Today J. Carlos Gomez, President Prime Capital Equities LLC in San Diego, CA is a guest on my blog. He's providing us with 3 things we should know about Mutual Funds.
1. How do they work?
A mutual fund is a basket of stocks grouped together into an investment vehicle. Mutual Funds can also be made up of bonds or a combination
of both bonds and stocks.
A Bond Mutual Fund is the same as a Stock Mutual Fund, except that the fund is made up of just bonds. A Bond &
Stock Mutual Fund is comprised of both.
Mutual Funds can be bought at most brokerages houses, such as Charles Schwab, Fidelity or Ameritrade.
A Stock or Stock Certificate represents ownership
in a corporation. Stocks or Stock prices are usually much more volatile
than bonds.
A Bond is a debt instrument or IOU. They are issued by banks, government agencies or companies
with an interest rate and a timeline when repayment will be made.
2. How much do they cost?
When considering a
Mutual Fund, one must look at how much they cost. All Mutual Funds
have a needed cost. It is called the Annual Expense Ratio.
It is the fee needed to pay the operating expenses to run a Mutual Fund. It is unavoidable.
On average the expense
ratio varies from .15% to 2% on a fund. For example, a Mutual Fund
charging .15% on $100,000 = $150 a year. A Mutual Fund charging
2% on $100,000 will cost you $2,000 a year.
Other cost to be aware
of are called Loaded fees. They are generally called Class A for Front
Loaded or Class B for Back-end loaded charges on a Mutual Fund. They
can range from
2.5% to 5%. A Class A
Mutual Fund will charge you immediately on your investment. For
example, a Front Load of 3% on a $100,000 investment will cost
you $3,000 plus the ongoing Annual Expense Ratio. The Front Load is only paid one time at the initial investment.
Class B Mutual Funds
apply their charges when you sell the Mutual Fund, but you still pay the
Annual Expense Ratio. It usually has a decreasing sliding scale over a
number of years. For example, if you sell
a Class B Mutual Fund with
a starting fee of 5%
after a number of years, it may only charge you 2% to exit the Mutual
Fund. So the longer one holds a Class B Mutual Fund the less likely
they will pay a fee if they
sell after the deferred charges period.
Sales charges or Class A
and Class B fees can be avoided on Mutual Funds. They are called No
Load Mutual Funds and they do not have Loaded fees when one buys or
sells them.
An investors still pays the Annual Expense Ratio regardless of whether a Mutual Fund is Loaded or not.
3. What is the difference between an Active and Index strategy?
An Active Mutual Fund
is trying beat a particular index. There are approximately 12,000
stocks traded daily in the U.S from 60 different countries.
The market or analyst
break up the market into different categorizes. Categorizes or indexes
are created into International, Emerging , Small and Large companies.
Other indexes could be
made from value and growth companies. One of the most famous indexes
is the Standard& Poor’s 500. It is a large capitalization or big
company benchmark.
You find Coca Cola, Exxon and Colgate in this index.
So an Active Mutual
Fund will attempt to beat the S&P 500. They do this by applying
different strategies that range from buying and selling stocks within
the index that they believe will outperform all the
other stocks.
Other strategies could
include timing the market and over or under weighting certain sectors of
the index. The strategies vary from one Active Mutual Fund to
another. There is no standard strategy
to beat a certain index. In general most Active Mutual Funds have an Annual Expense of 1% or more.
An Index Mutual Fund is
a plain vanilla strategy that follows a certain category. Other
popular indexes are the Russell 2000 and Russell 3000. They are
considered plain vanilla because they do not
trade much and the strategy is to copy the flow of an index. The average Annual Expense Ratio on an Index Mutual Fund is .20%.
One analogy to show the
difference between the two Mutual Fund strategies is a road trip from
San Diego to Los Angeles. Automobile A is the Active Mutual Fund and
automobile B is the Index Mutual Fund.
Automobile B strategy
is the go with the flow of traffic from San Diego to Los Angeles.
Automobile A will attempt to beat automobile B by switching from lane to
lane to gain an edge and even speed
when necessary. At the
end of the road trip Automobile A may have beaten automobile B, but
when the cost are accounted for, it tells a different story. To begin,
Automobile A
cost more to operate.
Automobile A created other cost when it was switching from lane to lane
because of the wear and tear on the vehicle. Usually Active Funds
trade more and the commission fees, realized
gain can drag down the performance.
They may have also have
received a speeding ticket by betting big on a stock that
underperformed that affected the actual returns.
In general, it is very
difficult to beat an Index strategies because of the higher fees an
Active Mutual Fund charges. If for example an investor chose an
under performing Active Mutual Fund that lagged the S&P
500 by 1.5% annually, the cost
could be substantial over time.
$100,000 x 1.5% = $1,500 a year. Over a period of ten years the underperformance could cost $15,000.
In Summary, an
investor should consider his risk tolerance and financial goals when
choosing a Mutual Fund. Morningstar is a website that helps investors
evaluate different Mutual Funds.
If an investor looking for more guidance, a fee only Advisor could help make recommendations and if needed manage monies.
I hope you found the information that J. Carlos Gomez has provided helpful. If you should have any questions please contact him at Carlos@primecapitalequities.com
As always thank you for reading.
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