The Benefits of Fund Investing

Professional money management

Mutual funds provide the benefit of full-time investment management expertise and recordkeeping services. Fund investors’ own shares in a diversified, professionally managed portfolio that most investors could not afford to create.

Diversification

A mutual fund is required to be diversified. Its assets are invested in many different securities. This reduces the exposure to individual security risk by spreading risk across many different securities. In addition to the diversification inside a mutual fund, mutual fund investors manage risk by purchasing mutual funds with different objectives. A balanced portfolio of different asset classes (stocks, bonds, real estate and commodities) and categories within an asset classes (value vs. growth stocks, or government vs. corporate bonds) is a risk management strategy.

Affordability

Minimum investment requirements and subsequent investment minimums are low enough on some mutual funds that most anyone can invest.  Plus, you have access to types of investments not always available for small investment amounts.

Convenience and Accessibility

Mutual funds may be purchased directly from a fund company, through a financial advisor, through an employer-sponsored retirement plan or from a fund supermarket. Each share purchased represents a widely diversified portfolio of investments, professionally managed for you.

Liquidity

Mutual fund shares may be redeemed at the closing price any day the financial markets are open. Some funds, especially international funds, charge redemption fees to discourage short-term trading. You may have your proceeds sent by wire, electronic transfer or check.

Types of Funds and Features

While the core features of mutual funds are the same, their investment objectives can be very different. Because each mutual fund has a specific investment objective, such as growth, capital preservation, or income, it is important to understand which funds are designed to meet your investment objectives. Mutual funds generally fall into these main categories:


  • Stock or Equity Funds invest in the ownership of companies through stocks.

  • Bond or Fixed-Income Funds invest in government or corporate debt to generate income.

  • Money Market Funds invest in short-term debt, pay interest and target a stable share price.

  • Asset Allocation Funds invest in a mix of stocks, bonds, alternatives and money market securities.

  • Alternative Funds do not invest in conventional securities such as stocks, bonds and cash. Rather, they invest in private equity, hedge funds, managed futures, real estate, commodities and derivatives contracts.

  • Alternative strategies on traditional asset classes include long and short equities as investment strategies. This involves buying long equities expecting to increase in value and selling short equities expected to decrease.

Mutual Funds

Mutual funds are the most common way people invest for the future with more than $20 trillion in investment assets. They are so popular because they  are a simple, convenient way to invest in stocks, bonds, money markets, commodities and other securities. Through mutual funds, almost anyone can invest in the financial markets as a means to meet financial goals. Nearly half of all U.S. households invest in mutual funds.

These professionally managed investment products use money from investors to create a diversified pool of securities to achieve a specific investment objective. Investors purchase shares, which represent ownership in the mutual fund. The price of the fund fluctuates based on the gain or loss of the securities that make up the fund. Investors in a mutual fund are entitled to a pro-rata share of the proceeds, or the losses.

Exchange Traded Funds

An exchange traded fund is a type of security that is similar to an index mutual fund, because it tracks an index, commodity or a grouping of assets. But unlike a mutual fund, it can be traded like a stock on an exchange, with prices changing as shares are bought and sold.

With an ETF, you get the diversification of a mutual fund as well as the ability to sell short, buy on margin and purchase as little as one share. As a general rule, expense ratios for ETF’s are lower than the average mutual fund. You have to pay a commission to purchase an ETF through a broker. 

One of the best known ETFs is called the Spider (SPDR), which tracks the S&P 500 Index and trades under the symbol Spy.

Closed-End Funds

Closed-end funds sell a fixed number of shares to investors during an initial public offering (IPO). This differs from open-end mutual funds which continually offer shares to investors. Since the issuance of new shares is closed to investors after the IPO, trading occurs on an exchange like the NASDAQ or NYSE, and investors can buy and sell shares of a fund as they would stocks. As a result, the demand for a particular closed-end fund may be greater or less than the actual value of the securities it owns, causing it to trade at a premium or discount.

Closed-end funds are actively managed and generally designed to provide a steady stream of income that pays out monthly or quarterly. Because of their unique closed-end structure and ability to use leverage, which also increases a fund’s risk or volatility, many closed-end funds offer shareholders the potential for higher distributions than traditional income investments.

Investment Methods

There are two principle methods of managing money in mutual funds, exchange-traded and closed-end funds – they can be either actively or passively managed.

