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The "Financial Planning Blueprint" Blog

  • Writer's pictureJason Flurry, CFP

Analyzing mutual funds and their role in your investment portfolio

Is what you have really what you think you have?

Most people have heard of mutual funds as a way to invest money. Even if they don’t know anything at all about finances, the vast majority of people who are saving for retirement are saving in mutual funds, usually through their 401(k), 403B, or other company-sponsored retirement plan. And, when I used to do financial education workshops for the state of Georgia’s retirement system, I would often ask people if they owned mutual funds. Almost every hand in the room would go up.

My next question would be, “How many of you are using mutual funds to save for retirement?” Again, almost every hand in the room would go up.

Then I would ask this question. “How many of you have ever seen a mutual fund?” Nobody’s hand would go up.

I would stand there looking puzzled for a second and say, “Okay, wait a minute. Let me make sure I understand you guys.”

I would ask, “How many of you purchased your home without seeing it first?” Of course, no one would raise their hand.

Still looking a little puzzled I would then ask, “How many of you have purchased a car without seeing it first?” Occasionally someone would raise their hand, but over 99% of the time no hands would go up.

So then at this point, people would begin to figure out what I was trying to say. My next statement was, “So, if I’m understanding correctly, you wouldn’t buy a house without seeing it first and most of you would never buy car without seeing it first, but you blindly send money from your hard earned paycheck every month into something you’ve never seen before - and you just been doing this year after year with tens of thousands of dollars involved… And you’ve never given it another thought?”

That’s when, usually for the very first time, people even recognized this behavioral decision for what it really is and saw just how much faith they were placing in a system they really didn’t understand.

Maybe you’ve never thought about it either, and if that’s the case, you’re not alone. Mutual funds have been very popular since the 1980s and their history dates all the way back to 1774 when the very first mutual fund was created. The idea of pooling resources and spreading risk to increase purchasing power and potentially provide greater investment returns was a smart one. But even a good idea can result in a bad outcome for you if you don’t understand what you’re doing.

So in this article I’m going to spend a few minutes showing you how mutual funds work and how you can use them effectively as a part of your overall investment recipe. They can have a place in a well-balanced portfolio, but more than trying to position mutual funds into your investment strategy, I want you to be aware of the concepts and principles that make up this investment vehicle. Then you can decide if they have a place in your plan and use them to your advantage with more confidence.

Seeing the invisible The mutual fund questions I used to ask my audiences were admittedly a little bit loaded because, of course, it’s actually impossible to physically see a mutual fund. My questions were designed to expose a thought process they had blindly accepted to be true and challenge that belief to help ensure that the financial and investment decisions they were making were intentional and well-informed. But, as a brand-new broker back in the mid-90s, learning to sell mutual funds was one of the very first things I was taught.

Every good broker needs to know how to sell a stock, a bond, and mutual fund in order to be successful. And here’s how it works. The pitch for an individual stock or individual bond is usually based around a story, but the introduction of a mutual fund is more of a concept. I still use a simple illustration to demonstrate this today when I’m working with our private clients and I’ll share it with you here so you can have a better understanding of what a mutual fund could look like if you could actually see one.

Envision with me if you will a bucket with a spigot on the side. Now envision you and a lot of other people putting money inside this bucket. If we were together in my office right now, I would use my whiteboard to draw lines back and forth from the bottom of the bucket going upwards to illustrate the water level in the bucket rising. That rising water level is you and everyone else collectively pooling your money to buy shares of the mutual fund. The manager of the mutual fund, or of our bucket here, would take your dollars and invest them in a variety of things depending on what that particular fund’s objective is.

Over time, if the fund manager is successful, the level of water in the bucket, or the amount of money you all have in the fund, will rise. And, obviously, that’s what you want. But that’s not the only way the water level in the bucket can rise over time. There are two other ways you can receive income from your bucket. That’s in the form of dividends and interest.

Now on my illustration, I would usually draw two arrows coming out of the spigot and pointing to dollar signs. One of those would represent dividends and the other one would represent interest. As the mutual fund earns dividends and interest, that water comes out of the bucket and you can decide to either keep it or you can reinvest it back into the bucket to make the water level go higher. If you decide to reinvest it, I would draw an arrow from the dollar signs back over the top of the bucket showing the reinvestment process.

