What is a Mutual Fund?

An Introduction

"... individuals get together to pool their resources. With that pooling – or mutualization -- ...they can reduce their risks through diversification and reduce their transaction costs."

Have you reached the point in life where you've decided to start saving? Or decided you want your savings to earn more, or you want a safe haven for the money you just inherited from Aunt Lucy.

Regardless of your motivation, we commonly deal with issues like these by purchasing, or investing in, mutual funds. Which prompts the question: What is a mutual fund?

A basic mutual fund definition goes like this: A group of individuals pool their money to buy stocks, bonds, and other securities. In doing so, they diversify their risks for greater safety, as well as reduce their costs and time needed to choose the right mix of investment vehicles.

We'll examine these and other key issues in more detail later, but we'll get started with a simple analogy. Let's suppose you decide to solve one of the issues above by buying a piece of property, perhaps with a house on it, perhaps without. Perhaps it's a revenue property, with renters, or perhaps not.

Lots of decisions, right? But, with the help of a realtor, you look at a dozen houses, and then make a decision based on criteria such as location, potential appreciation, revenue, if any, and the cost of upkeep.

As you looked at those properties, you might have wished you could own a piece of half a dozen of the best, rather than having to choose just one. If you could spread your investment around, you'd sleep better at night knowing you had a diversified portfolio of properties. Diversification means you don't bear the entire risk if something happens to the property you selected, if an outlaw motorcycle club moves in across the street for example.

And, assuming you're buying pieces of half a dozen properties, rather than putting all your money into just one, you'd likely invest with a group of friends or at least with people who shared similar goals. Because your group is collectively buying six homes, you could negotiate a much better deal with the realtor, bring your transaction costs down substantially.

Now, let's substitute stocks for properties. Instead of buying 100 shares of Apple and hoping for the best, you get together with a half dozen other people in your situation and buy a number of stocks. Again, you reduce your risks by owning a basket of stocks rather than just one, and you reduce your transaction costs. That's essentially what happens when you get invest in a mutual fund.

If we ask again, “What is a mutual fund?”, we'd also want to discuss tangibility. A house you bought to help fund your retirement is a tangible thing (something that becomes all too obvious when you get called in to fix the overflowing kitchen sink). A share in a mutual fund, though, is intangible. You don't even receive a piece of paper like a share certificate. But otherwise, being a mutual fund investor is much the same as sharing in the purchase and ownership of a number of real estate properties, rather than committing everything to just one property.

There's a parallel we might explore at this point, a parallel which will help us fully deal with the question, “What is a mutual fund?” That parallel has to do with insurance. Today, with dozens if not hundreds of brokers and insurers fighting to cover our cars and homes, it's easy to take insurance for granted.

But, a couple of hundred years ago, insurance of any kind was rare. But, it did emerge, at least in its current form, when groups of newly prosperous people got together to share risks. For example, most giant life insurance companies began when small groups of individuals began contributing to small funds in the seventeenth, eighteenth, and nineteenth centuries. Because the individuals created their own pools of funds, and were the owners as well the policyholders, these entities became known as mutual insurance groups.

The parallel, of course, is that individuals contribute together, and profit or share losses together. We see initiatives based on the mutual sharing of risks and the mutual sharing of rewards or losses. Today's credit unions operate on similar basis; each individual who wants to save or borrow must first become a member and buy a share or shares.

If we were to ask the question again, “What is a mutual fund?” we might now say a mutual fund is a vehicle in which individuals get together to pool their resources. With that pooling – or mutualization --comes the expectation they can reduce their individual risks by diversification and reduce their transaction costs. As we'll see in the articles that follow, good diversification and reduced transaction costs can make a very big difference in investment returns.

But, before doing that, let's also note it's no longer necessary to get together with your friends or family, as our forebears did a few centuries ago. Depending on where you live and invest, you will have hundreds. if not thousands, of existing mutual funds from which to choose. The modern challenge is not to find others with whom to mutually invest, but to narrow down the immense field of firms ready and waiting for us. That's a challenge we'll take up in other articles on the whatismutualfund1 site.

And, if that wasn't enough, mutual fund investors now have the option of buying Exchange Traded Funds (ETFs), which are similar in some ways. Again, this issue will be tackled in succeeding articles.

