I need to make enough money for my retirement. But I am not excited about the idea of watching the stock market all the time. So I let the management of my mutual fund do it for me.

Since science and technology are the things I love, I have the T. Rowe Price Science and Technology Fund deduct a specific sum from my checking account once a month and invest it in the fund.

They have been outperforming NASDAQ, and that's good enough for me.

The neat thing about this arrangement is that I win both when the share price goes up (the value of my shares grows) and down (my money buys more shares which then continue to grow over the long run).

I grew up in a Communist country, and now I'm a big capitalist (well, a small one for now, but I'm getting there).

It may not be the sexiest subject in the world, but the mutual fund is one of those few financial instruments well within the reach of almost everybody, so it's about time for a (mostly) serious writeup.

The Basics

Let's say our friends Joe and Bob want to invest in the stock market. Joe ponies up $5000, Bob matches him, and they use the total fund of $10000 to buy stocks. If any profits from the fund are mutually shared out to both Joe and Bob, they now have a simple mutual fund. That's really all there is to it... except that in real life Joe and Bob are probably too busy to micromanage their fund, so they'll hire their buddy Chuck to do the dirty work, perhaps paying him a commission of 10% on the profits.

Note, however, that the profits of a mutual fund are only theoretical until the money is actually withdrawn. If Joe & Bob's stocks go up by 10% during a year, they have to sell them all to realize their $1000 profit.

Why Mutual Funds Are Good

There are three major advantages to using a mutual fund instead of just buying stocks on your own:

  1. Diversification. If you only have $5000, you can't really buy shares in very many companies, so if even one of those companies tanks your profits may be wiped out. Mutual funds have big pots of money and can buy lots of shares, reducing the total risk of your investment.

  2. Economies of scale. If you buy one share of Acme, the commission will be a pretty hefty percentage of the value of that share. When a mutual fund buys one million shares of Acme, they pay a lot less per share.

  3. Last but not least, the non-financial advantage of mental health: maintaining your own stock portfolio can involve a lot of stress and work, as you have to constantly worry about what to sell, what to keep and what to buy. Why not sit back, let the money roll in, and let someone else get the ulcers?
Why Mutual Funds Are Bad

Now, your investment bank would love to tell you that they are also far more experienced than you at picking out shares that will perform well, and will throw statistics at you to prove it. Not so -- the issue has been studied a lot, and the long and short of it that the performance of mutual funds fits right on the same bell curve as picking stocks at random (ie. letting monkeys throw darts at the stock pages). In fact, the mean of the bell curve underperforms the DJIA, because three factors are playing against you:

  1. Commissions. Fees vary widely by company and risk, but usually you'll pay a percent or two whenever you put money in the fund or take money out, and also once per year as a management charge.

  2. Soft money. The mutual fund's stock broker makes a hefty chunk of change whenever those 1,000,000 shares of Acme change hands, so the stock broker loves it when the mutual fund churns a lot, buying and selling stocks all the time. How to best encourage this? Why, by giving a kickback. Actual bribery is of course illegal, but trips to Hawaii, letting their buddies rent a swanky Wall Street office for $1/month and similar types of soft money aren't. The only loser in this is the investor, especially in those funds where the small print says that the investor pays the broker's fees as well.

  3. Dividends. Stock owners get dividends when the company has a good year, but the dividends paid to the mutual fund go to the fund operators, not you.
So how can all investment banks claim that 95% of their funds outperform the average? Simple -- those that don't get rolled into other funds, and thus cease to exist. This is why investors tend to distrust funds that haven't been around for at least a few years.

How to Pick a Mutual Fund

Just the same, I think that the advantages outweigh the disadvantages, as long as you choose your fund wisely. Alas, choosing one is every bit as complex as picking out a stock in which to invest, so all I can do is offer some rules of thumb.

A few words about the investment bank you choose: be sure to read the small print about the commissions. The fees can be pretty hefty, especially for small investors, which for banks means less than $100,000. Some funds now market themselves as no-load funds, meaning that they charge no commissions except for a percentage of profits. This can be a saving grace in a slow economy and has the additional advantage of discouraging spurious churn, but is not so hot during a boom. Also remember that in nearly all countries money earned with a mutual fund is taxable income. Shop around and try out the comparison calculators you can find on many financial websites these days.

The central equation in investment is that rewards require risk. If you want to double your money in a year, you'll have to pick a fund that invests only in Bulgarian Internet companies, and risk losing all your money when Plonsky Internyet's CTO Vladimir heads for the Bahamas with the company's IPO proceeds in a suitcase. On the other hand, if you're happy with a return on investment a percent or two higher than the bank interest rate and have ten years to spare, you can be satisfied with a more conservative fund.

Stocks vs. Bonds

The two big financial instruments bought by mutual funds are stocks and bonds. Funds usually spell out their investment policy and most invest only in a certain type of stock or bond, although there are some multimarket funds that can invest in pretty much anything.

