A bad mutual fund can destroy your wealth – and in more ways than one! Even when they’re increasing in value, many funds tack on pricey “management” fees which will eat into your gains. Smart investors need to understand these hidden costs up front.
Here’s five things to consider when purchasing a mutual fund.
Would you like it if 3% of your investment disappeared before it even reached the stock market? That’s what happens with “load” funds, which charge a percentage of every investment as the “middle man” between your money and their expert fund managers. They’ll argue this allows them to cover operating costs over the life of your investment, so you’ll eventually earn more money over the long term. Unfortunately, the history of the stock market contradicts this claim, and statistics show that you’ll make more money if you’re not paying the “load”.
An expert stock picker has been hired to manage the portfolio of your mutual fund’s stocks, and the fund may also have a staff of operators fielding phone calls, 7 days a week, 24 hours a day. Who’s paying for that? You are. Every mutual fund includes ongoing “fees” that cover the costs of their parent company. Shop around for the fund that charges the lowest operating fees. There’s a surprisingly wide range – and high fees will affect your long-term performance.
3. Tax liability
It’s possible to pay no federal income taxes on the gains from a mutual fund – if the fund’s composition is tax-free bonds. But most funds contain stocks, which will incur capital gains taxes at the end of each year. Fortunately, there’s some funds that are trying to beat the system. For example, Fidelity’s “Tax Managed Stock” fund juggles its investments to avoid the highest of the capital gains taxes. It’s a “tax-efficient” fund whose five-year return before taxes was nearly identical to its five-year return after taxes.
Mutual funds diversify investments across a range of different stocks. But a badly-chosen mutual fund will “double up” on investments where you’re already overloaded. It’s dangerous to tie too much money to just one single investment type, whether it’s all in big companies, a specific market sector, or just one single country. Know the international/domestic percentage of your current holdings, along with their investment strategy (and how much they’re typically investing in bonds). Holding lots of stocks will diversify your portfolio – but in a strange paradox, mutual funds can actually decrease your diversification if their individual investments end up overlapping!
“If it don’t go up, don’t buy it,” Will Rogers once said. The performance of every fund is vigorously tracked – by newspapers, business magazines, and the Morningstar Guide to Mutual Funds. But some statistics can be misleading, since a lucky pick in a single year also inflates a fund’s three-year and five-year average. And sometimes funds replace their managers with an entirely different set of personnel.
If you’re buying a fund for its past performance – make sure you’re confident that it’s going to continue!