How Mutual Funds Work

Mutual funds allow people to get access to professional management without the need to have a large account. These services are usually limited to high net worth individuals whose accounts are large enough to justify the resources of a professional manager.

Even in these cases, a mutual fund will tend to have higher management skills employed in running it, due to the sheer size of the pooled account. If someone has an account worth several million dollars, that may be big enough for a good portfolio manager to guide it, but there are other portfolios out there of larger size, and the bigger sizes attract the best people.

This is because there’s more money to be made from bigger accounts, and the most money from the very large ones. Mutual funds are tyoically measured in the billions of dollars, and therefore attract some of the best talent out there.

The very best talent tends to gravitate toward hedge funds, which are both large and do not have the same constraints as mutual funds do. For instance, hedge funds can invest in pretty much anything they want as well as take short positions, betting on things going down as well as up.

These additional freedoms allow for the cream of the crop in the world of portfolio management to really shine, and due to the much more generous fees that hedge funds generate, this also allows them to be compensated much more highly than mutual fund managers and advisors.

For Many Investors, Mutual Funds May Be the Best Choice

Only a small percentage of individual investors qualify for hedge funds, which require accounts of a considerable size or significant expertise in the markets. You have to fit the minimum requirements or you won’t be allowed to open a hedge fund account.

It often isn’t enough to just meet these minimum requirements, as hedge funds often require minimum investments of half a million to a million dollars for them to even look at you. They aren’t really interested in the small money, they are going after the big to very big accounts.

For those who do qualify to open a hedge fund account, many may not want to do so due to not wanting to take on the additional risks that hedge funds bring. While hedge funds do tend to perform better on average than mutual funds do, especially in down markets, they also tend to be riskier, and entire funds have gone down in the past when they took on too much risk and the investments ended up going too far against them.

Many investors are well prepared and willing to take on these additional risks in order to shoot for better returns on their investments, although as always, one must be prepared to take on additional risk whenever it is present.

Given that most investors do not have accounts of the size to warrant professional management, they must either manage their investments themselves or invest in mutual funds. Managing your own investments is a viable alternative in many cases, where one ultimately make their own decisions, although this does take some skill to be sure.

Individual investors tend to underestimate the skill that is required to successfully navigate these waters over the long run, and there is a reason why there are professionals in this field, and that reason is that this is a very skill intensive profession.

The good news is that investing for the long term does require far less skill than trading in the shorter term, as the general idea here is that the tide will rise enough over time such that it won’t really matter what you invest in provided that the companies are sound, and many funds simply look to replicate an index by buying everything in it, which takes no skill at all.

If you’re looking to beat the market so to speak though, this is the part that does take skill, and many mutual fund managers fail to accomplish this. This is quite a bit easier to do with a relatively small portfolio than with one in the billions old dollars, but it still does take a fair bit of skill to pull off, to be in the right things at the right time.

Mutual Funds Are More About Access and Diversification than Management

Aside from the sheer size of the positions that mutual funds take on, the fact that they are very well diversified adds to the challenge of beating the market by a significant amount. The market here refers to the movement of major indices, such as stock indices or bond indices.

If you could have just bought the components of an index and your fund would have performed better, then all the time and resources spent looking to outperform the market with your selections has been wasted, and worse, they have acted against the mission of the fund and all financial investments.

It is not uncommon at all for mutual funds to underperform the market, for various reasons, and the fact that they take such big positions with stocks limits their flexibility and makes things more challenging.

If we were looking to add a certain basket of stocks as individual investors, since we would only be looking to take small positions in each one, we’re going to enjoy a lot of liquidity that funds taking large positions would not.

When you take a large position in a stock, this moves the market, and the spread widens. You also need to trade stocks that this can be done without affecting the market too much, where if you’re trading much smaller sizes you can just trade at the bid and ask pretty much and don’t just have to stick to the high volume stocks which can absorb your positions more readily.

So given that mutual funds do have better management but inherent disadvantages over trading yourself, and the fact that long term investing isn’t really that skill intensive and someone can just go with a representative basket of stocks and do fairly well, mutual funds aren’t really that much about getting the advantages or professional management.

The management is generally better but it needs to be in order to keep pace with the market,  Many funds, and the majority of the money in mutual funds, isn’t even actively managed, and they instead use passive management by just looking to track major indices.

Mutual funds can’t just ride a few hot stocks like individual investors can, as they would not only have to take bigger positions then they should in these stocks, they also have a duty to shoot for a lot of diversification, and this does tie their hands quite a bit.

On the other hand, many individual investors do seek diversity and while they could just track indices like index funds do, a great many investors do not have anywhere near a big enough portfolio to do so, or even have any sort of meaningful diversification. If you bought 100 shares of everything in a stock index, that is going to require a lot of money, and doing this with bond indices is really going to be out of reach.

Mutual funds are diversified with hundreds to thousands of different positions, whether they are actively or passively managed, and getting this broad diversification is the biggest reason by far that mutual funds can make sense for a lot of individual investors.

Investing in Mutual Funds

Mutual funds are not bought on the stock market, they are bought through dealers. The minimum amounts are set very small, where you can start investing in a mutual fund with as little as a few hundred dollars or a very modest regular contribution each month, which makes mutual funds very accessible to all investors regardless of the size of their investment accounts.

Mutual funds are not traded on price like stocks are. An order is placed with no real regard to what the fund’s share price is, as the decision to go with a mutual fund has to do with the fund’s objectives and past performance overall, not where they are trending in the very short term.

People do look at the past performance of the fund to decide between them, and the periods looked at can be in shorter terms like quarterly or annually, right up to the long term performance of the fund, but given that these investments are made in the longer term, generally 3 to 5 years or longer, short term fluctuations don’t really matter that much.

Orders are filled based upon dollar amounts invested, which are converted to fractional share amounts in the fund. As the fund’s price per share rises or falls, the value of one’s investment in it changes accordingly.

Therefore, one does not have to worry about minimums for buy or sell orders and orders that are even just a few dollars, such as one investing $50 a month, can be easily filled. The fund will take the net orders for a given day and place trades in the market to cover the net purchases or disbursements.

Reports are typically delivered quarterly, although you can usually check the valuation of your investments at any given time. It’s a good idea not to worry about longer term investments in the shorter term, as if there is no intention to sell, today’s market price just isn’t that meaningful or at least should not be seen as that meaningful.

So if someone seeks broad diversification and wishes to achieve that in a passive way, without having to worry too much about what is going on, a set and virtually forget approach, then investing in mutual funds can make a lot of sense.

There are over 30 trillion dollars invested in mutual funds worldwide, so this is a very popular form of investing indeed. There is certainly power in numbers with a lot of things and mutual funds are certainly one of the things where this holds true, giving even the smallest individual investor access to very broad portfolios which are managed by professionals.