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An Introduction To Mutual Funds: A Good Choice For Retirement Investing


by Dave Mason, PhD, CPA; Ann McCarthy, MBA, CPA; and Mark McCarthy, PhD, CPA


Congratulations! You did it! With your diploma in hand, you are officially a college graduate. Now you are eager to start your first "real" job. As you embark on your new career, consider the following scenario that is played out in offices everywhere.

Monday, 8:00 a.m.---With great anticipation, you arrive at the office of your new employer. Not knowing what the day holds, you are relieved to discover that Chris, another new employee, is also starting work today.
8:10 a.m.---You and Chris are shown around the office. You are introduced to the rest of the staff, learn where the coffee is, and get supplies for your desk.
8:30 a.m.---Joan, the benefits coordinator, calls you and Chris to her office to discuss your employment benefits and retirement options. After handing you some pamphlets, Joan begins, "So how do you want to invest your retirement funds? Do you want to invest in stocks, bonds, mutual funds, the money market, and/or annuities? We have many different plans from which to choose. Take a few minutes to look over the brochures."
8:40 a.m.---Your mind is racing! Stocks? Bonds? Mutual funds? Money market? Annuities? A retirement plan? Yikes! You were daydreaming about your Spring Break trip when investment options were covered in your Finance class. "Oh, if only I had paid attention in class that day," you lament to yourself, "I would know what to do now."
8:41 a.m.---Suddenly, you remember Chris. Turning to him, you ask, "So, what are you going to do?"


Chris? You asked Chris? You just made Chris your financial advisor! You need to be educated enough about investing to make wise and informed retirement choices. In our article in a previous issue of New Accountant, "Retirement Planning for New Graduates: It is More Important than You Think," we stressed the importance of starting early when contributing to a retirement plan. We also suggested investing retirement funds in the stock market. Over the long run, the trend of the stock market is upward, and stocks outperform bonds by a substantial margin. Investing in individual stocks, however, can be risky. So how can you invest in the stock market and minimize your risk? Mutual funds might be the answer for you.


Definition Of A Mutual Fund
You probably have heard the term "mutual fund" but may not have known what it meant. A mutual fund is a pool of money contributed by many investors that is used to buy a large portfolio of securities. A professional advisor manages the mutual fund. Currently, there are more than 6,700 mutual funds, and this number continues to grow. The professional manager running the mutual fund makes decisions on where funds are to be invested, how much to invest, and when to sell. With a mutual fund, an individual is investing in all of the different companies in which the mutual fund owns shares. As with individual stocks, shares of the mutual fund can be purchased and sold.


Advantages And Disadvantages Of Investing In A Mutual Fund
Before you invest your hard-earned money, you must first consider the advantages and disadvantages of any investment. Mutual funds, like all investments, have advantages and disadvantages.
The most important advantage of investing in a mutual fund is that it provides individuals with broad diversification. Diversification reduces part of the risk associated with investing in the stock market. By pooling their money, mutual fund shareholders are able to spread their assets among many different securities, thereby dramatically reducing the risk associated with investing in the stock market.

A mutual fund also provides professional management. When deciding how to invest funds, mutual fund managers have the expertise and insight to choose excellent companies with bright futures. The mutual fund managers are in constant contact with individual company managers. They have access to the floor of the stock market where the most pertinent company information is found.

There are other advantages of investing in a mutual fund. Mutual funds can be very cost efficient, so more of your money is put to work for you. Marketability allows you to buy and sell your shares at any time. Convenience allows you to purchase a mutual fund over the telephone.

One disadvantage of investing in mutual funds is that there are no guarantees. Unlike bank deposits, mutual funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other agency of the U.S. Government.

A second disadvantage is the potentially high costs. A combination of sales commissions and high operating expenses may offset the efficiencies that can be gained through owning mutual funds. Costs associated with mutual funds will be discussed later in the article.


Types Of Mutual Funds

There are essentially three categories of mutual funds: money market, fixed income, and stock. Within each category, there are a variety of types of funds.

Money market funds have relatively low risk as compared to other mutual funds. These funds invest in short-term IOUs issued by governments, corporations, banks, and other institutions. Two examples are U.S. Treasury bills and bank certificates of deposit (CDs).

Bond funds (also called fixed income funds) have higher risks than money market funds but seek to pay higher yields. There are many different types of bonds, such as taxable, tax-free, long-term, short-term, government, corporate, and junk. Bond funds can vary dramatically in their risks and rewards.
Stock mutual funds (also called equity funds) are a third type. These funds generally involve more risk than money market or bond funds; however, with more risk, they can offer the highest returns. Stock mutual funds should be considered for retirement accounts. These funds are a great way to invest in the stock market, but minimize the risk associated with holding individual stocks. Stock mutual funds are categorized based on the types of companies included in their portfolio. Listed below are some of the different types of investment objectives of stock mutual funds:

