What is a mutual fund?
A mutual fund is an investment company that pools money from small investors and invests those funds in the financial markets. Profits from those investments are shared by the fund’s investors in proportion to the number of shares in the fund they own, much like the profits from any company are distributed to its owners in proportion to how much of the company they own. The shares of the funds are priced each business day by adding up the value of all the securities (stocks and/or bonds) that the fund owns plus any dividends or interest paid by those securities that has not yet been distributed to the fund’s shareholders. Mutual funds must distribute any dividends, interest and capital gains earned to shareholders at least annually. It is important to understand that when you invest in a mutual fund, you own a small piece of all the investments that the fund owns. That is why it’s vital that you research and understand what securities a fund owns before investing or work with an advisor who can conduct this research for you.
Why Mutual Funds are perfect for 401(k)’s
As mentioned above, a mutual fund pools money from small investors and invest it in stocks and/or bonds. This pooling allows both diversification and access to professional management that would be difficult for small investors to achieve on their own. A 401(k) plan by its nature (mass participation and limited contributions) serves to produce a lot of smaller investment accounts. For this reason mutual funds are the perfect (realistically, the only practical) vehicle for 401(k) investments.
Stock or equity mutual funds invest primarily in common stocks. Common stocks represent ownership in a company. They are among the most risky mutual funds. They can be further categorized according to the kinds of stocks they invest in. The following categories of stock funds commonly offered in 401(k) plans are listed in order of increasing risk:
Large Company Growth – Growth managers like to buy the stocks of companies whose earnings are growing faster than the general market. They typically are not concerned by how much they are paying for those earnings.
Large Company Value – Value managers like to buy companies that they perceive are “bargains”. They care a great deal about how much they pay for a dollar’s worth of earnings.
Large Company Core – These managers do not espouse either a growth or value style of investing. Most index funds, like the S&P 500 Index Funds, are “Core” funds.
International Stock Funds – These funds invest in developed international markets (Japan, Germany, U.K., etc.).
Mid Cap U.S. Stock Funds – These funds invest in medium sized U.S. Companies.
Small Cap U.S. Stock Funds – These funds invest in small U.S. companies.
Emerging Markets Stock Funds – Funds that invest in companies in emerging markets (Brazil, India, China, etc.).
Bond funds or fixed income funds invest in all types of fixed income securities, including but not limited to, CD’s, government and corporate bonds and mortgage securities. All of these securities involve loans of one type or another. Typically bond funds are less risky than stock funds and provide more cash income.
Types of Bond or Fixed Income Funds:
Short, Intermediate or Long Term general bond funds – These funds invest in the entire spectrum of fixed income securities.
Government bond funds – These funds only in U.S. Treasury bonds.
Inflation Protected bond funds – These funds invest only in bonds that offer some sort of inflation protection, such as TIP’s or floating/variable rate bonds and notes.
Balanced funds invest in a combination of asset classes, typically some portion in stocks and some in bonds. Some balanced funds may be broadly diversified across many assets classes, some only as few as two. Some balanced funds maintain a fixed allocation to the asset classes they invest in, others give their managers discretion to change the allocation as they see fit to attempt to gain an advantage in return. Target Date funds are a specialized form of balanced fund that are managed to reflect how the manager feels someone who will retire on or around the target date of the fund should invest. Target date funds automatically get more conservative as time goes on relieving the investors of making those decisions. When used properly, target date funds can be a useful “one stop” solution for 401(k) investors.
Some mutual funds specialize in a particular kind of stock or bond. Examples include real estate companies, healthcare stocks, etc. Some examples of specialty funds commonly found in 401(k) plans include real estate, precious metals/natural resources and inflation protected bond funds. While these funds may have a place in many portfolios, they must be used with caution and always as part of a diversified portfolio as they can be quite volatile.
Index funds are designed to mimic the behavior of broad collection of stock, bonds or other securities. These groups of stocks or bonds are known as Indexes and are chosen to represent "the market" for a given type of security. For example, the S&P 500 represents the largest 500 companies trading in the U.S. Market. It is generally regarded as a benchmark for large company stock investing in the U.S. market. Index funds are typically much cheaper (1% less expensive, on average) than actively managed funds because they do not have to pay managers. The vast majority of small investors, including 401(k) investors are best served using low cost index funds. It is very rare to find active managers who have the ability to consistently outperform the appropriate index (after fees) and recent data suggests that it is becoming increasing difficult to do so. Most academic research also shows that there is very little to be gained by the small investor in using actively managed mutual funds.
Mutual funds charge fees for their services. Again, fees are shared by the fund’s shareholders in proportion to their ownership. Fees are reported as a percentage of the amount you invest. Mutual fund fees range from .05% for some large index funds to over 2.5% for some actively managed funds. Fees do matter as they reduce the return on your 401(k) investment. Again, 401(k) investors should focus on low fee index funds for their 401(k) portfolio.
How to choose the right funds for your 401(k)
· Get a list of funds available in your plan.
· Get all available information on each fund. At a minimum you should have the funds’ performance history over time and its expenses (cost).
· Categorize each fund by type (Bond, Large Cap Growth etc.).
· Have your portfolio allocation handy.
· If possible, print out a fund summary sheet for each fund. Many plans offer fund summaries from Morningstar or some other fund data company.
Arrange Funds by Type
· Arrange the available funds in your plan by type. If available, use the Morningstar categories on the fund summaries as these are usually more specific than those assigned by the plan vendor. Be very cautious when using descriptions like “most risky” and “least risky”. These tell you nothing specific about what the fund invests in, and can be quite misleading (or flat out wrong).
· In many plans fund choices are so limited that there may only be one fund choice per category
Fill Your Asset Allocation Prescription
· Prior to this you should have worked out an asset allocation plan. The first step is to match the fund categories to your asset allocation decisions. For example, if your first asset class to fill is 10% of the portfolio in Large Cap U.S. growth stocks, pull the data sheets for the large cap growth funds in your plan. If there is only one then you're done for that category. If there are no entries for that category then try and identify the next best type of fund for that portfolio. For example, if there is no large cap growth fund, a large cap core fund will probably provide enough growth to do the job. Remember that the most important task is to fill out your asset allocation and maintain a broadly diversified portfolio. Selection of individual funds is secondary as assets allocation, particularly between stocks and bonds, as this decision will determine 90% of your return.
If you’re a working American, your 401(k) plan is probably the only viable option that you have for saving for a secure retirement. Therefore, it is imperative that you invest effectively. I urge you in the very strongest terms to dedicate the effort to caring for your 401(k) that it deserves. This means taking advantage of every resource available to you. Check out the plan resources available online. If your plan is fortunate enough to have an advisor who will see you in person or by phone, by all means, make an appointment.