Investing Unit 8: Mutual Funds


 


 

Mutual Funds: A Shoestring Investor’s Friend

Mutual funds are a professionally managed portfolio of securities such as stocks, bonds, and real estate investment trusts that are sold to investors in units called shares (See Unit 6, Mutual Fund Investing, which deals exclusively with mutual funds.). The market price of fund shares fluctuates daily in response to market conditions and the performance of securities within a fund. Unlike UITs, mutual fund portfolios are always in a state of flux as securities are bought and sold. Unless they are closed to new investors, mutual funds are constantly receiving “new money” from investors and also must meet shareholder redemptions upon request.

The amount of money required to purchase shares in a mutual fund varies considerably. Some funds require an initial investment of $250 or $500 (or less), while others require $10,000, or even $25,000, to open an account. Like banks, mutual funds are free to set their own purchase and redemption policies. Unfortunately, many mutual funds with low initial minimums also have high expense ratios (the percentage of fund assets deducted annually for management and operational expenses). Therefore, in addition to the initial investment amount, fund expenses, objectives, and historical performance also need to be considered when making a selection.

What happens if you find a great fund but it requires more money than you have available? Don’t despair! In three instances, mutual funds typically reduce their entrance requirements to a more “shoestring” level. The first exception is for retirement accounts such as simplified employee pensions (SEPs) and IRAs. Some fund families lower the required deposit amount in order to build a long-term relationship with investors.

A second instance where initial fund purchase requirements are lowered are Uniform Gifts/Transfers to Minors Act (a.k.a., UGMA/UTMA or “custodial” accounts). These are accounts established for a minor child, generally for college savings. Once a child reaches the age of majority in their state (age 18 or 21), this money is theirs to do with as they please. Again, mutual funds that charge several thousand dollars to open a regular account may accept less for minors’ accounts.

The third way to purchase shares in an otherwise “out-of-reach” mutual fund is to open an automatic investment plan (a.k.a., “sharebuilder” or “asset builder” account). Typically, this is done through direct deposit. On the application form, an investor authorizes a mutual fund to deduct a certain amount (often a minimum of $25 or $50) periodically from his/her bank account or paycheck, which is used to purchase fund shares. In addition to the convenience of not having to remember to write a check, this strategy also avoids the temptation of spending the money first (out of sight, out of mind).

Mutual funds, recognizing that they are encouraging a long-term relationship, generally provide a price break or waive their minimum account requirements completely for automatic investment programs. For example, one well-known fund family requires $2,500 to open an account and $250 for subsequent deposits. Investors who enroll in its “Automatic Account Builder”SM investment plan still need $2,500 for a regular account, and $500 for retirement accounts, but only $100 for subsequent deposits, which can be made monthly or quarterly.

All-In-One Mutual Funds

What if you have money for only one fund and want to include several asset classes (e.g., stocks, bonds, cash)? Not a problem. This, too, can be done on a shoestring budget. The trick is to select a fund that invests in several asset classes and also has an affordable minimum. Three types of “hybrid” funds that combine asset classes are balanced, asset allocation, and life-cycle funds.

 

  • Balanced funds offer a mix of stocks and bonds, typically 60% to 70% of the portfolio in blue-chip (high quality companies that pay dividends) stocks and 30% to 40% in investment grade corporate bonds or federal government securities.
  • Lifecycle funds typically include cash, in addition to stocks and bonds, and may include both U.S. and foreign securities. The percentage of funds in each asset class is determined by the fund manager who attempts to earn the highest return possible by switching portfolio weightings in each type of asset according to market conditions. Lifecycle funds generally include three or four “portfolios” with varying percentages of funds in each asset class. These portfolios are designed to fit investors at various ages or risk tolerance levels. An example is the Vanguard Group’s LifeStrategy® Funds. Investors have a choice of four asset mixes: income (lowest percentage of stock in the fund portfolio), conservative growth, moderate growth, and growth (highest percentage of stock in the fund portfolio. Another example is T. Rowe Price’s Personal Strategy funds which offer a choice of three different portfolios: growt, balanced, and income.
  • Target Date (Target Retirement) funds are the third type of “hybrid” mutual fund. Like lifecycle funds, they contain a mixture of stocks, bonds, and cash. However, they differ from lifecycle funds because they usually have a future date in their title (such as 2030 or 2040) and they gradually become more conservative over time. As investors get older, the fund manager puts a lower percentage of stock in the fund portfolio without any action required on the part of investors. An example of a target date mutual fund is the Fidelity Freedom Funds (e.g., Fidelity Freedom 2040 Fund). Target date mutual funds are increasingly being used as the “default option” when workers are automatically enrolled in employer 401(k) plans.

 

Some mutual fund families also offer “funds of funds” that invest in a combination of funds within their family. Two examples are Vanguard STAR ($1,000 minimum) and T. Rowe Price Spectrum ($2,500 minimum; $1,000 for IRAs; no minimum for automatic investment accounts).

Another way to obtain broad diversification with limited funds is to purchase an index fund. Index funds track the performance of a market benchmark such as the Standard & Poor’s 500 stock index. With limited funds for just one “core” fund, an investor might select a “total stock market” index fund that tracks over 7,000 large, medium, and small U.S. companies. Some index funds can be purchased for $1,000 or less. With extra money, an investor can expand into additional index fund types (e.g., bonds, international securities) or into actively managed funds within these market sectors.

Let’s take a look at how a “shoestring” mutual fund portfolio might look. Let’s say that you have $2,000 to invest and your asset allocation mix is 10% cash, 30% bonds, and 60% stock. Within the 60% stock portion, you want to invest half in large company stocks and half in small company stocks. Your asset allocation might be as follows: $200 in a money market mutual fund, $600 in a bond mutual fund, and $600, respectively, in large and small company stock funds. With just $1,000 to invest, you’d place $100 in the money market fund, $300 in the bond fund, and $300 in each of the two stock funds. Of course, the trick will be finding specific funds that accept small deposits, but, as noted previously, this is often possible with automatic investing programs (i.e., DRIPs and DPPs).

Once a mutual fund account is established, resolve to add to it frequently using a strategy called dollar-cost averaging (See Unit 2 for details). With this strategy, shares are purchased at regular intervals (e.g., monthly) with a fixed dollar amount (e.g., $100). Dollar-cost averaging takes the emotion out of investing because share purchases are made on a regular basis regardless of what is happening in the financial markets. In addition, most investors don’t have large sums to invest, but rather, small sums periodically as they earn it.