Mutual funds are supposed to be a simple way to invest, but that doesn't mean the average investor understands the basics. Check out these questions...
Mutual funds are supposed to be a simple way to invest, but that doesn’t mean the average investor understands the basics. Check out these questions from the reader mailbag:
Q: My 401(k) just changed the funds in the plan, and my money was moved from an S&P 500 fund worth about $100 per share to another S&P 500 fund where the shares are worth less than $40. It’s supposed to be the same index, so how could the price be so different?
A: It’s a mistake to think the price of a mutual fund is as meaningful as the price of a stock. It isn’t.
In this case, two index funds tracking the same index are investing in a virtually identical fashion, but they set their price points differently. If we were starting two new funds today and each had $1 million to invest, the price they open at is a management decision. Fund A wants cheap shares, so they set a price of $10 a share and have 100,000 shares; Fund B wants a more impressive share price, so it slices the assets into 10,000 shares each valued at $100.
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If you invest $1,000, you’d get 100 shares of Fund A or 10 shares of Fund B, but there’s no monetary difference. The investment has the same value.
Focus on the key issues that determine performance — such as the costs you pay for exposure to the index — rather than the share price.
Q: I own some bonds and some bond funds. I don’t understand how a bond fund loses money on some days if it holds good bonds. If I own a good bond and hold it to the end, I know I will make money so long as there is no default. Doesn’t it work the same way for funds?
A: One key difference between people and mutual funds is that you don’t have to price your portfolio to sell each and every day. Mutual funds must set a daily price, a process known as “marking to market.”
Every day the fund must set its price, which involves determining what each security in the portfolio would have been worth if it had been sold at the day’s closing price.
Let’s say you own a bond, and interest rates rise. Bond prices move opposite interest rates, so when rates rise, bond prices fall. The price you can get for any bond in the portfolio on any given day goes down.
If you hold the same bond and ride it out to maturity — assuming no default — you will get paid your expected return. So will the bond fund, if it holds the paper to end — eventually, the net asset value reflects that things turned out OK — but its net asset value will fluctuate every day.
Q: Is this a good time to invest in mutual funds?
A: Generally speaking, it’s always a good time to invest in funds. Mutual funds were built to provide professional management and diversification at a reasonable cost. If you can get those qualities from a fund — especially if your alternative is high-cost, nondiversified, do-it-yourself portfolio construction — then owning funds makes sense.
Chuck Jaffe is senior columnist at MarketWatch. He can be reached at email@example.com or Box 70, Cohasset, MA 02025-0070.