Actively Managed

Portfolio management decisions of actively-managed funds are made by professional investment managers and research teams whose goal is to deliver higher returns than their benchmarks. The term refers to the ability of the fund to make timely, active decisions to buy and sell securities depending upon market conditions and opportunities. Actively-managed funds are not required to hold specific stocks or bonds and have the ability to get out of a holding or market sector when risks get too large. They differ greatly from passively-managed funds (defined below), such as index funds, which match or track the components of a market index. Active managers combine research, market forecasting, and their experience to make decisions based on the goals set forth in the fund’s prospectus, which may range from narrow to wide. They offer the potential to outperform indexes over time, but also feature the possibility of underperforming them. Actively managed funds also have higher management fees than passive funds in order to pay for the professional teams that manage them. The following chart lists the differentiating features of actively-managed funds.


Active
• Achieve specific outcome, absolute return or certain level of income
• Broad diversification
• Experienced management
• Ability to react to market conditions

Passively Managed

Stocks in passively managed funds (i.e. traditional mutual funds) are not actively managed by a portfolio manager, but instead replicate an index like the S&P 500 and pursue index-like returns. This is the opposite of an actively managed fund (defined above). While actively-managed funds strive to outperform indexes over time, passively managed funds track the components of a market index to deliver the performance of the underlying index. However, the returns do not usually equal their benchmarks because trading costs are involved. Passively-managed funds tend to have low tracking error, which is a measure of how closely a portfolio replicates an index.

Passively managed funds also have lower management fees than active funds since they are not paying for professional teams to actively manage them. Passively managed portfolios often do not own every security in the benchmarks so portfolio managers try to reduce trading costs by holding only benchmark securities that track the benchmark’s overall performance.

The chart below shows the differentiating features of passively managed funds.


Passive
• Capture market return
• Low tracking error
• Reduced turnover
• Low-cost

Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market cap weighted indices by using alternative weighting schemes based on measures such as volatility or dividends. Rather than weighting companies solely according to their size, smart beta uses fundamental analysis principles to determine which companies should be given a larger piece of the index pie. Smart beta strategies are popular for investors seeking factor diversification, but these strategies are not all alike. Carefully assess the indexes, biases and specific single or multi-factors each uses.

Using Investment Management Products

There are a variety of investment products you can use to build a diversified portfolio and build wealth over time. Each one offers unique benefits that when used together, can provide you with a well-designed and diversified portfolio. Actively-managed mutual funds, passively-managed index funds and closed-end funds are examples of vehicles that allow you to access professional money management and diversify risk. These three product options (described below) afford varying levels of management expertise, costs, and buy and sell trading benefits.

Asset Classes and Objectives

Mutual Funds Types of Mutual Funds

Growth Funds
Invest In Stocks of companies with high growth rates.
Suitable For Investors who can assume more risk and price movement to achieve growth.
Value Funds
Invest In Stocks of companies that appear to be undervalued.
Suitable For Investors who want long-term capital appreciation, dividend income and less price fluctuation.
Blend Funds
Invest In Growth stocks and value stocks.
Suitable For Investors who want to build wealth over time, when either of these types of stocks are in favor.
International Funds
Invest In Stocks of companies worldwide. These funds may have a growth, value or blend style.
Suitable For Investors who want capital appreciation accross a variety of economies. Currency and political risks should be considered.
Specialty/Sector Funds
Invest In Stock of companies in a specific industry or sector of the economy, such as health care, technology, leisure, utilities or precious metals.
Suitable For Investors who want to allocate a portion of their portfolio to a particular industry.
Taxable Bond Funds
Invest In U.S. government and government agency bonds, mortgage-backed and asset-backed bonds or bonds issued by corporations.
Suitable For Investors who want current income and can assume some principal risk. When interest rates rise, bond prices decline. If rates fall, bond prices rise.
Tax-Free Bond Funds
Invest In Bonds issued by state and local governments or agencies to raise capital for public works and improvements.
Suitable For Investors who want dividends free from federal taxes and, in some cases, state and local taxes. When interest rates rise, bond prices decline. If rates fall, bond prices rise.
 
Invest In A mix of stocks, bonds, alternatives and money market securities.
Suitable For Investors who want to build wealth through a single diversified portfolio.
 
