular are:
Money MarketsFunds that try to diversify across asset classes as well as within a given asset class are called Balanced funds. A specific type of this is called a life cycle fund. A life cycle fund tries to invest in assets that are appropriate for the average investor in the fund. For example a life cycle fund that targeted young investors would have riskier growth stocks whereas a fund that targeted retirees would likely have more invested in government bonds.
Stock Mutual Funds
Bond Funds
Within these broad categories there can be further stratification. For example: stock fund that invest only in internet firms, or stock funds that invest only in dividend paying firms.
Funds that specialize within a certain industry are often called sector funds. These are quite risky as they have not diversified away the industry specific risks.
Location of Holdings
Yet another way of classifying funds is where the assets are located. For example you can have Domestic or International funds. Some of the categories here include specific country funds (example the Mexico Fund) or region funds (example Latin America) or even by type of market (Emerging Market).
One important reason for locational municipal bond funds is for tax purposes. Interest earned on municipal bonds is tax-free in the state of the municipality. Thus an investor in Nebraska that buys a muni-bond issued by the Omaha City government need not pay state or federal tax on the interest. The interest on the bond would however be taxable for an investor in New York.
Miscellaneous
Hedge Funds-not a true "mutual fund" but in many
ways quite similar. Funds that take very large bets on various types
of investments. DO NOT assume that a HEDGE fund is low risk (the
word Hedge is not correctly used here). Very low liquidity. Money
is generally tied up for at least a year.
Naked Funds- Mutual fund that allows investors to
track every trade the fund manager makes.
Interval Funds-In an effort to remain fully invested,
certain mutual funds only allow withdrawals at certain times.
William Sharpe and Michael Jensen in the mid 1960s investigated Mutual Fund Performance. They used The Capital Asset Pricing Model (CAPM) and concluded that on a risk adjusted basis mutual funds did not outperform the market. Although there have been many subsequent, and more sophisticated, studies the results have not changed. It does not appear that mutual fund managers can consistently out perform the market.
The two main reasons why mutual funds can not beat the market are:
FinanceProfessor.com Blog articles on Mutual Funds
A list of companies and mutual funds that have good investment
links.
A look at the real expense ratio (lesson: active trading drives up costs) (aslo see FinanceProfessor.com's blog article on this)
www.Ibbotson.com has many good
articles on a wide range of topics centering around investments.
|
