*This post originally appeared on www.michaelmorrow.org.
Mutual funds are a popular asset that many investors hold. Investopedia defines a mutual fund as “an investment vehicle made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets” (Investopedia). This post will take a close look at mutual funds and examine their liquidity, safety, expenses, rate of return, and tax efficiency.
When it comes to liquidity, mutual funds usually get a good rating. If you want to access the money in the fund, you can do so without any penalties or extra taxes. However, the degree of liquidity depends on the type of funds you own. There are three different classes of mutual funds, and each class has different fees associated with it. To learn more about each class, have a look at this article.
If mutual funds received a rating for safety, the rating would not be very high. The success and failure of mutual funds depend on the performance of the market. When the market is up, so is the mutual fund. But when the market is down, so is the mutual fund. If safety is your biggest concern when it comes to your assets, then you should seriously consider how comfortable you are facing the risks of the market.
With mutual funds, there are two fees that immediately stand out: the fund management fee, or administrative fee, and the fee associated with using a financial advisor. Management fees can vary from low to high. However, Morningstar reports that the average management fee for a mutual fund is 1.25%. A 1.25% management fee is actually similar to the management fees of other assets out there. Many people need the assistance of a financial advisor to help them manage the fund, and that adds another 1 or 2 percent to the expenses.
Rate Of Return
Since mutual funds are tied to the market, their rate of return can vary significantly. Mutual funds have the potential to grow over time, but, as I detailed in a previous post on stocks, many investors fall prey to their emotions. They either get worried and sell too soon or chase top rated mutual funds with the hope of making more money.
DALBAR is an organization that analyzes the behavior of investors. Each year the organization releases a report that details the performance of the market in relation to individual investors. Over the last 30 years, the S&P has averaged 10.35%, but the typical investor has only averaged 3.66%. And while the bond market has averaged 6.73%, the typical bond investor has only averaged 0.59%. People actually tend to do worse with bond funds than with stocks.
Since you’re taxed when the fund manager sells individual assets, you can end up paying a lot of taxes on a mutual fund. Each year you’ll receive a 1099 form for the fund. If any assets were sold in less than a year, they’ll be considered ordinary income, and you’ll have to pay the expensive taxes associated with that. On the other hand, assets held for more than a year will be taxed as capital gains. If you use a mutual fund manager like the majority of people, you have no control over when the manager buys or sells assets. One strategy to avoid excessive taxes is to invest in an index fund that has low turnover rates rather than an actively managed fund.