If you're still in the car-seat-and-minivan years, mutual funds probably look like a pretty good investment vehicle. You don't need a big lump sum to get started, and there are funds to suit almost any investment style, so there's not much to keep you from getting started. For what a lot of people spend at Starbucks in a year, you can have a team of professionals handle your investments. However, those professional fund managers come at a price, and every penny you pay them cuts into your returns. That's why it often pays to invest in low-cost mutual funds.
Large investors take good care to spread their money across a range of industries and geographic areas, as well as companies of different sizes. This is called diversification, and it means that a crash in any one area can't hurt them badly. Mutual funds allow small investors to have the same advantages, by pooling their investment capital until the fund itself becomes a large investor. Your monthly investment buys you a percentage of the fund's returns. The fund managers buy and sell stocks to maximize your return. Some actively scout for good investments, while lower-cost "index funds" simply buy all the stocks on a given exchange or index.
Commissions and Fees
Of course, the fund companies are businesses in their own right, with high expenses for fund managers, researchers and administrators. They also pay commissions to salespeople in exchange for selling their product. These costs are covered by a fund's management fees and broker commissions, or "loads." Management fees are a small percentage, usually ranging from less than 1 percent to more than 2. Funds can charge commissions at time of purchase, at time of redemption or not at all. These are referred to respectively as front-loaded, back-end-loaded or "no-load" funds.
How Low Can You Go?
All of these fees have an impact on your returns over time. If two funds had similar portfolios, returns and management styles, lower management fees would make one of them more profitable. However, front-loaded funds take commissions out of your initial investment, which can sap their returns for the first several years. Funds with back-end loads reduce your commission costs over time, to reward you for keeping your money in the fund. No-load funds charge no commissions at all but often make up the costs by higher fees. There are free calculators online to help you evaluate the effect of all these variables.
Unfortunately, even after wading through the fees-and-loads jungle, you might still have some expenses to sap your returns. Sometimes, the normal operation of a fund triggers taxable income. Some of the companies in its portfolio might have issued dividends, for example, or perhaps the fund manager has taken a profit by selling a rising stock. Part of that tax bill gets passed on to you as an investor, even if your fund is down for the year. If this is a concern for you, let your broker know that you're interested in tax-efficient funds.
All of this adds up to a fairly complicated decision-making process, so talking to a professional adviser can save you some grief. Try to pick a fee-only adviser, if possible. They aren't in the business of selling product, so their advice is often more impartial than a salesperson's. Work together to select a range of low-cost funds, and compare them against each other using the Securities and Exchange Commission's free comparison calculator or a similar tool. Look for fees lower than 1 percent, and from that group invest in those with the most consistent returns and commissions on a no-load or back-end load basis.
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