A mutual fund is a professionally managed investment portfolio. For individual investors, a mutual fund spreads risk among multiple investments; a fund can also offer concentration in a single sector (such as government bonds, gold or technology stocks). Funds rise and fall along with the stock market, and each fund has a performance record, making it easy to compare one fund — and one sector — with another.
Investment Performance and Risk
The primary factor affecting mutual fund performance is the change in the value of its holdings. In general, share prices rise when the market is up, and mutual funds follow. Since the fund is diversified through many investments (in some cases, more than 100), fund shares aren't as volatile as the prices of individual stocks. If the fund manager has selected his investments carefully, the fund should beat the market averages — although most stock funds, in fact, do not. Cautious fund managers who park a higher percentage of their assets in cash offer a less risky environment for investors; for that reason, it's good to know the cash ratio of any mutual fund you are researching.
If the fund is concentrated in a single sector, the performance of stocks in this particular family, and specific economic factors, are the main drivers on fund price. Funds that hold foreign stocks, for example, will improve when the dollar weakens, simply because overseas shares become more valuable. Consumer stocks respond to the general state of the economy, while energy funds invested in oil and gas do well when crude oil prices are on the rise. Bond funds will perform well when interest rates fall and bond prices rise. Stock funds that invest in small companies, as a general rule, do better when the market is rising and investors are taking more risks with their money. Index funds simply mirror the performance of market indexes such as the Standard & Poor's 500 — making management of the funds easy and relatively inexpensive for investors.
Management Fees and Expense Ratio
Your return on a mutual fund consists of investment results, minus management fees and expenses. Every mutual fund charges fees for management, as well as the marketing and back-office clerical work needed to keep the fund operating. A recent New York Times article found the average stock fund charging 1.44 percent per year in expenses. This ratio (usually around 1 or 2 percent) will put a brake on investment returns; when comparing funds and reading prospectuses, always be aware of this number.
A fund's popularity with the investing public has some effect on performance. When investors are piling in, and buying new shares, the manager has more opportunities to place his money where he thinks it will achieve the best return. When a fund is performing poorly and investors are bailing out, the cash drain forces the manager to sell holdings, perhaps at a bad time when the market is down. In an extreme situation, a fund will close to new investors, because the manager feels he has no option for the growing assets except cash, which in turn will drag down returns. Always check net cash flow when researching funds.
Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.