If your objective over time is to get as much water in the bucket as possible, reinvesting these income streams and adding additional funds of your own would help the account to grow. And, of course, if you ever needed money from your bucket, you could turn the spigot on and take it out whenever you wanted.

Pretty simple, right?

After all, we can all visualize a bucket like that and how it would work as a financial concept for our savings. Plus, once that part is understood, we can add additional buckets to create more diversification and rebalance the water levels in our buckets over time to help us manage risk and earn more money.

Not all mutual funds are created equally The very first mutual funds that were designed were closed-ended investments that worked just like the bucket illustration I just used except for one other key feature. These closed-end buckets had a lid on them that prevented additional money from going in and fixed the amount of shares available to investors. In other words, once the bucket was full, no one else’s money was allowed in. It was capped or closed.

There are still closed-end funds on the market today, but they’re not nearly as popular as open-ended funds. When the stock market crashed in 1929, most of the closed-end funds that were in business at the time failed. They couldn’t receive additional monies, and that left them limited in their ability to recover from the huge market declines that followed.

Open-ended funds, however, fared better and most mutual funds you find available today are open-ended funds. Because of their popularity, there’s probably a mutual fund for everything under the sun and even money market funds, which most people think of as cash, are actually structured as mutual funds too. There are a variety of cost structures too ranging from some with upfront sales charges (often referred to as A shares) to others that have back in charges if you sell out of them too early (usually referred to as B shares). Some also have no upfront or backend fee but rather an ongoing charge you pay every year. These are typically called C shares and owning a mutual fund under this format is like leasing a car versus paying cash for an upfront or financing it over a fixed period of time. The ongoing fee that’s a part of most C shares can really eat into your returns and cost you a small fortune over time.

In the 1970s, index mutual funds came on the scene and John Bogle of Vanguard fame used them as a foundation to build one of the largest financial companies in America. These index funds offered investors the lowest cost structure of anything in the marketplace and they challenged the conventional way of thinking that said an active management approach, where some of the brightest minds in finance use their insight and information advantage to produce superior returns, was the best way to get the best results possible. Passive investing, on the other hand, simply let the markets behave however the markets wanted to behave. And, as a result of owning the index, some people felt like they had a better chance to capture more of the markets returns instead of speculating on the timing and individual investment decisions of their fund manager.

Determining which group is correct in their thinking is another topic for another day, but the studies have shown over and over that a more passive approach combined with a proactive strategy to monitor your investment allocation typically yields the best results over time. Owning mutual funds is one way to help accomplish this, but it’s not the only way.

The mutual fund advantage Mutual funds can offer someone an effective and efficient way to accumulate wealth through access to a broad range of tailored investment solutions that are based on sound investing principles and regulated by strict compliance standards.

Some of the benefits of owning mutual funds include:

  • Someone who’s financially unsophisticated can access professional portfolio management with smaller amounts of money invested.

  • Day to day operations are handled by the mutual fund company, so the administrative functions involved with managing your money are more streamlined and convenient for you keep track of as a shareholder.

  • By spreading your money among dozens, hundreds, or even thousands of individual investments, you systematically lower your risk of loss through diversification.

  • Mutual funds come in many flavors allowing you to select from a wide range of options that can help you meet a variety of investment objectives and adapt to your needs as they evolve over time.

  • The access to professional managers and the sheer scale of a mutual fund’s reach can provide opportunities for foreign and domestic investment that may not otherwise be directly accessible to investors.

  • Mutual funds are liquid, which means you can access your money whenever you need it as long as the fund provides redemption privileges.

  • Flexible contribution options exist, which allows all types of people to invest, including those who prefer to invest small amounts at regular intervals.

  • You can choose which type of product that best meets your needs based on the wide ranging levels of service and fees a particular type of fund offers.

  • Mutual funds are regulated, so they have a certain amount of accountability and intrinsic fairness built into their design that can provide safety and transparency to investors, although that transparency can be limited in certain situations. The regulatory documents mutual funds are required to maintain and distribute can be complex and hard to understand also. At least though, they are required to take that step, which is much more than corporations are required to do when they offer their company’s stock for sale on an exchange.

