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Newbie questons on Index/Mutual Funds

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  • #2
    jreddington
    Closed Accounts Posts: 5 ✭jreddington


    Index funds are a type of Mutual Fund.

    Funds can be "active" where you are paying a manager to research, buy, and sell stocks. Each fund will have a different criteria for the stocks that they hold. The fund pays this manager from the fund, usually as a percentage. Say the funds core investments go up 6% in a year, but the management costs were 1.5%, your net profit is 4.5%.

    Funds like Index funds are "passive" in that the manager only buys and sells as needed as investers put in and take money out of the fund. It may not invest in every one of the stocks defined by its index since that could be cumbersome. However, since they don't have to spend time and money tracking down the "best" stocks, their costs are lower. They could be down in the range of 0.5%. On the same 6% core gain, you get to keep 5.5%.

    Now if a manager is great and can earn 10% in that market, paying him the extra 1% is a good deal since your return is now 8.5%. However, every manager is playing against every other manager, institution, and individual stock invester, so on average, all managers make the same core return. In my example above, 6%. So ON AVERAGE, paying for active management makes no sense since you'll fall behind based on the extra management fees.

    When you buy funds, there can be an ufront load or sales charge, possibly as high as 5%. This is supposedly in exhange for lower annual managment fee percentages, but not always. Think of this fee as starting out immediately with a 5% investment loss that the fund has to make up.

    You can buy funds through a broker, or some fund families let you open an account where you can buy or exhange funds within the families. Making regular periodic purchases is a great idea, buying a little bit over time, averaging out your share cost. Some funds may have a minimum initial purchase, a different minimum addition, but possibly an even lower minimum for automatic regular purchases. Just make sure there are no fees for these small purchases since they can chew up your net return.

    A rather new development are "exhange traded funds" such as ishares (see ishares.com) which can be purchased on US exchanges. Seems their Euopean base is in Dublin but doesn't trade on the Irish market. May have to look at the London market. You pay the same brokerage fees for buying and selling individual stocks but this is usually far less than any loads or fees. Annual management fees once you own the fund are usually quite small. Not good for small periodic purchases since the brokerage fees would add up.

    Index funds are a great initial investment for "newbies". You can make a majority of your investment in a broad based index and then make smaller bets on some more specialized indexes.

    For all funds, the important thing is to check out all the fees, both initial purchase and ongoing management fees. If you go with actively managed funds, carefully check the past performance. Has the manager beat his performance index by enough to justify his management costs? And if management has recently changed, all bets are off. Of course, even with the same manager, past performance does not guarantee future success.


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