Several years ago, I met with a client who was retiring from his long-time employer. He wanted to purchase a basket of stocks for growth and income. We discussed mutual funds as an alternative to owning numerous stock positions. He wasn’t aware that mutual funds could own stocks. I informed him that a mutual fund is a portal for owning stocks, bonds, or other investments. He thought he had to choose between stocks or funds. After our meeting he felt more confident owning 10 to 12 mutual funds rather than 100 to 200 individual stocks.
What is a mutual fund? It’s a professionally managed portfolio of stocks, bonds, or alternative investments. A fund may have a specific purpose or a broad mandate. A globally diversified portfolio of mutual funds will give you access to tens of thousands of investments held across several sectors. Morningstar currently tracks over 27,000 funds, so you’ll have plenty of choices for your portfolio!
Mutual funds do not trade during market hours, but the investments they own do. At the end of the trading day, a fund company will add up all the gains and losses, net out the expenses, and divide by the number of shares to arrive at the net asset value (NAV). The NAV will determine the gain or loss from the previous day. If you were to look at your account during the trading day, you’ll probably see a bunch of zeros under the daily change. After the market has been closed for a couple of hours you’ll be able to see how well your funds performed during the day.
Mutual funds distribute dividends and capital gains throughout the year. Dividends are usually paid quarterly and capital gains annually. Dividends and capital gains add to your cost basis. For example, if you invest $100,000 into a fund and it pays a $10,000 capital gain and a $2,000 dividend, then your adjusted cost basis is now $112,000. Let’s say you sell your fund for $109,000. Your realized loss would be $3,000 but your overall gain is $9,000. Make sense? You invested $100,000 and sold it for $109,000. The $12,000 in dividends and capital gains were added to your basis allowing you to take the loss.
Most people like to buy stocks they know, names that are familiar. If it’s mentioned on CNBC, it must be a stock to own – right? Regional bias may play a part in your investment decision. If you live in Houston, you may own Exxon. A mutual fund will give you exposure to companies you’ve probably never heard of or considered buying. For example, The Dimensional U.S. Small Cap portfolio own shares of Medifast. Medifast has a year-to-date gain of 213%.
Is there a downside to owning mutual funds? In a globally diversified portfolio, you’ll own a few funds underperforming the broader market. Last year the emerging market sector rose 31%, this year it’s down 9%. Mutual funds are pass-through investments, meaning they pass on the dividends and capital gains to their shareholders and this will trigger a tax bill for investments held in taxable accounts.
Mutual funds also have internal fees called operating expenses. Some funds may also charge a front-end commission of 5% or more, so if you invest $10,000, they’ll deduct $500 from your investment. Other funds have back-end sales charges if you sell your fund. If you sold your fund for $10,000, they’ll send you a check for $9,500. Other funds have 12b-1 fees of .25% which are used for marketing purposes. If you invest in mutual funds, pay attention to fees. You can control the fees you pay, so pay attention to the bottom line. For the record, I only recommend funds with low fees and no sales charges or 12b-1 expenses.
Over time, it’s hard to beat the performance of a globally diversified portfolio of mutual funds with low fees. If you have a long-term time horizon and a tranquil temperament, the long-term trend of the markets will treat you well.
and knowledge with self-control, and self-control with steadfastness, and steadfastness with godliness… ~ 2 Peter 1:6
Bill Parrott is the President and CEO of Parrott Wealth Management located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.
Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.