A stock is a share in a company, so its value fluctuates with the company's value. Stocks are risky, stocks in emerging markets are very risky, and stocks in small companies are extremely risky. (Investing in Bulgarian Internet companies is thus suicidally risky.) However, in the long run -- meaning over 10 years -- stocks on the Dow Jones have gained about 12% a year. A special type of mutual fund called an index fund buys stocks that match the weighting of a major index like the DJIA, which means that -- again, in the long run -- the index fund will go up by 12% a year, minus any commissions. In my humble opinion, these are a pretty good bet for the long-term investor who can afford to ride out any recessions.

A bond is a promise by a company or a government to repay a loan with interest. Unlike stocks, which are unpredictable, the interest on a bond is fixed and the only risk comes from the possibility that the issuer may default (read: go bankrupt). If you buy U.S. Treasury bonds, this risk is pretty minimal, but this is also why bonds earn little -- 10% in a good year, 0% in a bad one, long-term average around 6%. Bonds are a good bet if you cannot afford to lose the money, are afraid that you may need to withdraw it suddenly, or the stock market is tanking or showing irrational exuberance.

The third category of mutual funds is the hedge fund, which involve complicated financial jiggery-pokery and promise absolute returns, ie. the gains of stocks with the security of bonds. If this sounds like too good to be true, it probably is. The entire concept is a relatively new, untested and above all unregulated one, and most hedge funds also have pretty prohibitive minimum investments, so if all this is new to you you'll probably want to steer clear.

Open-End vs. Closed-End

There is also one more division based on how the fund is structured. In an open-end fund anybody can join or leave the fund at any time, and the value of a share in the fund depends only on the fund itself. (This value is known as the Net Asset Value or NAV, and you can find listings for popular funds in financial newspapers.) The down side is that the size of the fund fluctuates constantly, and the manager has to buy and sell shares constantly to compensate.

A closed-end fund, on the other hand, is set up with a fixed amount of money and accepts no new investors, reducing churn. The only way to join a closed-end fund is to get someone to sell your their part of the fund, so the value of the fund depends on supply and demand. The down side is that timing matters -- it's not enough to want to sell, you need to find a buyer at your price too. (Yes, this sounds like a stock, and that's why many closed-end funds are exchanged like stocks on the NYSE.)

How to Invest

Most funds will require a minimum investment on the order of $1000, and some have much higher requirements. You can usually arrange to have a fixed amount of money placed in the fund every month, making the process of building up your fund more painless. Invest wisely and follow this regimen long enough, and when your children graduate or it's time to retire you'll have a handy sum on hand. You can (and probably should) diversify your investment by buying several funds, placing some money in bonds for security and stocks for growth. Figure out what your needs are and how much you can spare; just remember that once you get into mutual funds, there's little point to keeping cash around on low-interest bank accounts.

Obligatory Disclaimer

Past performance is not a guarantee of future profits. It's your money, you do what you want with it, and don't come crying to me if the Osmium Bulgarian Internet Growth and Security Fund goes tits up.

Mutual Funds are a Scam

Mutual funds, for years considered the obvious, sensible, go-to choice for the everyman investor, are now widely recognized to be a pretty bad option.

Consider that in 2011, 90 percent of all actively managed US mutual funds underperformed their benchmark index. Ninety percent! This means that the vast majority of people who were invested in mutual funds would have been better off investing in a low-cost index fund which simply attempts to match, rather than beat, the performance of the market as a whole.

And 2011 was not much of a fluke. Even in their "best" years, "only" 80 percent of actively managed funds underperform their benchmarks.

In other words, even the supposed "expert" managers who run these funds are considerably worse at picking stocks than darts thrown at a dartboard, which would have a success rate of 50-50 for beating the overall market, rather than 10-90.

A charitable explanation of this gross underperformance is that active trading and associated commissions and bid-ask spreads along with "reasonable" management fees tend to erode the performance even of relatively good managers.

A less charitable and probably more accurate description is that actively managed mutual funds are scams designed to enrich managers and issuers at the expense of gullible investors by lining their pockets with fees and commissions every year, regardless of actual performance.

So the lesson of all of this is you should just go ahead and buy a passively managed index mutual fund, right?

Wrong! While index mutual funds outperform actively managed mutual funds, they still have fees that are at least double those of the ETFs ("exchange traded funds") that track the exact same indexes. Not to mention that ETFs have other advantages such as the fact that they can be bought and sold at any time rather than only at the end of the day like mutual funds, and generally are more tax friendly than mutual funds because shares can be created or destroyed to meet changes in demand without generating taxable capital gains.

And while I highly recommend a portfolio of only index funds and perhaps a few carefully selected individual stocks for the average investor, even if you insist upon active management of your investments, the fees for actively managed ETFs are significantly lower than those for actively managed mutual funds.

So basically there is no reason to ever buy a mutual fund. Seriously, don't buy these things.

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