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Mutual Funds Investing

Mutual funds, like all investments, can occasionally be perplexing. Often when a specific mutual fund or ETF question comes to mind, no obvious source for an answer is apparent.

Here is a list of practical answers to frequently asked mutual fund questions. This quick reference guide is designed to be a "go to source" for answers to your mutual fund investing needs.

AAII's Mutual Fund area is your key to successful investing.

Mutual Funds: Diversification


How many different mutual funds should I own?


Should I make sure to invest in more than one fund family for diversification?


Mutual Funds: Size


Can a mutual fund be too large?


Mutual Funds: Portfolio Managers


Should I switch out of a fund if the portfolio manager changes?


Mutual Funds: Load Mutual Funds v.s No-Load Mutual Funds


What's the advantage to investing in no-load or low-load funds?


How do I distinguish a low-load fund from a load fund?


My fund just imposed a load. Should I bail out?


Clone Mutual Funds: Share Classes


If a mutual fund closes before I have a chance to invest and a clone is available, should I invest in the clone fund?


The mutual fund I'm considering offers class A, B, and C shares. Which one should I buy?


Mutual Fund Expenses


Should I be concerned with mutual fund expenses? After all, it's already reflected in the fund's performance numbers.


Should I pay any attention to the portfolio turnover ratio of a mutual fund?


Measuring the Risk of Mutual Funds


What does a mutual fund's beta coefficient measure?


What is standard deviation?


Buying Mutual Funds


Should I deal directly with the fund family when purchasing a mutual fund or go through one of the discount brokers that trade mutual funds?

Mutual Funds: Diversification

How many different mutual funds should I own?

The number of mutual funds suitable for an individual investor will vary depending on individual circumstances—there is no universal number that applies for everyone.

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However, as a useful yardstick, consider the range of funds derived from the rationale that diversification should be one of every investor's goals. Simple but broad diversification would imply four funds: a domestic equity mutual fund, a domestic bond mutual fund, an international stock mutual fund and an international bond mutual fund. Dividing the domestic equity portion into two funds—one specializing in small stocks and the other in larger capitalization stocks—brings the count up to five. Splitting the international equity portion into mutual funds specializing in developed economies and funds specializing in developing and emerging economies makes six. If you prefer a separate European fund and Far East fund, the total is up to seven. Building diversity in your domestic bonds by adding a junk bond fund stretches the number of funds to eight. And if we include a money market fund, the number is nine.

The benefits of diversification are difficult to achieve with commitments of less than 10% of your portfolio to any one area, which sets the upper range at not much more than 10 mutual funds. Thus, diversification implies a range of around four to nine mutual funds—all unique in investment objective and security coverage.

Overdiversification results in fund investments that essentially duplicate each other; this adds nothing to performance, but it will add frustration as well as cost in keeping track of and monitoring so many funds.

Should I make sure to invest in more than one fund family for diversification?

No, it is possible to stay within a mutual fund family and be adequately diversified. However, there is a danger in remaining doggedly within one fund family solely for convenience, and that is that you could overlook a better-managed fund elsewhere. For instance, rather than seek out the best international mutual fund, you may choose the one offered by the fund family you are in currently because it is most convenient.

Mutual Funds: Size

Can a mutual fund be too large?

Yes. But it can also be too small. The benefits or stigmatisms of size depend on the segment of the market that the mutual fund operates in, as well as its investment style.

For example, when it comes to a U.S. government bond mutual funds, a behemoth is probably best. Large mutual funds have lower costs, as a percentage of total assets, and the U.S. government bond market is one of the most efficient in the world, able to handle large transactions without significant price changes. Similarly, large asset bases benefit corporate bond mutual funds by spreading expenses and because credit risk is spread more widely among different issuers.

On the equity side, index mutual funds can benefit by size because expenses can be spread more widely. Index mutual funds are passively managed—that is, there is no portfolio manager who is constantly making investment decisions, so the investment advisory fee is low. A low annual expense ratio is one of the advantages of investing in these kinds of funds.

