What's the Payoff?

Updated July 10, 2020 | Infoplease Staff

When you buy a share in a mutual fund, you're buying both a share in an investment company and a service from that company (or more accurately, the management company that sponsors it).

The service you buy is convenient and relatively inexpensive access to the capital markets. The value of your shares in the company depends on the company's profits (how well the mutual fund invests and performs in the markets).

Structure

When people refer to mutual funds, they usually mean open-end funds which can issue an unlimited number of shares. The more money investors put into the fund, the more shares it issues. There is no limit to the size of a mutual fund: Fidelity's legendary Magellan Fund has well over $50 billion in assets under management.

Funds use shareholder money to buy assets. The stocks or bonds a fund holds comprise its portfolio, and the financial professional who decides what to buy and sell is the portfolio manager.

Market Timing

Every day the fund's accountants calculate the value of each share. This is done by totaling up the value of all assets in the fund's portfolio and dividing that figure by the number of fund shares outstanding. The resulting number is the fund's net asset value (NAV). All fund managers share one goal—to make the NAV go higher.

How does the mutual fund company make money?

Management Fees

Fund managers charge management fees, which are generally pretty small, often less than 1.5% of the money you invest. This small percentage, however, is enough to be profitable for the fund company, since so many people are investing so much money.

Types

There are four general mutual fund types:

• Stock funds buy stocks. Their investment objective is usually specific to a certain stock type—small cap, large cap, international, etc.
• Bond funds hold only bonds. As with stock funds, they can be designed to purchase particular grades of bonds.
• Balanced funds invest in a mix of stocks and bonds.
• Money market funds stick with safe, short-term debt instruments such as commercial paper, banker's acceptances, repurchase agreements, and certificates of deposit. Because they have low risk, they typically provide the lowest returns among mutual funds. Their main uses are to park money between investments, hold emergency savings, and save for short-term goals. A small investment in money markets may also reduce some risk in a long-term investment account.

Mutual Fund Choices

Funds are usually categorized by the type of assets they invest in—small cap stock, intermediate bond, etc.

Index Funds

One type of fund that bears a special mention is the Index Fund, which invests in the companies that comprise the various “indexes” (Standard & Poor's 500, Russell 2000, etc.). The fund buys a portfolio of stocks that are expected to behave almost exactly as the index does. This is called passive management, since the account doesn't change and the portfolio manager doesn't make daily investment decisions.

How to Judge Mutual Funds

Because it's not possible to predict the future, people often look at a mutual fund's historical performance to gauge how the fund might behave in times to come. While it may be tempting to focus solely on how much money the fund has earned for its investors (the return), it is also important to draw other lessons about the fund, such as the risk level of its investments, its expenses, and its style of investing. However, it is important to realize that many things change over time, including market conditions and personnel working for the mutual fund. There are countless examples of funds achieving spectacularly high returns in one year only to incur equally spectacular losses in the following year.

There are many services available to track fund performance, the best-known of which is Chicago-based Morningstar Inc.

Morningstar provides data on mutual fund expenses, management objectives, major investments, and historical returns. The company also provides the well-known “star” rating for funds—one to five stars according to performance. In advertisements, fund companies love to tout high Morningstar ratings. But as with any type of numeric or thumbs-up-thumbs-down rating, you should look beyond the rating to learn more about the fund before you invest.

Historical Returns of the Asset Classes

There's a disclaimer that every mutual fund company in the country has to use in its sales literature: “Past performance is no guarantee of future results.”

Keep that warning in mind as you study your investment options. The greatest stock-picking method in the world cannot predict the future. We can't know what the stock market is going to do tomorrow, let alone a year or ten years from now.

We can, however, hazard very educated guesses about all the markets. Based on more than a century of financial market analysis, we can reasonably predict some basic things—that stocks will continue to perform better over the long-term than bonds, that small cap stocks will offer the best overall long-term returns of all the asset classes (types of assets: stocks, bonds, etc.), that U.S. Treasury securities will continue to be the safest investments available. But when we speak about return for the asset classes, we're always speaking in the past tense.

Comparison: Stocks, Bonds and Inflation

“Gentlemen prefer bonds,” goes a well known saying.

That may be true, but then gentlemen are losing out. They'd be better off listening to Peter Lynch, the legendary Fidelity Magellan Fund manager, who says, “stocks are where the action is.”

Indeed, historically stocks have offered the highest possible returns of all the asset classes. Ibbotson Associates, the Chicago-based consulting company, provides some statistics that demonstrate the high performance of stocks. Since 1926, the stocks that make up the S&P 500 (a listing of 500 commonly traded large cap stocks, including such titans as Monsanto, Microsoft, Campbell Soup and General Electric) have achieved an average annual growth rate of almost 12%. That's nearly double the rate for the next most historically lucrative investment choice, long-term corporate bonds, which have grown at about 6.5%.

The big decision in investing is between equity (stocks) and fixed income (bonds). But even within those two categories there has been great variety in return. Small cap stocks have historically offered the highest equity return. Similarly, corporate bonds have offered a higher return than government bonds. Treasury Bills have been pretty much the lowest earners, with a little more than 5% average annual return.

Time Traveling Trader

Find out how much asset classes have made over time.

When charting the return on asset classes, you should also look at the rate of inflation. Inflation is what makes something that used to cost $10 a few years ago cost $12 today, meaning that your money doesn't buy as much as it used to. If you want to have enough money to live well in your retirement, your investment return has to compensate for the inevitably higher prices that will exist 10, 20 or 30 years from now.

Even Treasuries have historically provided some protection against inflation. So even the most conservative investment account possible has beaten hiding your money under your mattress. But you're probably not going to whip inflation by much unless you invest in higher-return investments. That means taking more risk.

Here's a purely hypothetical scenario put together by the Securities Industry Association: If you invested $1,000 in a cash account (such as a CD) yielding 5%, you could grow your investment to $1,629 over ten years. But assuming a 3% inflation rate (over the past 70 years, inflation has averaged more than 4% per year), this sum would actually be worth only $1,201. At 4% inflation, you would have only $1,083—not a lot to show for ten years' worth of investing.

The moral of this story? Every day your money is worth a little less than it was the day before. Whether you call yourself a saver or an investor, you've got to keep moving just to stay in place. And if you want to get ahead, you really have to run.