How Does a Mutual Fund Work?

Hey…don’t feel bad that you’ve heard of mutual funds but you have no idea what they are. Some financial professionals don’t know what a mutual fund is either; they just know how they work…kind of. How does a mutual fund work? Here it is in easy to understand terms.

A Mutual Fund is a Company

It’s kind of amazing how many financial professionals don’t know that a mutual fund is a company. Don’t believe me? Read it for yourself. (Page 6) This should change the way you view them because you can put some expectations in place.

Because it’s a company, it has to make money. For the company to exist, it has to have employees, computers, and office, etc.  Just like when you go to a restaurant, buy a car, or buy groceries, part of what you pay goes to keeping that company in business. (The overhead) Your job is to keep your price as low as possible while still getting great value. Make sense?

If you know how to shop for groceries, you understand more about mutual funds than you think. They’re simply offering a for-hire service.

How it Works

Most people don’t have enough knowledge or experience to invest their money on their own. You can try some DIY home improvement or experiment with photography but you can’t do that with your money. You don’t gamble with your financial future.

Mutual fund companies collect your money, put it with other people’s money and invest it with certain goals in mind. They might take all of that money and buy a bunch of stocks based in the United States or they might create a portfolio for people planning to retire in 2035—called a target date fund. There are all kinds of mutual fund companies that want your money.

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If you had a spare $100,000 lying around, you could find 4 other best friends with $100,000, (it could be any amount, really) put the money together, and form a mutual fund. (With the help of a whole lot of high-priced lawyers.) Some people actually do this on a much smaller scale.

The Problems with Mutual Funds

Mutual funds are expensive. Their costs have come down but you still have to pay a lot of money to do business with most mutual fund companies.

The expense ratio is the percentage of the company’s total assets that go toward running the company. (It’s overhead costs) The higher the number, the less money you’re making. The average expense ratio is about 0.71%. That might not seem like a lot but small differences in the expense ratio can cost you hundreds of thousands of income over a couple of decades! Check out the example, here.

It wouldn’t be so bad if the companies were offering you high-quality financial advising as part of the fees but they aren’t.

About 89% of mutual fund managers underperformed the market over the past 5 years.

The bigger problem is all of the other fees. Fees like advertising, some of the commissions for the people recommending the fund, and costs for hiring the fund managers are part of the expense ratio but there are plenty of fees that aren’t. For example, some charge you to get out of the fund if you sell too early. There are also soft dollar expenses, Sub-TA fees, and plenty of other costs that leave the consumer unable to gauge the true expenses of the fund. It’s basically impossible to know what you’re paying.

Also Read: How Does a Non-Working Spouse Prepare for Retirement?

And maybe the biggest problem of all? Many mutual funds don’t perform very well! About 89% of mutual fund managers underperformed the market over the past 5 years. THAT’S TERRIBLE.

What does that mean? I can tell you how to start a simple investment account, invest all of your money into one product at a cost of about $7, leave it there for 5 years and you’ll probably make more money than those high-dollar fund managers.  And your expenses will come in at 0.05% – 0.09%. (Oversimplified example…your finances are more complicated than that but the stats are true.)

Keep Things Simple

moneyIf you have a company 401(k), 403(b) or other plan, you are locked in to what they offer you. Unless you have a self-directed option, you’re kind of stuck until you leave the company or retire.

If you already have some money saved, there are better ways than mutual funds. Fee only financial advisers who invest directly into stocks and bonds simplify things. They charge you a flat fee based on your account balance—normally between 1% and 2%. Others charge by the hour for a la carte services. That’s it. No hidden costs to worry about.

They have the knowledge and experience to create the same structure as a mutual fund without all of the expenses. It’s simply called a diversified portfolio. Quality fee-only advisers will capture better returns at a lower cost. In other words, more money in your account.

Caution!

Let’s be clear. Just because they’re fee only doesn’t mean they’re without fault, or even good at their jobs. There are good ones and all of the others. You have to find a good one. Ask me…I’ll help you with that.

Bottom Line

Hopefully you understand how mutual funds work now. I’m not advocating that you save money by investing by yourself unless you have the knowledge and experience to do it right. I’m also not saying that fee-only advisers are all good and all other advisers are bad. I’ll be writing a lot about this topic.

Ask Me

Have questions about mutual funds and how they work? Want to know more about fee-only advisers and how they work? Click the button below and complete the form. We’re always here to answer your questions.

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