However, size can be a detriment to actively managed stock mutual funds. These funds may lose some flexibility when assets reach $500 million and many eventually close before reaching $1 billion because of trading and stock selection difficulties. Actively managed mutual funds that focus on larger companies begin to resemble index funds when assets are large and spread over many stocks, so you may be receiving a near market index return while paying extra for active management.

Size can also be a detriment to mutual funds specializing in small stocks. These stocks have less trading volume, and it can be difficult to trade larger positions without affecting prices (pushing prices up on purchase, and down when sold).

The change in size of a mutual fund may also impinge on certain fund managers' investment styles. For instance, a small stock fund manager may essentially be a stockpicker whose success draws substantial new money into the fund, and his performance may slip as he attempts to digest the new infusion of cash.

Portfolio Managers

Should I switch out of a mutual fund if the portfolio manager changes?

No. The change of a portfolio manager is not reason, in and of itself, to leave a fund. Instead, monitor the mutual fund closely to make sure the new manager is continuing the old manager's style, and that any changes won't significantly affect your investment. New portfolio managers have been known to take command of a mutual fund and sell off securities, reflecting a change in style. A significant portfolio realignment might mean greater capital gains distributions, and therefore taxes, unless you hold the mutual fund in a tax-sheltered account. On the other hand, if the mutual fund is an index fund or less actively managed, the portfolio manager may not be all that important. Or the new portfolio manager may continue with the old style and perform just fine.

Switch to a mutual fund with a similar investment objective only when the performance of your fund falls off against other funds with the same investment objective, or if your existing fund changes objectives so that it no longer reflects the objective you are seeking.

Load Mutual Funds vs. No-Load Mutual Funds

What's the advantage to investing in no-load mutual funds or low-load mutual funds?

Investors should realize that:

  • A load is a sales commission that goes to the seller of the mutual fund shares;
  • A load does not go to anyone responsible for managing the fund's assets and does not serve as an incentive for the fund manager to perform better;
  • Mutual funds with loads, on average, consistently underperform no-load funds when the load is taken into consideration in performance calculations;
  • For every high-performing load mutual fund, there exists a similar no-load or low-load mutual fund that can be purchased more cheaply;
  • Loads understate the real commission charged because they reduce the total amount being invested: $10,000 invested in a 6% front-end load fund results in a $600 sales charge and only a $9,400 investment in the mutual fund;
  • If a load mutual fund is held over a long time period, the effect of the load, if paid up front, is not diminished as quickly as many people believe; if the money paid for the load had been working for you, as in a no-load fund, it would have been compounding over the whole time period.

The bottom line in any investment is how it performs for you, the investor, and that performance includes consideration of all loads, fees, and expenses. There may be some load mutual funds that will do even better factoring in the load, but you have no way of finding that fund in advance. The only guide you have is historical performance, which is not necessarily an indication of future performance. With a heavily loaded mutual fund, you are starting your investment with a significant loss—the load. Avoid unnecessary charges whenever possible.

How do I distinguish a low-load mutual fund from a load mutual fund?

It is best to stick with no-load or low-load mutual funds, but they are becoming more difficult to distinguish from heavily loaded funds. The use of high front-end loads has declined, and mutual funds are now turning to other kinds of charges. Some mutual funds sold by brokerage firms, for example, have lowered their front-end loads to 5%, and others have introduced back-end loads (deferred sales charges), which are sales commissions paid when exiting the mutual fund. In both instances, the load is often accompanied by annual charges.

On the other hand, some no-load mutual funds have found that to compete, they must market themselves much more aggressively. To do so, they have introduced charges of their own.

The result has been the introduction of low loads, redemption fees, and annual charges. Low loads—up to 3%—are sometimes added instead of the annual charges. In addition, some funds have instituted a charge for investing or withdrawing money.