Size---a manager invests primarily in companies of a certain size:
Small capitalization ($150 million to $500 million)
Mid capitalization ($500 million to $5 billion)
Large capitalization (greater than $5 billion)
Growth---companies with above average growth potential and lower than average dividend yields
Value---companies that are currently out of favor with investors and offer higher than average dividend yields
International---foreign companies
Sector---companies that are in a certain type of business such as health care, financial institutions, technology, and pharmaceutical
Index---invest only in companies that make up a specific index like the Standard & Poor's (S&P) 500. Index funds do not require a professional manager since the companies to be included in the portfolio are already determined by the composition of the index


How A Mutual Fund Makes Money
An investor in a mutual fund makes money in two different ways: current income and/or capital gains. It is important for an investor to understand the difference between these two sources of income.
Current income is produced when a mutual fund invests in interest-paying bonds or money market instruments or dividend-paying stocks. This income is paid out to the shareholders of the mutual fund in the form of dividend income. Normally, shareholders can choose to receive the dividend income in cash or to have the dividends reinvested in more shares of the fund. In a retirement fund, the dividends are normally reinvested in more shares of the fund.

Capital gains occur when a security held by the mutual fund appreciates or rises in value. As long as the fund holds the security, there is an unrealized gain. These gains remain in the fund, which raises the market value of the mutual fund shares. If the security is sold, then the capital gain becomes realized. Realized capital gains are paid out periodically to shareholders. When the mutual fund pays out its realized capital gains, the fund's share price is reduced by the amount of the distribution. As with current income, these realized gains can automatically be reinvested in more shares of the fund.

Mutual Fund Fees
As with any type of investment, there are fees and costs associated when investing in mutual funds. Any fee or cost in a mutual fund reduces the overall return and earnings of the investment. Research on the performance of mutual funds has shown that, on average, funds having the lowest expenses yield the highest returns. If expenses are lower, then more of the investors' money is being put to work for the investors. Mutual fund costs fall into two categories: sales charges or "loads" and operating expenses.
A load is a commission that the mutual fund deducts from the amount invested before buying shares of the mutual fund. This commission goes to the salesperson and the company. By law, the percentage cannot be higher than 8.5%. For example, if you invest $2,000 and a mutual fund has a 5% load, the mutual fund takes $100 ($2,000 x 5%) off the top. The remaining $1,900 is used to buy shares of the mutual fund. There are some funds that do not charge a front-end load but charge a back-end load. With this type of mutual fund, a percentage is deducted when you sell the mutual fund. The charge usually starts out at 5 or 6% for the first year and decreases each year thereafter until it reaches zero.

Operating expenses represent the basic costs that all mutual funds incur. Examples of such costs are fees paid to the fund manager, legal and accounting services, postage, printing, telephone service, and other costs of running the funds. The management fee usually ranges from 0.5% to 1% of the fund's total asset value. Some funds also charge a 12b-1 fee, named for the Securities and Exchange Commission rule that originated it. A 12b-1 fee permits a fund to pay commissions to brokers and other salespersons, and occasionally to pay for advertising and other costs of promoting the fund to investors. The 12b-1 fee for a "no-load" fund cannot exceed 0.25% of the assets.

All of these costs, except the load, added together produce an expense ratio---the ratio of total expenses to net assets of the fund. The average stock mutual fund expense ratio is approximately 1.5%. For every $1,000 invested in a mutual fund, $15 a year goes toward covering the cost of running the fund. This also means that a mutual fund having a return of 12% before deducting expenses ends up returning 10.5% to the investors. Watch out for fees! Remember...lower expenses means that more of your money is put to work for you.


Selecting The Right Mutual Fund
An employer offering a retirement plan may arrange for employees to have retirement accounts with different mutual fund companies. For example, Merck & Co. employees can choose from 10 different mutual fund families such as Fidelity Investments, Vanguard Group, T. Rowe Price Associates, and Franklin Templeton Group. Each of these families has a number of individual mutual funds from which to choose. If you are on your own in establishing and funding your retirement account, then you will have to choose a mutual fund (or funds) for your retirement savings. Today, over 6,700 mutual funds are available, and this number continues to grow. In either case, choose the mutual fund that meets your objectives and will give you the highest return in the years to come. So how do you select the mutual fund that is right for you? Research, research, research!

Information about mutual funds is easily accessible. One source is a prospectus that is obtained by calling the mutual fund company. A prospectus, often available on the Internet, contains much of the relevant information needed to make a wise decision. Morningstar is another good source. Morningstar is a service that not only provides information about different mutual funds, but it also rates the performance of the funds over one-, three-, and five-year periods. Each mutual fund is assigned a rating of 1 to 5 stars, with five being the highest. Only 10% of the funds followed by Morningstar receive a 5-star rating. Morningstar, however, does not follow every mutual fund available. Other sources include monthly periodicals, such as Money and Mutual Fund Magazine, that provide information and recommendations about mutual funds. There is also a wealth of information on the Internet about mutual funds. An abundance of information is available to help you choose a mutual fund that is right for you.