Invest In High quality, short-term U.S. government and corporate debt securities. Tax-free money market funds are exempt from federal taxes and, in some cases, state local taxes.
Suitable For Conservative investors who want stability of principal, some current income and immediate liquidity.

Building a Portfolio

Selecting Funds for Your Portfolio

When it’s time to make decisions about the type of funds you will invest in, you will want to consider some of the factors already discussed: your time horizon, your rate of return, and your specific goal. There are mutual funds designed for almost any situation. The chart below can be used to identify the types of funds best suited to your particular investment objectives. Refer to it as you begin to formulate your portfolio, keeping in mind you'll probably want to have a mix of these investments.

BUILD YOUR PERSONAL PORTFOLIO

Mutual Funds Fund Types and Your Objectives

If Your Objective Is You Want The Following Fund Type These Funds Invest Primarily In Potential Capital Appreciation Potential Current Income Potential Risk
Maximum Growth
  • Growth
  • International
Common stocks with potential for rapid growth. May employ certain aggressive strategies. High Very Low High to Very High
High Growth
  • Growth
  • Specialty
  • Sector
  • International
Common stocks with long-term growth potential. High Very Low High
Growth
  • International
  • Value
Common stocks with potential for dividends and capital appreciation. Moderate Moderate Moderate to High
Current Income
  • Equity Income
  • Bond
Dividend-paying bonds. Very Low High Low to Moderate
Current Income & Protection of Principal
  • Taxable Money Market
Money market instruments. None Moderate to High Low
Tax-Free Income & Protection of Principal
  • Tax-Free Money Market
Short-term municipal bonds. None Moderate to High Low

Principles of Building a Portfolio

Building a portfolio to fit your investment goals can be achieved with a variety of products or funds such as those in the chart above. It is important to begin by establishing a plan and determining whether your goal is to build wealth over time, generate income or other objectives.You may consider having different portfolios for different goals that incorporate your time horizon, risk, etc.

Basic Strategies

Setting yourself up for investment success involves developing a realistic and informed perspective on how to put your financial resources to their best use. Start with the end in mind by identifying your investment goals, your time frame and your tolerance for risk (discussed in Performance and Risk ). The time frame refers to when you make an initial investment and when you plan to access the money. Create a preliminary plan by selecting the types of accounts and products that will help map your goals to a fund’s goals. Investing should be about making decisions that are right for your situation, but keep in mind that diversifying your funds across asset classes and sectors helps spread the risk. Monitor your progress on a regular basis, review your investment allocation mix and make adjustments accordingly.

Achieving Goals

Investing in a well-designed portfolio has the potential to meet your short-term or long-term objectives. Short-term goals may range from minor home improvement projects to saving for a car; long-term goals may include saving for retirement or for your kids’ college education. Modern portfolios include approaches and funds intentionally chosen and allocated with your goals in mind. Revisit your portfolio often as goals may change based on life events such as buying a house, starting a family or beginning a new job.

Using an Advisor or Going at it on Your Own

Once you have familiarized yourself with the power of investing and why to invest, you have options on how to go about building and managing your portfolio. One way is by investing independently. This means that as an individual you will want to stay up-to-date on the industry and have timely awareness of emerging opportunities by using tools, resources and reading a variety of financial publications and investment newsletters. You are not relying on another individual to provide recommendations or consult with you, but you also do not have to compensate an investment professional for their services.

The other option is to use an investment professional or advisor. It is the job of an investment professional to work on your behalf, stay abreast of industry changes and inform you of investment opportunities. There are many types of financial advisors available to help, but financial planners holding a CFP certification have met education, examination, experience and ethics requirements. Investing requires a certain amount of vigilance and monitoring of your portfolio activity, which can be managed by an investment professional should you choose to go that route. Investment professionals require compensation for their work and they can be compensated in one of two ways. The first way is through fees, which are based on assets under management and/or a flat hourly rate for the investment professional’s advice. The second way is from commissions, which are based on your investment transactions.

Below are general questions to ask an advisor when considering how different investments fit within a portfolio:

  • Am I taking advantage of the right financial products?
  • Will my investments provide me with income?
  • How does my risk tolerance relate to the investment choices?
  • What tax-saving strategies should I know about?
  • Is anything missing from my financial strategy?