What is a mutual fund? Well, I hope this article has helped you develop a better understanding by giving you analogies, history, and parallels. Grasp the essence of the idea of mutual and you will be able to approach mutual fund investing more confidently and more successfully.

What is a Mutual Fund 2: Diversification

"...a mutual fund offers solutions to the problems of company, industry, and other risks through diversification...."

When the patrons of Lloyd's Coffee Shop on Tower Street in London began insuring ships and their cargoes in 1688, they used an approach that has served both insurers and investors well: They diversified.

The 'Names', as the founders of Lloyd's of London were known, each opted to insure a small portions of many ships and cargoes, rather than insuring all or a substantial portion of just a few ships and cargoes. That way, if a ship sank, as ships often did back then, the loss was spread among many Names. No one individual was likely to be bankrupted that way. It's much better to lose a small amount a few times than be bankrupted by one big loss.

Similarly, most investors, past and present, have diversified their risks. And, they've done it in the same way as those who drank coffee in Lloyds more than three centuries ago. They've bought small pieces of many companies, rather than buying a lot of just one or a few companies.

Today, investors look at several different types of risk, and work to diversify among them. Let's start with 'asset risk', which refers to choices involving stocks, bonds, and even our old friend, cash. Often, stocks go up when bonds go down, and vice versa. And since you can't predict which will be in favor at any given time, you protect yourself in advance by holding all three: stocks, bonds, and cash. By spreading out your investments among these three classes, you'll minimize setbacks.

Turning specifically to stocks, when you invest in an individual company, you expose yourself to what's called 'company risk.' This is the potential loss of some or all of your investment in a company that gets into trouble. Normally, when a company gets big enough to 'go public', to start selling its shares on a public stock exchange, it's generally quite sound; at least compared to most small businesses. Yet, problems still occur. Consider the fallout among banks from the stock market plunge in 2008.

While we're on the subject of banks, let's not forget what's called 'sector risk' or 'industry risk'. This is the same problem as company risk, but on a bigger scale. We saw that with the whole financial sector, worldwide in 2008. In the recession that followed, we also saw industries such as transportation get into trouble. And, as we know, transportation was already suffering by mid-2008 because oil prices had skyrocketed in the preceding months.

And, let's recognize yet another risk, 'geographic risk,' which occurs when a particular region or country gets into trouble. In 2011, Europe faces debt crises in several countries, a mixed willingness among the governments and banks of other Euro countries to bail out their poorer cousins, and a desire in almost all those countries to maintain rich social programs.

As you can imagine, trying to buy a set of stocks diversified enough to overcome these risks would be tough. You would have to screen through literally thousands and thousands of stocks, from dozens of nations, to find the 20 to 40 that would balance your risks appropriately.

Fortunately, mutual fund companies have computers and software that can do that sort of digging. What's more, the fund companies have professional stock pickers who know how to interpret the data coming out of the software. You've no doubt seen them on TV or read them in the business section of the paper. As we'll discuss in a future article, their conclusions can be as mistaken as anyone else's, so we'll treat their advice cautiously.

Still, though, the point remains that with one or more mutual funds, solutions to company, sector, and geographic risk can be relatively easy to find. Not that an investment in mutual funds to overcome these risks will necessarily be profitable, but you can get the job done without too much fuss or mental strain.

An equity fund will give you anywhere from a few dozen to a few hundred companies in one basket. If one or two, or even a half dozen of them, were to suddenly go broke, your holdings would be reduced but not wiped out. In the most optimistic case, some companies will thrive in an environment that drives other companies out of business, a benefit perhaps of sector risk. You overcome company risk by spreading your bets among many companies, rather than just one or a few.

That's also the case for industry risk or sector risk. Invest across a number of sectors by selecting the right mutual fund and you've covered off most of your exposure. For example, in a recession, transportation companies will drop in value, but at the same time, consumer companies (such as Walmart and McDonald's) will do just fine.

And, you can reduce your geographic risk by buying global funds, or buying into funds from countries other than your own. Since 2008, for example, we've seen the economies of the developed world struggle to get out of the recession, while the emerging markets have generally grown rapidly. In fact, China's economy has been so hot it's had to take measures to try to slow down growth. Investors in developed countries who shifted their emphasis to emerging market mutual funds in 2009 would still enjoy opening their monthly statements in mid-2011.