When investing, select a mutual fund that will yield a good return. What constitutes a good return? To address this question, a benchmark for good returns must be established. Certainly, you want to put your money into a mutual fund that will provide returns which are better than average. The S&P 500 is a stock market index that many stock mutual fund managers use as a benchmark for comparing their return performance. This index is made up of the 500 largest companies in the United States, known as the Fortune 500. Of the 262 stock mutual funds tracked by Morningstar, only 21% have exceeded the S&P 500 over the last ten years. Why are so many stock mutual funds performing below the S&P 500? Two of the most important reasons for underperformance are advisory fees and management expertise:

1. Advisory Fees---mutual funds charge customers an average of 1.5% of their assets invested in the fund. Therefore, managers must beat the market average by 1.5% each year just to equal the market average. Studies have shown that funds charging lower expenses perform better than those charging higher expenses. These findings are true for the past one-, three-, five-, and ten-year periods.

2. Management---with so many new mutual funds being established, many of the funds are being managed by individuals with little or no track record. When choosing a mutual fund, examine the manager's track record. Managers with solid track records tend to perform better than those with little or no track records.
How should you go about finding a mutual fund that is going to perform better than the benchmark S&P 500? Since advisory fees and management are two of the main reasons why mutual funds fail to beat the S&P 500, they are two criteria that should be used when selecting a mutual fund.

First, look at management tenure and performance. How long has the current manager been running the mutual fund? It takes time to build a track record. A manager that beats the S&P 500 for the first couple of years of his or her tenure probably does not have a long enough track record. In addition, a mutual fund may boast a great track record, but those returns may be the result of a manager that is no longer running the fund. A mutual fund is only as good as its current manager. One rule of thumb is to look at funds where the manager has been in place for at least six years.

Evaluating the performance of the current fund manager is extremely important. How well has the fund performed over past one, three, and five years? Morningstar assigns 4 and 5 stars to the funds having the best performance. When evaluating performance, consider the average returns for one-, three-, and five-year periods and the consistency of the yearly returns. A high one-year return may be the reason for an excellent five-year average return. For example, if you have two different mutual funds with the same five-year average return, one fund may have beaten the S&P 500 every year (consistency). The other fund may have had one great year and returns less than the S&P 500 for the other years.

Second, consider the costs and fees. Funds with lower expenses outperform funds with higher expenses. Think twice before putting your money into a mutual fund that charges any type of front-end load, back-end load, 12b-1 fees, or unusually high management fees (>1.5%).

Consider Index Mutual Funds
What if you want to invest in stock mutual funds, but don't have the time to research, research, research? If you feel that you won't have the time or don't want to take the time to evaluate the different mutual funds, consider investing in an index fund. These types of funds are gaining in popularity. An index mutual fund is designed to match the returns of a specific index such as the S&P 500 (large companies), Russell 2000 (small companies), and Wilshire 5000 (all companies). The fund is made up of all the stocks that comprise the index. An S&P 500 index fund will hold shares of the 500 companies that make up the index, no more or less. An index fund will not beat the index it is trying to match, but year after year it will come very close to the return of the index. Expenses are the reason for not quite matching or beating the market index. Remember that expenses of a mutual fund take away from the investor's return. However, index funds tend to have the lowest expenses of any type of mutual fund. Why?

First, an index fund does not need a highly compensated manager to decide which companies to invest in, when to sell, and when to buy. The companies that make up an index are the same ones in the portfolio.
Secondly, within an index fund, there is very little buying and selling of stocks since the make up of an index will only have minor changes each year. In contrast, when a professional manager decides to buy and sell stocks, the commissions incurred reduce the return of the mutual fund. The average expense ratio for actively managed mutual funds is approximately 1.5%. Index funds may have expense ratios as low as 0.2% to 0.3%. The difference of approximately 1% in average expense ratios between actively managed mutual funds and index funds may not sound like much. Be aware that the additional 1% in expenses can make a staggering difference when you are ready to retire.

Assume that you start investing $2,000 a year at age 23 and continue until age 65. Also assume that the average stock market return, before expenses, for those 43 years is 11.3%. If you invested your money in an actively managed mutual fund with a return of 11.3%, after deducting expenses of 1.3% the annual return would be 10%. Therefore, you would have accumulated $1,303,282. Now, assume the money was invested in an index fund that matched the stock market before expenses. With an expense ratio of 0.3%, the fund would earn an annual rate of 11% and you would have accumulated $1,773,925. The 1% difference in return from a lower expense ratio produced $470,643 more in funds available at retirement.

Index funds are an excellent choice if you don't want to spend time researching the many different mutual funds available and keeping up with their performance. With an index fund, you get a winning combination! You will pay the least amount of expenses and beat 70 to 80% percent of all the actively managed stock mutual funds.


Final Thoughts
Early in your career, you will have to make decisions on where your retirement funds are going to be invested. If the stock market interests you, then mutual funds are an efficient way to invest. With so many different mutual funds available today, where to invest may be a difficult decision. Following the guidelines discussed in this article will help you in choosing a mutual fund. If you want to invest in the stock market but still feel unsure about which mutual funds to choose, then putting your money into an index fund may be the right move for you.
Regardless of which investment plan you choose, remember that you need to be educated enough about investing to make wise and informed retirement choices. A thoughtful investment now can yield a big payoff later.

Dave Mason is an assistant professor; Ann McCarthy is a lecturer; and Mark McCarthy is an associate professor. They all teach in the School of Business at East Carolina University, Greenville, North Carolina.

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