Employee Education: Class 302 – “What is a Mutual Fund?”

When it comes to investing, the first step is often the most difficult. With all the various and sundry investments available, it can cause investor paralysis. With this understanding, 401(k)s have endeavored to strike the appropriate balance between simplicity of use, but depth of benefits, in tailoring the investments made available through them.

To help you with investments in 401(k), we have taken a top-down approach in our education process. We began with the end in mind by discussing the importance of self-reflection with investing in Class 102 – “Investments” before beginning to discuss investment strategies in Class 202 – “401(k) Investing Strategies” and broad investment categories to effect these strategies in Class 203 – “Investment Categories”. Now we will discuss the specific investments prevalent in 401(k)s.

As they are the most common investment made available in 401(k) plans, we will begin this discussion with Mutual Funds. A mutual fund is an investment in which a professional money manager, a “portfolio manager”, is charged with investing the pooled monies of a multitude of different investors pursuant to a specific mandate. In the mutual fund world, this mandate is called the prospectus, and it is the legal document of how the mutual fund will operate. All mutual funds in America are required to be registered with the Securities Exchange Commission (SEC) and are subject to the Investment Company Act of 1940.[a][1]

Oftentimes mutual fund mandates restrict the portfolio manager to investing in a specific area of one of the broad investment categories discussed in Class 203 – “Investment Categories”. As a result, a mutual fund’s name is commonly aligned with this mandate. As a hypothetical example, the ABC Mutual Fund company decides to create a mutual fund with a focus on buying stocks of large companies headquartered in the United States. Thus, they decide to name their fund the ABC Large US mutual fund. While the decision on what truly constitutes a “large” US company versus a small US company is ultimately up to the mutual fund company, there are general guidelines that the mutual fund industry uses. These guidelines and other segmentations that define mutual funds are very helpful in determining the specifics of a mutual fund’s investing stratagems. We will discuss the more specific segmentations mutual funds often use in our next class, Class 303 – “Investment Segmentation”.

Mutual funds are the bannermen of 401(k)s and have been since the 401(k) was first created. There are numerous reasons for this, most of which were designed to address a difficulty facing investors who were just getting started in their savings and in effecting the investing strategies discussed in Class 202 – “401(k) Investing Strategies”.

A. Instant Diversification

B. Professional Management

C. Ease of Use

For the work they provide, mutual funds have certain costs that they charge to those who utilize them. This main cost is referred to as the “Expense Ratio”. The Expense Ratio represents the total annual fund operating expenses and is the line of the fee table in the prospectus that represents the total of all of a mutual fund’s annual fund operating expenses, expressed as a percentage of the fund’s average net assets. The expense ratio of a stock or asset fund is the total percentage of fund assets used for administrative, management, advertising (12b-1), and all other expenses. In example, an expense ratio of 1% per annum means that each year 1% of the fund’s total assets will be used to cover expenses. The expense ratio does not include sales loads or brokerage commissions.

This isn’t the only expense, there is also the cost of transacting trades for the mutual fund’s investments and other incidental charges that can only be found by reading the mutual fund’s Statement of Additional Information (SAI). This document is not light reading though, so if you go to this depth, prepare to really dig in.

Let’s refocus though on the significance of cost as you consider a mutual fund. It’s important to note that whenever a mutual fund reports gains or losses in its statements, say for a calendar year, these gains or losses are net of all expenses. Put another way, after all fees, cost, trades, and expenses are taken out, mutual funds report what the bottom line gain or loss was. This bottom line gain or loss is what mutual funds are required to report. Thus, while expense ratios are important to consider when choosing a fund, bear in mind that it’s just one component of the decision. Don’t get tunnel vision on cost and allow yourself to stray from your strategy and risk!

Now that you have a good idea of how mutual funds works, it’s time to look at the bigger picture. In this case, the bigger picture is an infographic further discussing mutual funds courtesy of Mint.com, “What is a Mutual Fund?”!

Depending on the structure of your 401(k), it is quite likely that mutual funds are the only available investment. Other 401(k)s may have access to other investments such as Exchange-Traded Funds, company stock, or Self-Directed Brokerage Accounts (SDBAs) wherein it is possible to invest in individual stocks, bonds, or a host of other investments. Of these, only the Exchange-Traded Fund is rising in popularity. Accordingly, here is another big picture, once again courtesy of Mint.com, “What is an ETF?”, discussing the Exchange-Traded Fund.[b]

In summary, a mutual fund is an investment in which a professional money manager, a “portfolio manager”, is charged with investing the pooled monies of a multitude of different investors pursuant to a specific mandate. Due to several factors, mutual funds have become the de facto investment of 401(k) plans. While there are other investments common to 401(k), the only other investment gaining in usage is the Exchange-Traded Fund. [2]

[a] Investing in mutual funds involves risk, including possible loss of principal.
[b] An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.

[1] Investment Advisers Act of 1940, http://www.sec.gov/about/laws.shtml#invcoact1940.
[2] Mint.com, “What is an ETF?”, http://www.mint.com/blog/wp-content/uploads/2011/12/What-Is-an-ETF.png.