1 SMART Step
You've taken the first step.
Now let's see how far you can go.
About Mutual Funds
Benefits and Trade-offs
Which Fund Is Right for Your Needs?
What is a mutual fund?
A mutual fund is a “packaged product”, a type of investment vehicle known as an “open-ended fund” made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets.
Share price: The price per share to buy into the mutual fund. This is not that important because the funds are sold in small fractions this is really only a marker to determine change in value and capital gains.
Net Asset Value (NAV): Mutual fund shares are typically be purchased or redeemed daily at the fund's net asset value (NAV) per share. A fund's NAV is calculated at the end of each business day by dividing the total value of the securities in the portfolio by the total amount of shares outstanding.
Dividends: Dividends are typically pass-through from the stocks and bonds held in the fund.
Capital Gains: Capital gains are the taxable gains derived from the increase in NAV of a mutual fund.
Mutual fund Taxation
Taxation of mutual funds is pass-through based on the securities held in the fund, though mixing securities may erode some tax benefits.
Capital Gains & Dividends: Like stocks funds held greater than one year are taxed as capital gains while short term holdings of less than one year are taxes as income. Tax free investments like municipal bond funds will be treated as such by the federal and state governments (see bonds for more detail).
Fees and taxation: Many fees for mutual funds are tax deductible. These tax deductions do not need to be itemized on your taxes they are simply built into your statement by incorporating the amount into your cost basis.
Mutual Fund Selection
Your portfolio goals, objectives, and strategies are consistent with the fund objectives and strategies
Your risk tolerance and time available to do research and monitor investments are consistent with the volatility and diversity of the fund
Quality: A quality fund is one that consistently out performs its corresponding index (ROI, Prospectus, & Management Team)
The fees and expenses are reasonable to the type of fund and the expected return on investment
Mutual Funds’ Role: Mutual funds are an ideal tool for passive investing while allowing better performance than index funds. They also work well when used for sector rotation or market timing to increase returns while still maintaining diversity and minimizing risk.
Benefits and Trade-offs
Watered down returns
High fees compared to other securities
Deviation from stated investment strategy
Limited choice (often limited to a single fund family for practical reasons)
Inherent Investment Risks
Share Performance risk (depends on fund)
Market Fluctuation risk (low)
Call and Prepayment risk (minimized)
Mutual Funds Do’s and Don’ts
Do your homework (use “Morningstar”) -- Don’t take the work of an “advisor” receiving commissions, gifts, vacations, and free lunches from fund companies.
Do focus on long-term average annual return compared to the industry average and index -- Don’t focus on fees (it’s better to pay 2% for a fund that returns 15% annually than 0.5% for a fund returning 8% annually)
Don’t buy B-shares – Do buy I-shares or No-Load funds when available, otherwise buy A-share for investments >5 years and C-shares for <5 years and emergency funds.
Don’t use companies that charge exchange fees
Don’t use a financial advisor that charges fees for mutual funds (commissions are already built into the fund company fees)
Don’t use a financial institution that buys A, B, C or R shares in a “wrap rate” or fiduciary account if they do you are double paying
Best Mutual Fund Companies
Best No-Load Funds: Dodge & Cox has had the best performing no-load funds for decades and is often used by financial institutions to bolster their portfolio performance even though they won’t sell them to clients because Dodge & Cox refuses to pay marketing fees and commissions to financial institutions.
Best short term funds: Invesco C-Shares: Best short term funds because they have front or back load and no hold period allowing you to buy and sell in the same week without fees. Fidelity C-Shares is next best with a 2 month holding/maturity period.
Best Starter Funds: Acorn (using Vanguard Funds): No min to start fund ($5 - $5,000). American Funds is also good and can be opened for $250 or $25/month.
Best funds for passive investors: Passive investors need only a few high quality funds in both equity and bonds (growth, growth & income, and income). The good companies for this are Dodge & Cox and American Funds although many other companies could meet these criteria.
Best funds for active investors: Active investors need a large variety of quality funds with specific focuses ranging across all sectors. The best companies for this are Fidelity and Vanguard.
Best 529 Education Savings: No matter where you live you can opt to use a 529 from another state. Virginia’s 529 uses American Funds and is defiantly one of the best in the country, but always check your state 529 and state tax benefits available. American Funds will wave all sales fees for you and your employer in your employer signs a simple form allowing AF to send them some marketing material (it’s worth it).
NOTE: You should research individual funds on “Morningstar” before deciding on a fund or fund family. If you don’t have time for that than just buy ETF index funds.
Summary of Mutual Funds
Mutual funds are a great way to diversify your portfolio to decrease risk and reduce time spent on research.
Mutual funds like all investments involve risk. Your principal and investment return in a mutual fund will fluctuate in value. Your investment, when redeemed, may be worth more or less than the original cost.
