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In the previous post of the Investing Guide for Beginners series, we covered stocks and bonds. They are essential financial investing instruments. They both have their pros and cons. Bonds are more stable but will generally return less over time. Stocks are more volatile but should return more.
In a balanced portfolio, you need both. But picking stocks and bonds is a lot of work. And it is a dangerous and challenging game. It requires a lot of knowledge and time. Fortunately, there is a better alternative. You can invest in large baskets of stocks or bonds.
Mutual funds are doing that for you. They are like a collection of stocks or bonds. Instead of investing in a single stock, you can invest in a selection of stocks.
In this article, we will cover mutual funds in detail! We will see what is important when choosing between different mutual funds. And finally, we are going to cover a fundamental subject: passive investing or index investing.
A mutual fund (or investment fund) is investing in a collection of stocks, or bonds, or both. This fund is managed by some people (the managers of the fund). And you can buy a share of the collection. By owning a share of the fund, you own a share of everything the fund owns.
For instance, let’s take the case of a fund that owns 100 different stocks. If you buy one share of the fund, you now earn a part of 100 different stocks. And you only had to buy one share of one fund! This is a great way to diversify your investments and not have to pick individual stocks.
The performance of a fund is the performance of its financial instruments. If the set of stocks performs well, the fund will do well. But, if the collection of stocks performs poorly, the fund will do poorly.
I focus on funds of stocks and bonds. But some funds invest in metal, currencies, real estate, or even wood. There are even funds of funds. I am going to focus on funds using stocks and bonds. There are funds with 100% of stocks and funds with 100% of bonds. And there are also funds with some allocations to both.
How to invest in Mutual Funds?
Various financial institutions provide mutual funds.
Your current bank probably has a large offer of mutual funds. Every large bank in Switzerland has its offer of mutual funds. You can ask your bank about it, and they will give you the set of mutual funds they offer. Some banks also offer access to funds from different financial institutions.
Some fund providers like Vanguard and Blackrock are also offering access to mutual funds. They are not banks, but they are managing a huge amount of money in their mutual funds.
You can directly invest in mutual funds from your bank or financial institutions. You will probably have to open an account. And then, you will be able to buy shares of funds.
You can also use a broker account to access mutual funds, but not all brokers offer this service. And it is not as convenient as simply going through a bank.
Generally, mutual funds are sold and bought once a day. So you will usually have to wait for a day before your purchase (or sale) is executed.
How to choose a mutual fund?
While you do not have to pick individual stocks, you still have to pick a mutual fund (or several, to form a portfolio). There are several important factors when choosing a mutual fund.
First of all, there are two kinds of funds. There are actively managed funds and passively managed funds.
We will focus on actively managed funds first simply because they are the most used funds. And also because your bank is likely only to offer you this kind of funds. But we will go over passive funds very shortly and then focus on them.
Some people, the managers, manage active funds.
The managers decide which stocks to pick. They also decide when to buy and when to sell. Doing so is called market timing. The managers also have some other expenses, such as the advertisement for the funds. They want to have as many investors as possible. And managers need to be paid. All this translates into costs. And guess who is paying the cost of these people? The investors of the fund, of course.
The cost of a mutual fund is the Total Expense Ratio (TER). The TER is the total percentage of your investment that pays for the expenses each year. If there is a TER of 2%, each year, 2% of the fund value is lost to fees. If the fund returns 10% in one year, you will only see 8% of performance. The TER of active funds ranges from around 1% to 3%. Some outrageous funds take up to 5% of fees. But we should not speak about these funds.
Fund managers are justifying these costs by saying they are smart enough to beat the market. For an active fund to be interesting, it needs to beat the market by at least its TER value. And they need to beat the market consistently.
Guess what? Active funds are not outperforming the market consistently. Each year, only about one fund in six is beating the market. So why not invest in these funds? Simply because they are very rarely able to beat it consistently for many years. Market timing does not work!
Nobody can predict the future. Do not take my word for it; everybody is saying it. You can take a look at my book review of The Little Book of Common Sense Investing by John C. Bogle. It is full of facts about how active funds are failing to beat the market.