Of course, there are also some disadvantages to owning mutual funds. Some of them include:

  • Actively managed mutual funds can suffer from something known as “Style Drift,” which means they can deviate from their mission to speculate or overweight their allocations based on a hunch, gut feel, or educated guess. If your mutual fund manager is adding additional investments outside of his or her normal asset class, it can make managing your individual allocations difficult due to overlap.

  • The fund manager’s efforts to time the market and boost returns through specific investment selection in actively managed funds can add risk due to speculation.

  • Excessive trading in any kind of fund can increase fees and taxes and create an internal drag that hurts your returns over time.

  • Income and capital gains earned have to be distributed, just like in my bucket example earlier. That feature in any account that’s not a retirement account makes all of the income you receive taxable to you along the way, even if you’re reinvesting the money back into the fund. This taxable feature applies in years where your fund loses value too. It’s often very surprising to people when they learn that they can lose money and still owe taxes on a mutual fund investment in a year where their accounts dropped in value.

  • Index funds usually don’t have any front-end or backend sales charges, but they will have some type of ongoing management fee. Because of that fee, they can never match the return of the index they mirror because they have to account for their expenses to run the fund. Most fees are very low, but some fund companies actually charge in excess of 1-2% for managing an index for you. See for examples of this. That kills your chances of building wealth, even with this passive strategy, so be aware of what funds are involved in owning index funds if that’s a part of your strategy.

  • Some mutual funds may have built in restrictions that prevent their fund managers from doing what any rational person would normally do when managing other’s people money, like selling stocks as the economy heads into a recession or avoiding bonds as interest rates rise. They and everyone else may feel like it’s the wrong thing to do to stay fully invested when times are bad, but their investment charter can require them to stay fully invested at all times - so their hands are tied. Most of their investors don’t know that about their particular fund, so they can get hurt in a down market. Don’t let that happen to you.

  • Mutual funds usually have quarterly or annual reporting periods, so you can see what individual investments each fund holds at different times during the year. There is a sense of transparency and fairness in the spirit of this disclosure, but there is often a lot of window dressing that goes on just ahead of reporting periods. The fund manager can own a lot of things during the quarter or during the year you may never see, especially if the bet they made didn’t work out in their favor. Naturally, the fund company only wants to show you that they are investing in things that are doing well, and they can reshuffle the deck ahead of a reporting period just long enough to make it seem that things are better than they may actually be.

There is no perfect investment A lot of the things that I learned as a broker turned out to serve the best interest of the firm rather than the clients I was most interested in serving. One thing I did learn, however, that has served me and my clients well over the years is the philosophy that there is no perfect investment. A mutual fund, just like any other investment, has benefits and burdens. It can be used like an ingredient in a recipe to provide certain features and attributes that can improve the results of your financial future. But, just like in any other recipe, you need to understand what’s in the ingredients you’re using to help ensure that your outcome is going to be in line with your expectations.

As you’ve seen, mutual funds have become a mainstay of how people invest their money. That’s not likely to change. And, with a variety of positive features mutual funds offer, that’s perfectly fine. It’s important for you to understand how mutual funds work so that you can use them to your advantage whenever possible. Unfortunately, though, most people never give a second thought to where they’re sending their money when they invest in mutual funds. They think that because they’re offered in their 401(k) at work or because they’ve heard of big names like Fidelity and Vanguard that they’re safe.

As I hope you’ve seen here, there’s a lot more to it than that. And now, in just the last few minutes, you’ve gained more insight and knowledge about how mutual funds work than most people ever learn in their lifetimes. That financial literacy and understanding can help you do better and have more peace of mind as you work to build the best possible life for yourself and for those you care about the most.

Mutual funds can give you an option to manage money on your own, but often times it’s not the investments themselves that give you an advantage. To really improve your chances of success for the future, you need to have a solid game plan. And only about 10% of financial professionals have the experience and accountability to help you design a plan that acts in your best interest. If you’ve never had a plan like that built, or if you’d like to get a second opinion about the plan you have in place now, we can give you a complementary, independent look at where you are versus where you think you may be. And, even more importantly, we can show you where you need to be in order to reach your goals.


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