Redemption fees work like back-end loads: You pay a percentage of the value of your fund when you get out. Loads are on the amount you have invested, while redemption fees are calculated against the value of your fund assets. Some mutual funds have sliding scale redemption fees, so that the longer you remain invested, the lower the charge when you leave. Some funds use redemption fees to discourage short-term trading, a policy that is designed to protect longer-term investors. These mutual funds usually have redemption fees that disappear after six months.

Probably the most confusing charge is the annual charge, the 12b-1 plan. The adoption of a 12b-1 plan by a mutual fund permits the adviser to use fund assets to pay for distribution costs, including advertising, distribution of fund literature such as prospectuses and annual reports, and sales commissions paid to brokers. Some mutual funds use 12b-1 plans as masked load charges: They levy very high rates on the fund and use the money to pay brokers to sell the fund. Since the charge is annual and based on the value of the investment, this can result in a total cost to a long-term investor that exceeds a high up-front sales load. A fee table is required in all prospectuses to clarify the impact of a 12b-1 plan and other charges.

The fee table makes the comparison of total expenses among mutual funds easier. Selecting a mutual fund based solely on expenses, including loads and charges, will not give you optimal results, but avoiding mutual funds with high expenses and unnecessary charges is important for long-term performance.

My mutual fund just imposed a load. Should I bail out?

If your mutual fund imposed a load, you may be grandfathered in and allowed to invest new funds without a load. But if they do charge a load on additional money you want to invest, you are faced with a dilemma. Don't sell on the news that the mutual fund is going to impose a load, but certainly don't commit new money if you will be charged an unreasonable load.

Clone Mutual Funds & Share Classes

If a mutual fund closes before I have a chance to invest and a clone is available, should I invest in the clone fund?

Most mutual funds close because the portfolio manager feels a larger fund size will hamper his investment flexibility and style. Therefore, it is unlikely that any "clone" fund will in fact be a perfect clone of the original—what would be the point of closing the first one? Clone funds—the Roman numeral II funds—often do not have the same portfolio manager or precisely the same investment strategy as the original. Any mutual fund should be judged independently on its own financial merits.

Almost all fund family Web sites now provide a description of the fund's investment objective along with the name of the portfolio manager.

The mutual fund I'm considering offers class A, B, and C shares. Which one should I buy?

Many mutual funds that have sales charges are offering investors a choice as to how the load will be paid. The different share classes reflect these various options, and generally the choices run somewhat like this: Class A mutual fund shares have a front-end load, a sales commission on the money invested that is charged when the money is first invested; Class B mutual fund shares have a back-end load, a sales charge levied on the value of the fund shares when they are sold, which sometimes decreases and eventually disappears; Class C mutual fund shares might have no front-end or back-end load, but instead contain an annual charge against your fund's value, a 12b-1 load. Other combinations of varying levels of these three loads may also be offered as investment options.

If you intend to be invested in the mutual fund for a long time, opt for the front-end or back-end load option, and avoid a high (greater than 0.25%) 12b-1 charge. If you intend to be in the fund only for a few years, select the mutual fund class that does not charge a front-end or back-end load.

Of course, the best course of action is to avoid all loads, or at least high loads.


Should I be concerned with mutual fund expenses? After all, it's already reflected in the fund's performance numbers.

Mutual fund expenses, including the management fee, reduce fund performance and all quoted return numbers reflect these costs. But the reason to examine past performance is to get an indication of the portfolio manager's skill. And while the performance numbers may provide some indication of the manager's past skill, the future performance of that manager remains uncertain. The only certainty about the fund's future is the expenses, which are assessed regardless of whether a fund's performance has been relatively good or bad.

Exceptionally high expenses are nearly impossible for portfolio managers to overcome relative to similar mutual funds with average or low expenses. The lower the expenses, the better. Mutual funds with low total assets under management, particularly if they are not part of a large family of funds, will have high expenses relative to assets under management. In addition, newly established mutual funds have a high expense hurdle to overcome.

