What is a Mutual Fund? A basic understanding…

I suppose this should be one of the first posts seeing as how most people are invested in mutual funds (and have no idea what they are, what the differences are between them, and what kinds of mutual funds there are out there). It is also of note that many investors might be better off getting out of mutual funds at a certain point… but I’ll get into that in another post!

A mutual fund is a means for small investors to pool their money together (MUTUALLY) with other small investors so that they may hire a Mutual Fund Manager to take the collective funds and create a diversified investment portfolio that is invested on behalf of all the small investors. If Investor A has $1000 of his/her money in the mutual fund and Investor B has $10,000 of his/her money in the mutual fund and the Mutual Fund Manager has guided the portfolio to a 10% return, then Investor A now has an $1,100 stake in the fund and Investor B as an $11,000 stake in the fund.

So you might be wondering who the charitable soul is who has decided to manage this investment portfolio on all these investors’ behalf? Well, don’t you worry! He/She gets paid, and paid well! One of the most oft reported pieces of information on mutual funds in the media is what is known as the MER of the fund.  MER stands for Management Expense Ratio and is in essence how much money is paid to the Mutual Fund manufacturer in order to cover all costs of running the fund.  This includes the pay for the mutual fund manager, his/her research team, support staff, the paper your statements are printed on, the lights and phones in the office, not to mention paying the mortgage on the building and property, advertising the fund, etc. Oh, yeah it also includes the commission your financial advisor may earn for selling the fund to you and maintaining a relationship with you.

The MER is deducted before all performance reporting. So in the example above, if the MER of the mutual fund was 2%, then the mutual fund manager was actually able to generate a 12% return.  Once the 2% MER was deducted, we are left with 10%.

Most people are quite content to pay 2% (and not really noticing it because it doesn’t show up anywhere on their statements) (Then again, most people don’t even know that they are paying it!).  Once you actually break it down for people (and when you are dealing with larger and larger investment portfolios) then they start to pay more attention. For example if someone with a $1 million dollar portfolio is paying a 2.5% MER and there is a similar fund out there with a 1.5% MER, that’s $10,000 being left on the table every year. If we apply the same thought process like we did with the savings account question, multiply that amount by a couple of years and the foregone growth and it quickly become a matter of hundreds of thousands of dollars if not millions!

But of course, we have to look at why people would want to use a mutual fund in the first place. Well if you have $1000 dollars to invest, you are not going to get a very diversified portfolio if you try to buy a bunch of stocks individually. The commissions per transaction would eat up a sizeable chunk of your $1000 right off the bat.  You may need to earn a 30% return just to break even!  And if you could do that with confidence I’d be wondering just how it came to be that you only have $1000 to your name!  That is why I kept using the words “small investor” in the beginning of this post. Once you have a larger portfolio (generally speaking, nearing $100,000) you CAN start to create a diversified portfolio without brokerage costs killing you.

The other point to mention is that some people use mutual funds because they want a dedicated team of experts handling their hard earned cash. Remember a mutual fund manager and his/her team works almost ’round the clock and they are immersed in the world of investing and have studied long and hard to get where they are.  So a lot of people who don’t have the time, knowledge or desire to handle their investments will hire a professional to do it for them.

Okay, I think that is probably enough of a primer on mutual funds to get started with.  Let’s let that sink in before getting back into it… because there is a lot more to it, that’s for sure!

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
Related Posts