Recipe for a Mutual Fund
/Last week I randomly asked 10 people to describe a mutual fund, and I received all sorts of answers. So, I thought it was time to give a layman’s description of what makes a mutual fund a mutual fund. To limit the scope of this blog, I am only looking at stock mutual funds. We’ll save bonds for another day.
To put this in perspective, I’m going to start out by saying, “to make a mutual fund you have to start with a recipe”. Like any good chef, you’ll need to choose your dish, how much of each ingredient you’ll need, and how long to cook, refrigerate, or cure it. Take Paella for instance. There are a lot of ingredients that go into the pot and it takes a long time to cook. Mutual funds can also have many ingredients and may take a long time to cook. When chefs make a signature dish, they choose from a variety of ingredients. Instead of a combination of meat, fish, fruits, vegetables and seasonings, our mutual fund consists of individual stocks. Individual stocks can be any combination coming from 11 sectors: consumer staples, healthcare, utilities, communications, energy, industrials, technology, materials, consumer discretion, financial and real estate.
The two most basic mutual fund recipes are the S&P 500 and the Total Stock Market which are also called index funds. The recipe for the S&P 500 is to run a query of the largest 500 U.S. stocks and add these proportionately into a mutual fund. The Total Stock Market, on the other hand, queries for the largest 5,000 stocks and then creates the mutual fund. These two mutual funds/index funds are commonly used as benchmarks to compare performance against many other mutual funds.
When we look inside at the ingredients of these two index funds, we find about 22% of the stocks are from the technology sector, whereas the utility, materials, energy, and real estate sectors only hold about 2% each. The remaining sectors each hold between 5-18%. This can be interpreted as it takes more technology to run our country than it does the remaining sectors.
Now, just like a good chef comes up with a new recipe or makes a change to his/her current recipe, active fund managers come up with new mutual funds and/or make changes to their current mutual fund. On average, the actively managed mutual fund picks between 20-40 stocks that he/she sees as being a good fit for their strategy.
I hope this gives you a starting point to look deeper into the understanding of what goes into the making of a mutual fund.
