Investing in funds
What Graham thought funds did well, his arithmetic on closed-end funds at a discount, and Zweig's checklist for choosing one.
FinanceGraham ch. 9About 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Tell open-end (mutual) funds from closed-end funds
- Calculate how a discount or a sales charge changes what you get for your money
- List the fund traits Zweig looks for and why chasing past returns fails
Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.
The Intelligent Investor: Benjamin Graham's ideas: lesson 7 of 25
- Graham ch. 1
- Investment versus speculation 4 min
- Graham ch. 2
- Inflation and the investor 4 min
- Graham ch. 3
- A century of market history 5 min
- Graham ch. 4
- The defensive investor's portfolio 4 min
- Graham ch. 8
- Mr. Market 5 min
- Living with fluctuations 5 min
- Graham ch. 9
- Investing in funds 5 min
- Costs and the market
- Is advice worth paying for? 7 min
- Reading the accounts
- The balance sheet always balances 5 min
- Graham ch. 5
- Defensive investors and stocks 4 min
- Graham ch. 6
- What the enterprising investor avoids 4 min
- Graham ch. 11
- Security analysis for the lay investor 4 min
- Graham ch. 12
- Per-share earnings and their traps 4 min
- Graham ch. 7
- What the enterprising investor does 5 min
- Graham ch. 13
- Comparing four companies 4 min
- Graham ch. 14
- The defensive investor's screen 4 min
- Graham ch. 15
- The enterprising investor's screen 7 min
- Graham ch. 16
- Convertibles and warrants 6 min
- Graham ch. 17
- Four extreme case histories 7 min
- Graham ch. 18
- Eight pairs of companies 7 min
- Graham ch. 19
- Shareholders, managements and dividends 5 min
- Graham ch. 20
- Margin of safety (1): the idea 5 min
- Margin of safety (2): in practice 7 min
- Graham appendix 1
- The superinvestors of Graham-and-Doddsville 6 min
- Graham postscript
- Graham today 7 min
Try first
You haven't learned this yet, so guess. Guessing before you read helps the explanation stick. Nothing here is scored.
Already know this? Take a 3-question check and skip ahead.
Get all three right and the lesson is marked done.
Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 9, "Investing in Investment Funds"
What it is
Two kinds of fund.
- An open-end (mutual) fund issues new shares to anyone and buys them back at the day's net asset value (the value of its holdings per share).
- A closed-end fund has a fixed number of shares that trade on an exchange, so their price can sit above or below the value of the holdings.
Graham's view. Funds as a whole had served a useful purpose: they encouraged saving, protected many people from costly mistakes, and earned about what stocks earned. But their results were no better than stocks as a whole, and they may have cost more than buying shares directly.
His closed-end rule. In his day, most mutual funds were sold with a charge of about 9% above net asset value, while closed-end shares could often be bought at a discount of 10–15%. Buy the discounted group, he said, and you get about one-fifth more for your money. (Zweig notes that diversified closed-end stock funds at a discount have since become hard to find, and that funds without sales charges are now common, so this is Graham's arithmetic for his day.)
Quick check
Tap an answer to check it.
A closed-end fund's holdings are worth 20 a share, and its shares trade at 17. What is the discount?
- 3 is the difference in money, not the percentage
- Divide by the value of the holdings, 20, not the price
Show answer
15%. (20 − 17) ÷ 20 = 0.15.
Why it matters
Funds are a common way to own shares, so choosing one well matters. And the most common way people choose, by recent returns, is one the evidence says works poorly.
Zweig summarises decades of research: the average fund doesn't pick stocks well enough to cover its costs; higher expenses mean lower returns; funds that trade more tend to earn less; and funds with high past returns rarely stay on top. The hottest funds of 1999 lost all of those gains, and more, over the next three years.
Worked example
Two ways to put 1,000 into stocks through funds, in Graham's numbers:
- Mutual fund with a 9% charge: you pay 109 for every 100 of holdings, so 1,000 buys about 917 of holdings.
- Closed-end fund at a 10% discount: you pay 90 for every 100 of holdings, so 1,000 buys about 1,111 of holdings.
1,111 ÷ 917 ≈ 1.21: about one-fifth more, if both sets of holdings do equally well afterwards.
Common mistake
Buying a fund because it was last year's top performer. In Zweig's account, a fund at the top often attracts a flood of new money, swells in size, loses its manager to a rival, or simply had luck that runs out. A good past return is the weakest reason to buy.
Key terms
- net asset value (NAV)
- the value of a fund's holdings per share
- open-end (mutual) fund
- issues and redeems shares at NAV
- closed-end fund
- has a fixed number of shares that trade on an exchange, often at a discount or premium to NAV
- sales charge (load)
- a fee paid when buying (or selling) some funds
- discount
- a closed-end fund's price below its NAV
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| net asset value (NAV) | the value of a fund's holdings per share |
| open-end (mutual) fund | issues and redeems shares at NAV |
| closed-end fund | has a fixed number of shares that trade on an exchange, often at a discount or premium to NAV |
| sales charge (load) | a fee paid when buying (or selling) some funds |
| discount | a closed-end fund's price below its NAV |
Practice
Sort it
Zweig's checklist: a good sign, or a warning sign, in a fund?
The managers own a lot of the fund's shares themselves
Their interests line up with yours.Show answer
Good sign. Their interests line up with yours.
Low yearly expenses
High fees are permanent; high returns are not.Show answer
Good sign. High fees are permanent; high returns are not.
Heavy advertising of last year's No. 1 return
The best managers often don't chase your money.Show answer
Warning sign. The best managers often don't chase your money.
The fund closes to new investors before it gets huge
It protects existing shareholders.Show answer
Good sign. It protects existing shareholders.
Its holdings look almost exactly like the index, at a higher fee
You'd pay more for the same thing.Show answer
Warning sign. You'd pay more for the same thing.
Quick quiz
Tap an answer to check it.
Why can a closed-end fund trade below the value of its holdings?
- The discount is in the share price, not in the holdings
Show answer
Its shares trade on an exchange, so their price depends on buyers and sellers. Price is set by the market, not by redemption at NAV.
Which approach to choosing a fund does Zweig warn against?
- He puts costs among the most important things to check
Show answer
By its recent past returns. Past winners rarely stay winners.
In short
- Open-end funds trade at NAV; closed-end funds trade on an exchange, often at a discount.
- Graham: funds were useful, but no better than the market, and may have cost more.
- His rule: discounted closed-end funds gave about one-fifth more for the money than mutual funds bought with a 9% charge.
- Zweig: start with low cost and good stewardship; treat past returns as the weakest reason to buy, and look at them last.
Mastery check
Answer without looking back. Score 80% or more and the lesson is marked done. Your result is kept only in this browser.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
What is a fund's net asset value?
Show answer
The value of its holdings per share.
You buy a fund at 9% above its net asset value, paying 1,000. Roughly how much of that is holdings?
Show answer
About 917 (1,000 ÷ 1.09).
Name two of Zweig's good signs in a fund.
Show answer
Any two of: managers own its shares, low expenses, willing to differ from the index, closes to new money before it gets huge, doesn't advertise heavily.
Further reading
- Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 9.
- On this site: Costs go on forever and Why past winners rarely repeat.
Finished? Mark it done to fill in your leaf on the Finance map.