What is a mutual fund, then? As we've seen here, a mutual fund offers solutions to the problems of company, industry, and other risks through diversification. These solutions are never perfect, but as we've seen, they give those of who aren't rich or idle an opportunity to diversify our portfolios competently and quickly.

What is a Mutual Fund? 3: Investing Transaction Costs

It's an investment vehicle that helps us reduce the transaction costs involved in buying and selling stocks, bonds, and other securities. It's the equivalent of belonging to a buying club, where members use their collective purchasing to reduce their costs.

If you haven't yet started investing, you haven't yet had the pleasure of opening your online account, or your paper statement, and discovering you've been whacked by a new fee of some kind for buying or selling shares. Brokerage firms, the companies that buy and sell stocks on behalf of investors, make their money by charging fees or commissions of various kinds, and they like to apply as many as they can.

And, I'm a relatively new investor, so I've only experienced the fees of discount brokers. Before the discount brokers came along, commissions and fees were much higher, and could take a huge bite out of your investing returns. That was especially true if you dealt in relatively small numbers of shares, say less than thousands at a time. Still, even in this age of discount brokers and even super-discount brokers, fees and commissions can and do hurt. And, to add insult to injury, you may have to pay taxes on those fees.

When you invest through a mutual fund, you're usually buying in large quantities, and you're sharing those transaction costs with thousands of other small investors. Quite simply, mutual funds bring economies of scale to stock transactions, in terms of both the numbers of investors involved and the number of stocks bought and sold.

While you won't see any transaction costs on your mutual fund statement, they are there, covered under something called Management Expenses and listed as MERs – Management Expense Ratios. Generally, these expenses will cost 1% to 3% of the assets under management by the fund company. The MER covers not only trading costs, but also the salaries of staff, advertising, and any other expenses required to operate the mutual fund company.

You don't pay these MER costs directly; instead, they're deducted from the earnings of the mutual fund, but they still cost you. For example, if the XYZ Equity Fund earned 10% last year, and its MER was 3%, then it will have reported a yield of 7%. If the MER was 1.5%, then it would have reported an 8.5% return. The yield, of course, is the gain (or loss) you would have experienced over a specific period of time such as a month, a year, or 5 years.

In addition, some funds charge front-load or back-load fees, which provide commissions to independent sales people. Since the sales people add no value to investment returns, we're almost always better off with no-load funds, which are funds with no commissions at all, just MERs.

As this article is being written, many investors are moving away from mutual funds and moving to Exchange Traded Funds ETFs). Saving money is the main attraction, with ETFs usually charging less than 1%, and sometimes substantially less than 1%. In a later article, we'll compare mutual funds and ETFs, but for now we'll continue to focus on the reduction of costs through the use of mutual funds.

Costs matter when it comes to investing, and they matter because of the effect of compounding over time. A few dollars today may not seem like much, but when you lose those few dollars every year, and the earnings and capital gains on those dollars, the costs add up very quickly.

I like to look at costs from the perspective of how long it takes to double any given amount of money. To do that, I use the Rule of 72. Divide 72 by the rate of earnings or appreciation, and you'll know how many years it will take to double your money.

For example, if you start with $100,000 and earn 6% a year, it would take you 12 years (72 divided by 6) to get to $200,000. If you could boost your return to 8% a year, it would take only 9 years (72 divided by 8) to double your starting capital.

By reducing your costs even modestly, you can reach your investment goal much sooner. Or to put it another way, you can reach your investment goal with less starting capital if you can reduce your costs. But no matter which way you work it out, small reductions in transaction costs makes a big difference in compounded returns.

Until mutual funds came along, investors with small or modest amounts of capital couldn't win for losing. The costs involved in buying and selling stocks would often be greater than the capital gains and dividends they could expect.

So, what is a mutual fund? It's an investment vehicle that helps us reduce the transaction costs involved in buying and selling stocks, bonds, and other securities. It's the equivalent of belonging to a buying club, where members use their collective purchasing to reduce their costs.

Wrapping Up...

After reading these three articles you should have a better, more prodound sense, of the logic involved in buying mutual funds. When you buy mutual funds, you protect your capital through diversification, and you reduce your costs by sharing them with thousands of other small investors.

All of which should increase your odds of successful investing, and move you closer to your goals, whether that's to buy a new car, a new house, or just a couple of chairs at the beach on a tropical island.