Mutual funds also expose us to some downside risks we need to consider

By: Robert F. Abbott, freelance writer and author of Big Macs & Our Pensions

Ups & Downs

If you buy mutual funds, you’re entering the same arena as stock traders, with lots of ups and downs. There are no guarantees that your money will grow, or that you’ll even get back what you put into them (there are some rare exceptions to this rule, but they cost you in other ways).

Generally, the more risk you take, the more your potential reward. By reducing your target returns, you can often reduce the amount of risk exposure. Many of us try to get the best of both worlds by diversifying our funds. In other words, rather than buying one or two funds, that we buy say five different funds, each with different risk/reward characteristics.

One rule of thumb for retirement planning suggests that the lower your age the more risk you can take. The rationale is that younger investors have more time to make up for losses than older investors. An alternative strategy involves keeping the bulk of your funds in reasonably safe funds, while putting 5% or 10% into riskier funds that might deliver higher rewards.

Fees & Commissions

One of the ongoing knocks against the mutual fund industry has been the cost of buying and staying invested in funds.

Commissions generally refer to percentages paid to commissioned sales people. Often we refer to these commissions as ‘loads’ – sales people may receive a front-load (a commission when you buy a fund), a back-load (a commission paid after a certain number of years or when you sell the fund), or some other type of load.

Unless you have some compelling reason to do otherwise, search for what are called no-load mutual funds. No-load means what it says: no deductions to pay a sales person or institution. Since they’re very commonly available, you should be able to find no-load funds without any difficulty.

When it comes to mutual funds, we also need to consider the expense ratio, the amount we pay the mutual fund company. To cover their costs – everything from office space to brokerage fees – fund companies obviously need to charge us something. How much is a contentious question.

Many funds charge fees in the 1% to 3% range, depending on how much time and money it takes to manage each fund. For example, an actively traded fund (lots of buying and selling of securities within the portfolio) will cost more than a passive fund (with very little buying and selling).

Fees of 1% to 3% may not seem like much, but they come right off the top. If your fund earns 6% a year and the fee is 2%, you’ve lost a third of your gains. Keep in mind, too, that the fund company gets its percentage whether the fund makes or loses money. So, if your fund loses 5% and you pay 2% in fees, you’ll be down 7% for the year.

By the way, the level of fees has nothing to do with how well a fund will do in the future. So, as a general principal, buy the lower-priced fund if you’re looking at funds that are otherwise similar in their overall risk and return.

Too Much of a Good Thing

One of the great advantages of mutual funds is being able to diversify, which is a standard strategy for reducing your risk and increasing your long term returns.

But, some mutual funds, especially some of the big ones, become too diversified. If they hold too many stocks (depending on the type of fund), they’ll behave much like an index fund. For example, a stock/equity mutual fund with more than 100 stocks.

If that’s the case, then you might as well own an index fund or ETF, rather than a equity fund. An index fund is a type of mutual fund made up of stocks from a particular group, such as the Dow Jones Industrials or the S&P 500. They cost much less (the fees are significantly lower) than equity funds. An ETF is another type of mutual fund, usually made up to reflect an index of some kind, and offering fees that are much lower than equity funds and index mutual funds.

Conclusions

These are three of biggest mutual fund concerns for investors, but others exist as well (do an online search for ‘mutual fund disadvantages’ for more information).

Despite the concerns, compelling reasons still exist to consider mutual funds rather than directly buying and selling stocks or bonds. In this introductory set of articles, my goal is to make you aware of the pros and cons of mutual funds.

In the end, knowing equals succeeding. The more you know, the more you’ll be able to take advantage of the positive aspects of mutual funds, and dodge the downsides.

One final note: Doing nothing, or letting your money sit in a low-interest checking account also poses a risk: Inflation risk. If inflation gets to 2% a year, while your savings earn half a percent, you fall behind by 1.5% a year. That’s compounded, of course, and adds up to a significant chunk of your savings over time.

Next, read about the Types of Mutual Funds

The Writer

Robert F. Abbotttop mutual funds is a freelance writer; see his profiles and analyses of value stocks at GuruFocus.com . He is also the author of Big Macs & Our Pensions: Who Gets McDonald’s Profits?

In this book, you will:

  • Discover the Ownership Revolution, and what it means to your retirement funding.
  • Find out how much of your lunch bill is a profit for McDonald’s, and who gets the profits.
  • Learn how corporate profits fuel one of the greatest social programs ever developed.

Click here to read a free preview at Amazon.com