There is no standard answer to the question of which mutual fund is a better
investment because each fund has a unique way of handling risk. Some investors
love risks, but others do not. “The higher the risk, the higher the return” is
a basic tenet of investing. The next time you receive an offer that sounds “too
good to be true” – you can get high returns for very low risk – it very often
is.
Any buyer of shares in mutual funds, whether closed or open-ended, should be
familiar with the features of a mutual fund: share price, volatility, asset
size, cost, and turnover.
Share prices of mutual funds are affordable, which account for their
popularity and growth. One can invest in a mutual fund share for as low as
$500, making them popular in employer-sponsored defined contribution retirement
plans.
Volatility measures changes in the market price. Since the fund’s
shares are traded in the financial markets, and the fund invests in bonds or
stocks that are also traded in the same markets, investor behavior influence
buy and sell decisions that affect the share price due to the law of supply and
demand. Demand pushes up share prices while supply brings them down. Any event
that affects demand or supply affects the share price.
Asset Size is a feature emphasized by sellers, but this is not the
most important indicator of the fund’s future performance. Based on several
studies, a fund’s performance actually goes down with asset size because the
larger the fund, the more difficult it is to manage. However, in the hands of a
good manager, a bigger asset size may be good since it allows the fund to
influence the market’s buy and sell decisions.
Cost is often the most important feature overlooked by mutual fund
investors. Otherwise known as fees, these expenses have a significant effect on
fund returns. Most investors do not know how much they are paying. The fund
collects these fees – ranging from 0.1% to 2.0% of the funds invested – every
year, whatever its performance. A study showed that funds charging 0.51% to
0.99% of Net Asset Value had higher returns than funds charging between 1.50%
and 1.99%. Several expenses affect fund returns, and investors need to
understand how each expense affects them.