DISCLAIMER: This is totally from my own personal experience and point of view. I am not a professional financial advisor, nor do I claim to be one. I’m just a girl trying to make it through the world and pass on what I’ve learned so far from reading, talking to others, and by trial and error. I’m also purposely keeping it simple.
PART 4: WHAT TO LOOK FOR IN A MUTUAL FUND
Now for the fun part, how to pick which mutual fund to invest your money in, but before we do that, you gotta learn some more terms…
Large-cap, Mid-cap, Small-cap
It simply means how big the company is, or what their “market capitalization” is. A large-cap company can have many levels of what their market cap is – some investors say these large-cap companies hvae to have a market cap of over $5 billion, other say over $10 billion, and still more others say it depends on what percentage they fall into – so if the top 5% of all the companies in that industry are worth over $15 billion, then that’s what they use to determine “large-cap”. You won’t need to worry about ‘market cap’, just only enough to understand that it means how much they control as a percentage of the stock market, and that large-cap is the…well, largest. Mid-caps can be anywhere from $1 billion to $10 billion and small-caps are under $1 billion.
What the hell is “stock”, exactly?
All stock is, is basically part of a company. You’re investing in the company’s future, which is why it’s important to remember if you’re buying individual stocks, to think of it as lending them money and determine whether they’ll succeed or fail; so much like lending money to your younger cousin who wants to open up their own car detailing business, you grill him or her on what their business plan is, who their customers are going to be, how else they will raise money, who else they’ll be working with, etc, because before handing over your money, (I hope), you’d want to make sure you’re going to get it back.
So with that being said, the most important things to look for in a mutual fund are:
No, this isn’t a short-form for mermaid, the sea, or even this very expensive face cream for $165 per 1.7 oz.
MER = Management Fee + Fund Expenses, and it just basically means the FEE to buy into the mutual fund because you have to pay the portfolio manager’s compensation and other expenses associated with running a fund. MER’s can range from 0.22% to as high as 3% (or higher.. I don’t know all the mutual funds out there), depending on how involved the manager gets.
So for example if the portfolio manager pores over set of 15-20 stocks that he handpicked from looking over at all the available stocks, and he looks at these 15-20 stocks every day or every week, and does extensive researching to throw out certain ones he thinks might fall, and buy new ones with hidden potential, his MER will likely be higher because he’s more involved, and there’s more work that he’s doing to keep the mutual fund performing at its peak.
In contrast, a low MER mutual fund, like an index fund, doesn’t take much to manage. All they do is meet once every quarter or so, do a review the 100+ stocks they have that represent the stock market as a whole, see whether they need to eliminate any and/or add any, and that does it until their next quarterly meeting.
That’s not to say that ALL proactive fund managers are not worth their weight in gold, but just that you better be sure she’s worth what she’s asking for. I’m not condoning paying more for a fund manager, but you have to really ask yourself if she’s worth it. Self-made millionaires have said “Yes, it’s worth it”, but in general, they manage their own money, instead of leaving it in the hands of someone else who won’t love your money quite as much.
An example of an index fund would be the S&P 500 that contains 500 stocks of large-cap corporations, most of which are American. All these investors have to do is find the top 500 large-cap corporation stocks available out there and group those as the S&P 500 fund, which is a fairly routine exercise for them, because they don’t need to pore over every single one of those 500 stocks in great detail. This is done on a semi-regular basis because new companies will come in and begin publicly trading – also known as “IPO’ing” aka “Initial Public Offering”, or basically their first sale of stock to the public to raise more cash to do more research and investments. Another reason why they review the S&P 500 stocks on a semi-regular basis is because old companies/stocks may decide to leave the stock market altogether either forcibly or willingly and go private, which means they buy back all of the stock that public investors (you and I) have bought in the past, for a premium or at a low price, and keep the stock privately held by the company and its employees/members – and this is important because it changes who is part of the S&P 500 on a semi-regular basis.
Sure, these large-cap companies that are part of this index fund may not gain $100 in a day, and lose $200 the next day per stock, but that’s because they’re bringing in so much money a year that they’re more reliable (just have to work on their expenses!), less likely to go under (can probably secure financing better than a small startup), and are so big, that it’s less of a chance that they’ll get wiped out completely, unlike some of the small-cap companies.
So back to MER’s. Keep in mind that this is a percentage of YOUR profits, because you’re paying them for the privilege of buying into the mutual fund.
Compare for example:
Fund A and Fund B
Fund A has an MER of 2%
Fund B has an MER of 0.50%
Both did very well this year.
Fund A earned a respectable return of 8%
Fund B also earned a good return of 7.5%
Assuming that inflation is 3% (inflation just means that you need more money to buy the same goods. Take for example a bottle of Coke in the good old days selling for 50 cents. How much is a bottle of Coke now? $2. That’s inflation at work, my friend)
If you just glanced at both funds, you’d say: “DAMN! Why did I invest in Fund B? It earned an extra percentage this year. This is BS. I’m switching everything over to Fund A, it seems to be doing much, much better.”
You’d be wrong.
Let’s do the math.
Fund A Returned: 8%
minus Fund A MER: 2%
minus Inflation: 3%
A’s Real return Calculation:
8% – 2% – 3% = 3%
Fund B Returned: 7.5%
minus Fund B MER: 0.5%
minus Inflation: 3%
B’s Real return calculation:
7.5% – 0.5% – 3% = 4%
What!? How did Fund B earn more!?
Well, because of Fund B’s lower MER, or cost to buy the mutual fund, it returned an extra 1%. It may not seem like a lot, but when you multiply 1% by the million you will (soon) have in the future, and if you think hard about it, it’s actually an extra $10,000 that you GAVE to the person who handled Fund A, because they charged you more for the privilege to gamble with your money.
Can you imagine if Fund B earned the same 8% as Fund A?
Yea…. you’d be getting another 1.5% of a return on your money over Fund A.
Although this lesson can be applied to stocks as well, but except for MERs, look for commissions, or any other similar fees. Some can charge up to 30%.
Not all funds are created equal either. If you take TD Bank for example, their Investor Series versus their E-Series mutual funds, have different MERs – 0.98% versus 0.48% respectively. So be sure you do all of your research. (E-Series is cheaper because all the trading is done online instead of calling them and having them click the buttons for you. More on that in Part 5.)
Now, a lot of company retirement plans don’t let you choose from a wide array of mutual funds. They basically give you an option of about 15, so you may not have a chance to pick the dirt cheap MER Mutual funds (I’m in the same boat), but what you can do, is exercise your financial muscle and go through each of the funds, listing out their MERs, and discount most expensive half of the funds. The other half, is what you should really be looking at, and from that, you see how they’ve done in the past year, 3 years, 5 years, 10 years, and think about the world. If there’s a Canadian domestic mutual fund in there, and you think Canada will really prosper in the next year or even in the next month, then buy it. Just reading the paper to get a pulse on the world can do more than expand your knowledge about world events and not only make you a fun fixture at cocktail parties, being able to spout on today’s events, but it can make you a lot of money.
So in my humble opinion, the best mutual fund to pick is the…….(stay tuned!)