If the expense ratio of a bond fund is approaching 1.00%, or a stock fund 1.50%, think twice before investing. And don't forget that stock index funds often charge 0.25% or less.

Should I pay any attention to the portfolio turnover ratio of a mutual fund?

The portfolio turnover ratio (given in the prospectus and annual report) is the lower of purchases or sales of assets in the fund relative to the average assets in the mutual fund for the year. A turnover ratio of 100% indicates that the dollar value of fund purchases or sales equaled the dollar value of total fund assets during the year. This doesn't mean that every single share was changed once during the year; perhaps only a small portion of the assets were transacted intensely. A portfolio turnover ratio of 200% indicates the portfolio by value was turned over twice during the year, and so on.

Is this important? Yes. The higher the portfolio turnover, the greater the transaction costs, which can hurt the performance of the mutual fund; while these costs are reflected in the fund's net asset value and its performance figures, they are a concern for the future performance as noted in the question above.

Equally important for taxable investors, the higher the turnover, the more likely the mutual fund is to make capital gains distributions; and taxes must be paid on these distributions.

What is high turnover and what is low? Stock funds average around 80% portfolio turnover, and bond funds are close to 100%.

Use portfolio turnover as a tie-breaker. If you find two mutual funds in the same category that are equally appealing, lean toward the fund with a lower portfolio turnover.

Measuring the Risk of Mutual Funds

What does a mutual fund's beta coefficient measure?

This modern portfolio theory statistic measures a mutual fund's volatility relative to a broad benchmark, commonly the S&P 500 index. Although betas are normally associated with stocks, they are also used for bonds.

Beta is typically calculated on the basis of monthly returns over the past three years. A mutual fund that seesaws in perfect sync with the market has a beta of 1.0. Portfolios that are more volatile relative to the S&P 500, such as aggressive-growth funds, have betas greater than 1.0; more conservative investments, such as utility funds, have coefficients of less than 1.0. Beta readings for gold, international, and other mutual funds that move independently of the S&P 500 are not meaningful, so it's wise to check the standard deviation along with beta when you're examining volatility. Both are found in AAII's "Individual Investor's Guide to the Top Mutual Funds" and at

What is standard deviation?

The most insightful and dependable barometer for all mutual funds, standard deviation reflects the degree to which returns fluctuate around their average. It is usually based on monthly returns over the past 36 months. The higher the number, the greater the volatility; for a stock fund that has an average annual return of 12% and a standard deviation of 20%, you can expect to earn between 32% and -8% in about two out of every three years.

A useful summary statistic, standard deviation allows you to make comparisons across as well as within fund categories. The standard deviation generally tends to work better than beta because it is a purer, more universal number; it is not based on the relationship of return to fluctuations in an index. For bond funds, standard deviation is a more comprehensive yardstick than duration because it reflects all sources of volatility, not just interest-rate risk.

AAII provides a useful 'risk index' based on the standard deviation of a fund relative to the average standard deviation for its category in the Quarterly Low-Load Mutual Fund Update. A fund with a risk index of, say, 1.4 is 40% more volatile than its group average.

A Caveat: Risk statistics are based exclusively on historical numbers and are not necessarily predictive. The period used to calculate the measure may not be representative of the future investment climate. While a mutual fund's risk is generally more predictable than its return, major changes in the way it is managed can cause its future volatility to differ strikingly from past ups and downs.

Buying Mutual Funds

Should I deal directly with the mutual fund family when purchasing a fund or go through one of the discount brokers that trade mutual funds?

Discount brokers such as Charles Schwab and Fidelity Brokerage offer the convenience of buying different funds without going directly to each fund family and opening separate accounts. Only one brokerage account is necessary, and all mutual fund positions are consolidated in one report. Some of these transactions incur brokerage costs; others are essentially costless. Not all mutual funds or fund families participate, but if convenience is important and your mutual fund transaction sizes are reasonably large, these fund services offered by discount brokers may deserve a look.

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