So popular that there are well over 10,000 available to choose from! Most articles focus on picking a fund but I’m going to ask a completely different question. Are the benefits of mutual funds mutually beneficial?
What is a fund?
To start let’s define what a mutual fund is for those readers who may be a little unsure. A mutual fund is an account (called a fund) where many people pool their money for the purpose of investing. Imagine you want to buy a McDonald’s franchise. However the cost of opening this store is going to be almost $ 2 million. You do not have that much money so you look for partners. Eventually there are 5 partners, each splitting the $ 2 million startup investment. Then 4 years later the 5 of you decide to sell. You sell the complete business for $ 10 million and divide the profits 5 ways. That would be a partnership. And yet it’s also a good picture of how a mutual fund works.
A mutual fund is a bunch of people who become small partners. They pay in their investment and then someone else runs the business – in this case a stock portfolio. However there are some partners who don’t pay in. In fact they get paid to not pay in. They are the fund managers and all the people involved in the business. And that’s where the mutual benefits break down.
The inequality comes in the form of SEC rules. According to SEC rules a mutual fund can only buy stock, hold it, and sell it later. That means a mutual fund can only make money when the stock market goes higher. The plan of the fund manager is to buy low, and sell high. Unfortunately the stock market does not always go up (just look at the October 2008 market crash). So inevitably the fund’s value will go up and down. At the end of the year investors are hoping generally for an annual return, or growth, of about 15-20%.
This description may not sound bad to you. That’s because you have probably adjusted to this treatment and assume it is “the rules of the game”. After all this is how you have been programmed to respond. But what you may not know is what happens behind the scenes.
It may not be legal for a mutual fund to trade your MONEY during a down market, but they CAN trade the fund’s assets. And they do. And they make bank. In fact the trading behavior of institutional investors is so predictable an entire segment of stock market analysts spend their time watching behavior of institutions and trading off of that behavior.
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