Mutual fund prospectuses contain more complete information including the fund’s investment objectives, risks, charges and expenses as well as other important information that should be carefully considered. Your Financial Advisor can provide a prospectus which you should read carefully before investing or sending money.
MUTUAL FUND SHARE CLASSES
Bottom Line Up Front
A-Share = You own (includes D-Z Shares, except R)
C-Share = You rent (includes R-Shares, many "No Load Funds")
B-Share = Lease to own
A-Shares: LONG TERM INVESTING
Good value for investments > 3 years
*Sales/Commissions (Fees) are paid up front: One time fee as much as 5.75% decreasing with cumulative quantity you have invested with the company becoming 0% at or above $1,000,000.
*For each mutual fund company you choose to use you will pay an average of $10,000 over a lifetime in sales fees to reach $1,000,000. (This does not apply to D-Z Shares)
B-Shares: DO NOT BUY
*Reduced upfront fee in exchange for an extra annual fees built in for a term of 7-10 years and a high penalty if you sell before that period.
*Example: Advisor tells you that you buy in at half the cost of A-Share now and it will convert to an A-Share in 7 years as long as you don't sell in the next seven years. They may gloss over the part where your investment is reduced by 0.5% for the next 7 years to pay the advisor (that's not just 3.5% of your investment it includes your profit compounded annually, that could be 5% in this conservative example) .
*No matter what you are told you are better off buying A-Shares.
C-Shares: SHORT/MID-TERM INVESTING
*Cost effective for < 5 years or emergency funds
*Most funds have a 1% penalty if withdrawn prior to 1 year holding period.
- Invesco C-Shares (can be purchased at most financial institutions): Have no fees or penalties for deposit and withdraw, great for short term saving or tactical investment (allow 3-5 days to convert back to cash).
- Fidelity C-Shares (Fidelity/Fidelity Advisor can be purchased at many financial institutions): 2 month holding period.
*Note: During the holding period the shares can still be exchanged at no additional cost for any other C-Share in the mutual fund company.
*An R-Share is normally a version of a C-Share made specifically for a retirement account. Sometimes the rates are reasonable and sometimes they are not.
*You own these just like A-Shares
*These are mostly no load shares, institutional shares, admin shares, and employee shares.
*These are A-Shares with reduced or no fees to purchase, many not available to the public (or everyone would buy them).
No Load Funds: NO LOAD MAY NOT BE A GOOD DEAL
*No commissions/sales fees ("load" is a term used to mean commissions and sales fees: Front Load = commission on purchase; back load = deferred sales charges; level load = annual commission added on to the normal expense ratio such as with C-Shares).
*Many no load funds are simply index funds (and this may be fine).
*Some "No Load" funds have high expense ratios making them just another C-Share whether or not they call them that. Example: A "non C-Share no load fund" with an expense ratio of 1.2 would be a much more expensive long term investment than an A-Share with an expense ratio of 0.6 (even if you paid 5.75% to buy into it).
*Bottom line typically treat "No Load Funds" like C-Shares for evaluation purposes.
Mutual Fund Fees
Internal Fees: All funds (including no-load funds, index funds, and ETF) charge annual expenses to cover the fund's operating costs. These expenses are deducted from the fund before its returns are calculated. Internal fees include:
Management fees [fixed fee by fund]
General & administrative expenses (G&A) [fixed fee by fund]
Distribution and service fees (12b-1 fees) [may vary by share class]: This is a type of “load” a level load, or wrap rate sales charge imposed by the fund company to pay for advertising and sales commissions. (Is still charged on some “No Load Funds”)
Load Fees: Not all funds have an associated load.
Front-end sales load / purchase fee: A type of fee that some funds charge their shareholders when they buy shares. Purchase fees are paid to the fund company and split with the financial advisor making the sale. (These fees are charged on A, and B shares and sometimes other shares like R shares.)
Back-end load / deferred sales charge / redemption fee: Fees that some funds charge their shareholders when they sell or redeem shares. Like a front loaded fees deferred sales charges are paid to the fund company and split with the financial advisor making the sale. (These fees are charged on A, and C shares as well as a few other types when sold in less than a year and B-Shares when sold prior to maturity at 6 to 10 years.)
Exchange Fee: Exchange fees are uncommon and not imposed by most reputable fund companies. These fees are impose on shareholders if they exchange (transfer) to another fund within the same "family of funds.” (We recommend avoiding any company that charges exchange fees)
Fees should be taken into consideration but only relative to returns. Don't pay more than you have to, but you will need to pay more than the minimum to find a fund that constantly out performs the index. Remember don not focus on fees, focus on long-term average annual return compared to the industry average and the index (it is better to pay 2% for a fund that returns 15% annually than 0.5% for a fund returning 8% annually)