Mutual funds are often recommended or presented to investors as one of the easier and less complicated investing options out there. On the surface, many people may grasp the basics of what a mutual fund is, but that understanding can quickly become clouded over when you start reading about some of the different types available.
For instance, spend a few minutes researching and you are bound to come across the terms “load” and “no-load.” These are not very descriptive terms in and of themselves, so many investors struggle to understand what they mean, and whether one option is better than another.
While mutual funds are a very approachable investment for many people, they are far from a “one-size-fits-all” investing solution. It is extremely important that you do your homework and ask the tough questions before handing your money over to anyone.
With that in mind, here are some very important things that you need to know.
What is a Mutual Fund?
First things first; let’s talk about what a mutual fund actually is. It’s collection of stocks, bonds, cash and other securities which are all managed by a professional. Because they are a simple way to invest in a diversified portfolio, they often make great entry-level investments for those just starting out with financial planning.
There are many advantages to a mutual fund. Among them is the security of knowing that a professional will be watching your investments for you, and furthermore, trustees will be watching that professional.
The term “mutual” refers to the fact that many people are investing in the same fund together. You’re buying a “share” of the overall investment, which will be combined with the money others put in. On your own, you probably only have enough to invest in 1 or 2 stocks, which isn’t a very diversified portfolio. More money from more people means you get to invest in more industries.
Now, of course, mutual funds have managers, and breaking down how you pay for their services brings us to the next point.
Load Vs. No-Load Mutual Funds
To put it simply, the “load” is another term for the fee or commission paid to your financial advisor. The catch here is that in some cases, the payment comes straight out of the money you’re investing, before you invest it. A “front end” load thereby lowers your initial investment right off the bat.
Let’s look at an example: if you were looking to invest $10,000 in a mutual fund that has a 5% load, that would mean that $500 is coming right off the top of your investment on day one. Now, you are actually investing $9500 into the fund instead, and a lower investment generally means lower returns.
Naturally, there may be fees associated with any investment fund, and those fees do not necessarily go away just because you paid the load up front. You need to find out if and how your financial advisor will still collect some sort of fee or hourly rate over the life of your investment.
On the other hand, a no-load mutual fund does not require any payment to be made up front to a financial advisor. As mentioned above, there will be periodic fees deducted from your investment account, as would happen with any type of investment being overseen by a manager. The main difference here is that you would begin by investing all $10,000, thereby potentially earning returns on a higher dollar amount from day one.
No-Load Doesn’t Always Mean Less Costly
So why on earth would anybody want to pay a load on a mutual fund? This is where all that homework comes in.
Sometimes, a no-load mutual fund may offer a lower percentage of return than a mutual fund that does charge a load. For example, a $10,000 investment with a 5% load might return 12% annually, while a no-load investment of $10,000 might return 10% annually. Depending on how long you intend to keep this investment, the mutual fund with the load payment may actually wind up being more profitable in the long run. However, it is true that in the short run no-load mutual funds tend to be more profitable.
Now let’s talk about fees. When you first begin researching mutual funds, ask for a complete breakdown of all the fees you can expect to pay over the life of this investment. These fees may include redemption fees, purchase fees, exchange fees, account fees, and annual operating costs. All of these fees should be spelled out to you when you are considering making an investment. A smaller investment with high fees may have to remain in the fund for a long time before you see any return.
Ask your financial advisor to show you several different options, and how they would each fare over time once you factor in load, fees, and commissions. Remember to be realistic about how long you intend to keep your money in a mutual fund. You may be presented with an option that may be tremendously profitable in 10 years, but you may have had your sights set on a two or three-year investment, and nothing longer than that.
As always, the real value in any investment is finding a professional who is willing to listen to your goals, work only in your best interest, and offer you complete transparency. While you are researching financial advisors and mutual funds, if at any point you feel that the advisor is not being completely honest with you, walk away. Find someone you trust.
Mutual funds are designed to generally add diversification at a reasonable cost, but entering into a mutual fund with too many fees can very quickly negate any profit you would have otherwise made. A good financial advisor will be able to point that out to you immediately, and steer you toward something more appropriate for your unique situation.
For a more complete breakdown of the fees associated with financial planning, click here to download “The True Cost of Investing,” a free informational whitepaper.