Mutual Funds and Index Investing

Posted on Categories ETF, Investment
Investing - 3. Mutual Funds - Index Investing
This post is part 3 of 5 in the series Investing – All about investing.

In the previous post of the series, we covered stocks and bonds. They are important financial investing instruments. They both have their advantages. Bonds are more stable but will return less. 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’s a difficult one. It requires a lot of knowledge and time.

So why not let other people pick bonds and stocks for you ?

Investment funds are doing exactly that for you. In this post we are going to cover them!

Mutual Funds

A mutual fund (or investment fund) is a group or stocks, or bonds, or both. This group is managed by some people. And you can buy a share of the group. By owning a share of the fund, you own a share of everything the fund owns. For instance, if the fund owns 100 different stocks. If you buy one share of the fund, you now earns a part of 100 different stocks. And you only had to buy one share of one fund! 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 set of stocks performs poorly, the fund will do poorly.

I’m going to focus on funds of stocks and bonds. But there are also funds that invest in metal, currencies, real estate or even wood. I’m going to focus on funds using stocks and bonds. There are funds with 100% of stocks and funds with 100% of bonds.

How to invest in Mutual Fund ?

Mutual funds are provided by various financial institutions. You current bank probably has a large offer of mutual funds. Every large bank in Switzerland has its own offers of mutual funds. You can ask your bank about it and they will give you the set of mutual funds they offer.

So how to choose a mutual fund ?

They are several factors that are important when choosing a mutual fund. First of all, there are two kinds of funds. There are actively managed funds and passively managed funds. We are going to focus on actively managed funds first. Simply because they are the most used funds. And also because your bank is likely to only offer you this kind of funds.

Active Funds

Active funds are managed by some people, the managers. These people decide which stocks to pick. They also decide when to buy and when to sell. This is called market timing. The managers also have some other expenses such as advertisement. And managers need to be paid. All this translate into costs. And guess who’s paying the cost ? The investors.

The cost of a mutual fund is the Total Expense Ratio (TER). This is total percentage of your investment that pays for the expenses. If there is a TER of 2%, each year, 2% of the fund value is lost to fees. If the fund returns 10% of performance, you’ll only see 8% of performance. The TER of active funds range from around 1% to 3%.

Fund managers are justifying this cost by saying they are smart enough to beat the market. In order for an active fund to be interesting, it needs to beat the market by at least its TER value. And they needs to beat it consistently.

Guess what ? They are not beating the market consistently. Each year, only about 1 fund in 6 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. Don’t 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’s full of facts about how active funds are failing to beat the market. Or read this excellent post, on The Simple Dollar.

So active funds are too expensive! What can I do ? 

You should avoid active funds. It’s just a was to give your money away to pay for managers. You need to invest in cheaper funds. I said they were two kinds of funds. It’s now time to delve into passively managed funds, or passive funds.

Passive funds

There are two issues with active funds. First, they have high cost because of the 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 were to invest in each company in the market ? This is called indexing. A passive fund will follow an index. The most famous example is the S&P 500 will follow the 500 biggest companies in the US market. If you buy a share of a fund following the S&P 500 index, you’ll buy a share of 500 companies at once. No market timing here. You will replicate the performance of these 500 companies.

And the second advantage is that it’s much cheaper. There are still managers in the funds. And there are still some buying and selling costs. But most of it is automated. This result in lower cost! On average, passive funds have a TER of around 0.05% to 0.3%. This is about 10 times lower than active funds.

Indexes

Now, there is still is the question of the choice of indexes. I cannot make the decision for you. But I can give you a few information about indexes.

As there are a lot of active funds, there are a lot of indexes as well. Some are quite small. The Dow Jones Industrial Average (DJIA), or the down, is the one of the oldest index. And probably the most famous one. It contains 30 large companies from the US. The SP&500 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. This is about 98% of the US market. When I say biggest, I’m talking in market capitalization. The value of all the shares of the company. Currently, Apple is the company with the largest capitalization of the world. Finally, there are even indexes that cover the entire world. Such as the FTSE Global All Cap Index which covers all the stocks in the world. Pretty nice diversification, right ? :)

You can also find the same kinds of indexes for bonds. Bonds for the entire US market or bonds from all over the world. You can also find indexes for specific sector the industry (Technology or Banking). And you can find indices about stocks that pay a large dividends.

We talk about market capitalization before. It’s important 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-cap. In other words, bigger companies have a bigger share. Let’s take the S&P 500 for instance. The 10 biggest companies in the index form about 22% of the entire index! This is very important to understand if you are interested in indexes. Most indexes are like this. There are a few that are equal weighted. In this system, all companies in the index have an equal portion of the entire index. This is more rare.

When you choose a passive mutual fund, you basically choose the index you want to follow.

Summary

Now you should understand that mutual funds are a very good option for investing. They are a great tool for diversification. Index funds (passive funds) are generally very cheap and contain a large number of stocks (or bonds).

Personally, most of my portfolio follows the FTSE Global All Cap Index. It means that I’m investing in the entire world stock market. You can take a look at my portfolio.

Now, what if your bank does not offer your good funds ? You will soon see that most banks do not offer cheap passive indexing funds. Why ? Simply because they want to make more money out of you ;) So what is the solution? Exchange Traded Funds (ETFs). We will cover ETFs in detail in the next installment in this Investing series.

Do you have any question about these mutual funds ? Is it clear why you should use passive funds rather than active funds ?

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