INVESTING 101 No. 6: Everybody in the Pool!

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No. 6: Everybody in the Pool!
<LI style="LIST-STYLE-POSITION: inside; LIST-STYLE-TYPE: square">Mutual funds are generally the first choice of people with little time or money to spare, but you should know what you're getting into.

By KATHY M. KRISTOF, Times Staff Writer

<!-- MEDIUM RECTANGLE AD -->If you want to invest but don't want to spend hours each month reading financial statements and tracking stock market performance, there is an easy way out: mutual funds.

Mutual funds are generally the investment vehicle of choice for two types of people: those who don't have a lot of time and those who don't have a lot of money.

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</TD></TR></TBODY></TABLE>Those ranks appear to be rapidly swelling. Whereas roughly 20 million Americans invested through mutual funds in 1986, the funds today boast of more than 77 million shareholders. Assets held by fund companies have more than quadrupled over the same period, rising to $5.5 trillion in September from $810.3 billion a decade ago.

Mutual funds are investment pools that collect money from many investors and use it to buy stocks, bonds and other investments. The type of securities the fund buys is spelled out in a detailed investment document called a prospectus. Each investor then owns a pro-rata share of the assets in the pool. (This article is about open-ended mutual funds, the most common type. There are also closed-end funds, which trade like stocks.)

The fund company employs an investment manager, who chooses the specific stocks or bonds to buy and sell based on criteria spelled out in the prospectus. It also calculates the value of the pool's investment holdings each day, divides that by the number of shares owned by individual investors, and reports the result--the net asset value of each share. Most of these net asset values are reported in major newspapers, including The Times, just like the prices of individual stocks. [You can get quotes on many mutual funds by clicking here and entering "MUTUAL:" and the symbol for your fund after the colon.]

What's made mutual funds so popular? They make investing easy. You buy a fund with a general mission and let the manager worry about exactly what to buy and when to sell.

The other compelling draw of mutual funds for most people is the fact that they allow you to diversify even a small investment portfolio in a cost-effective way. That's because when you buy a share in a mutual fund, you're buying a piece of all the securities the fund owns.

For example, a growth fund will own dozens of different stocks in various industries. An income, or bond, fund is likely to own a wide array of bonds with different maturities.

Most funds also keep some assets in cash, both to pay off customers who decide to sell their fund shares and to use for better investment opportunities as they arise.

What does it cost to get this diversification? Some funds levy a sales charge when you buy the fund (often called a front-end load) or when you sell the fund in the first few years (a back-end load). There are also fees to pay the managers and other expenses.

No-load funds normally charge only an annual management fee, which is subtracted from the return you earn on your investment. Management fees range from 0.2% to about 2.5% of assets, depending on the type of fund you choose.

But these fees can be less than what an individual pays, especially investor buying very small amounts in individual stocks and bonds.

Consider a hypothetical investor, Mary Jane, who is able to set aside $100 a month.

If she buys individual stocks, at least $8 of her $100 will go to paying trading fees--that's the minimum commission charged by even the least expensive online brokerage service. That would leave her with $92 worth of stock for her $100 investment. Assuming she buys a different stock each month in order to diversify her portfolio, she'd spend $1,200 on 12 different corporate stocks over the course of the year. But because of the fees, she would get just $1,104 worth of shares. If her portfolio gains 10% in value, she has just $14 more at the end of the first year than when she started.

If, on the other hand, she buys shares in a no-load mutual fund, she gets a $1,200 stake in the investment pool. Assuming she earns the same 10% annual return but pays a 1% management fee, the value of her portfolio at the end of the year rises by 9%, to $1,308.

It's worth mentioning that some mutual funds make it easy for people like Mary to invest. Literally hundreds of mutual fund companies offer automatic investment programs through which shareholders can kick in as little as $50 a month.

Mutual funds also allow investors to bet on an industry, nation or kind of asset with fairly small amounts of money. If, for example, you are convinced that Japan's stock market will rise next year, you can buy a few thousand dollars' worth of a Japanese mutual fund that invests directly in a variety of stocks on the Tokyo Stock Exchange--something that would be difficult and expensive even for someone with 10 times as much money.

But there are disadvantages.

You give up a great deal of control when you invest through a mutual fund. The fund manager not only picks the stocks and bonds to buy and sell, he or she determines when to trade them. Where an individual investor might postpone a trade in order to postpone a taxable gain, for example, a mutual fund manager might not.

You also can't buy or sell an open-ended mutual fund in the middle of a trading day. Orders are held until the end of the day when the net asset value is computed. You can't jump in or out at a moment's notice.

And some mutual funds have high fees or trade stocks so often that you might be better off without them. If you invest large amounts, the management fees may amount to more than you would have paid buying on your own. Consider an investor who has $100,000 to sink into stocks, for example. He buys $10,000 worth of shares in 10 companies, paying $150 in commissions through his online discount broker. Had he invested through a mutual fund that charged a 1% management fee instead, his annual cost of investment would have been $1,000 rather than $150. In this case, trading on his own saves him $850.

Not all mutual funds have these disadvantages to the same extent. Some have very low fees, including "index" funds that simply buy and hold all the stocks in a particular index and leave them alone, adjusting only if the index changes.

Next lesson: How to Use International Stocks
 

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