So active funds are too expensive! And they are not beating the market anyway! What can I do?
You should avoid active funds. It is just a way to give your money away to pay for fund managers. You need to invest in cheaper funds. I said there were two kinds of funds. It is now time to delve into passively managed funds or passive funds.
Passive funds – Index funds
There are two issues with active funds. First, they have a high cost because of all the transactions done by the managers. And because of the salaries of the managers as well. Second, they are trying to beat the market, and they are failing.
What if instead of picking stocks, one fund was to invest in each company in the market? Doing that is called indexing. A passive fund will follow an index. The most famous example is the S&P 500. This index will follow the 500 biggest companies in the US stock market. Since they are doing index investing, passive funds are often called index funds.
If you buy a share of a fund following the S&P 500 index, you will buy a share of 500 companies at once. No market timing here. The fund will replicate the performance of these 500 companies. If the market does good, your investment will do good. If your market does not do good, so will your investment.
And the second advantage is that it is much cheaper. There are still managers in the funds. And there are still some buying and selling costs. But most of it is automated. Passive investing results in a lower cost! On average, passive funds have a TER of around 0.05% to 0.3%. These fees are about ten times lower than active funds (on average).
When you are investing for the long-term, you need to be careful about fees. Investing fees are much more costly than you think.
Now, there is still is the question of the choice of indexes. I cannot decide for you. But I can give you some information about indexes.
As there are a lot of active funds, there are a lot of indexes as well. Some are quite small, while others are very large. There are indexes based on countries, and there are indexes based on the size of the companies. Since index investing is very popular, there are now many indexes available in the stock market.
Here are some examples of popular indexes:
- The Dow Jones Industrial Average (DJIA), or the Dow, is one of the oldest indexes. And probably the most famous one. It contains 30 large companies from the US.
- The SP&500 index is the index of the 500 biggest companies in the US stock market.
- The Russel 3000 index is the index of 3000 biggest companies in the US stock. These companies are about 98% of the US market.
By biggest companies, I mean by market capitalization. The market capitalization of a company is the value of all the shares of the company. Currently, Apple is the company with the largest capitalization in the world.
Finally, there also are indexes that cover the entire world. Such as the FTSE Global All Cap Index, which includes all the stocks in the world. Pretty nice diversification, right?
You can also find the same kinds of indexes for bonds. For instance, there are funds with bonds from the entire US market or bonds worldwide. You can also find indexes for a specific sector in the industry (Technology or Banking, for instance). And you can find indices about stocks that pay significant dividends.
We talked about market capitalization before. It is essential because most indexes are market-cap weighted. It means that inside the index, each company represents a portion of the fund based on its market capitalization. In other words, bigger companies make up a bigger share of the fund.
Let’s take the S&P 500, for instance. The ten biggest companies in the index form about 23% of the entire index! It is very important to understand if you are interested in indexes. Most indexes are like this.
There are also a few equal-weighted index funds. In this system, all companies in the index have an equal portion of the entire index. But this is much rarer.
When you choose a passive mutual fund, you choose the index you want to follow. However, there are several index funds for each index. Since they are all investing in the same stocks, the best option is generally the cheapest one. You also have to consider the size of the fund. It is generally better to invest in a large fund. I have an entire guide on choosing index funds.
Now you should understand that mutual funds are an excellent option for investing. They are an excellent tool for diversification. It is much easier than picking the stocks yourself.
Index funds (passive funds) are generally very cheap and contain a large number of stocks (or bonds). They are the best instrument for investing in the stock market. You will still have to pick the indexes in which you want to invest.
Personally, most of my portfolio follows the FTSE Global All Cap Index. It means that I am investing in the entire world stock market. You can take a look at my portfolio. And it is not more difficult for me. I have to buy shares of the fund each month to invest in the world market.
Now, what if your bank does not offer your good funds? You will soon see that most banks do not provide low-cost passive indexing funds. Why? Simply because they want to make more money out of you! So what is the solution? Exchange-Traded Funds (ETFs) are the solution. This is the next step in our Investing Guide for Beginners series.
Do you have any questions about these mutual funds? Is it clear why you should use passive funds rather than active funds?