Time to Make Cents

In an earlier entry, I wrote at length about the negative aspects of mutual funds. I mentioned how 80% of funds fail to earn a rate of return that equals (or exceeds) the stock market’s annual rate of return. The optimist inside each and every one of us recognizes that 20% of mutual funds do manage to beat the market. Perhaps you feel that you can find these funds. Before you go searching, there is some general knowledge and strategies you should obtain.

Mutual funds may be added to a portfolio in order to diversify or to include sectors that are too expensive to include in the portfolio otherwise. One positive aspect of mutual funds is that unit prices are relatively cheap compared to other investments. Unlike stocks, mutual fund investors do not need to wait until they can afford full units. Investors can by a decimal (or percentage) of a unit, making mutual funds more accessible to those with limited amounts of investment capital. Another positive aspect of mutual funds is that they are quite liquid. That is, it is easy to convert mutual fund units into cash. Other investments, especially debt instruments or stocks that trade at extremely low volumes do not offer this benefit. Liquidity is especially important if you foresee a potential need to quickly turn an investment into cash. The benefits of liquidity do not come without a downfall. Milton Freidman’s “There is no such thing as a free lunch” holds true. In order to ensure that mutual funds are liquid, fund managers must allocate a sizable amount of capital to cash to ensure that units that are sold can be purchased back. This cash could be allocated to other, higher yielding investments. Therefore in order to maintain liquidity, fund managers must give up the opportunity to invest that money and potentially earn a higher rate of return for investors.

The load is a charge associated with purchasing a mutual fund. Some mutual funds have front-end loads (the fee is charged when the mutual fund is purchased) while others have rear-end loads (the fee is charged when the mutual fund is sold). Regardless of front-end or back-end, investors who purchase mutual funds with loads are forced to pay a fee. There is an alternative though. No-load funds do not charge an extra fee to purchase of sell the mutual fund. They are typically sold, distributed and managed through banks or investment companies. As a result, there is no “middle man” which eliminates the need for an extra fee. There is no benefit to purchasing a mutual fund that has a load. Studies have proven that mutual funds perform equally, regardless of their associated load. Since there is no correlation between performance and load, save your money and invest in no load mutual funds.

Fund managers, as you may remember, manage mutual funds. In exchange for their professional management, mutual funds charge each investor a percentage of the total they invested. This percentage is known as the Management Expense Ratio, or MER. The fallacy stated by mutual fund companies is that mutual funds with higher MERs are more actively managed and thus earn higher returns for investors. Time and time again studies prove this to be incorrect. This is understandable, especially when you consider the fact that anyone (regardless of credentials, knowledge, experience or lack there of) can become a fund manager. When you are purchasing a mutual fund, ensure that it has a low MER. Any fund that has a MER under 2% is an excellent value, but anything under 5% should be considered. The MER is not everything though and like all investments, the total package must be considered before making an investment decision.

Mutual funds are able to utilize Dollar cost averaging effectively. Dollar cost averaging is the strategy of buying a fixed dollar amount of an investment on a regular schedule. This works particularly well with mutual funds, because units do not have to be purchased at discrete values and decimal units can be purchased. Dollar Cost Averaging is effective because as a mutual fund decreases in value, more units can be purchased. As the mutual fund increases in value, fewer units can be purchased. Over time, the average cost per unit will drop. This strategy is effective even when a large amount of cash is on hand that could purchase a large number of units. Dollar cost averaging reduces the risk of purchasing a large amount of an investment at a high price. The fee structure of mutual funds (the MER) makes dollar cost averaging even more effective because the fee is a fixed percentage of the amount invested. When investing in stocks, this is not the case. For example, if a trade costs 1 dollar to execute and $9 is invested (bringing the total cost to $10) then the commission collected represents 10% of the total cost. If the same commission charge exists on a transaction to purchase $99 of stock (and total cost is $100), commission now only represents 1% of total cost. By charging a fixed fee that is based off of a percentage, costs remain equal. As a result of this, it would be unwise to invest small portions of money into stocks because of the large amount (in terms of percentages) that is spent on commissions. Mutual funds do not suffer from this issue because an equal percentage is charged on all investments.

To reiterate, there are three steps one should take to ensure they are experiencing the highest returns possible with their mutual funds.

1) Only invest in no-load funds.
2) Invest in Mutual Funds with low MERs (ideally less than 2%)
3) Utilize dollar cost averaging.
Good luck and make sure to consider these ideas when investing in mutual funds as part of your portfolio.