A mutual fund is a type of investment where many people pool their money together to invest in different things like stocks, bonds, and other assets. These funds are managed by professionals who try to make the fund grow by buying and selling investments. The investments are chosen based on what the fund is supposed to achieve.
Mutual funds allow regular people to invest in a variety of things, like stocks and bonds, that they might not be able to invest in on their own. When you invest in a mutual fund, you own a part of it, and your gains or losses depend on how the investments perform. Mutual funds usually have a lot of different investments, and their overall performance is measured by how much the total value of the investments changes.
Many mutual funds are run by big investment companies like Fidelity Investments, Vanguard, T. Rowe Price, and Oppenheimer. Each mutual fund has a manager, also called an investment adviser, who has a legal duty to do what’s best for the people who invest in the fund.
How Are Mutual Funds Priced?
The value of a mutual fund is influenced by how well the securities it invests in perform. When an investor purchases a unit or share of a mutual fund, they are essentially buying a portion of the fund’s portfolio performance or, more specifically, a fraction of the portfolio’s overall value. It’s important to note that investing in mutual fund shares differs from investing in individual stocks. Unlike stock ownership, holding mutual fund shares does not grant any voting rights to the investors. Instead, a mutual fund share represents investments in a diverse range of stocks, bonds, or other securities. This diversification allows the mutual fund to spread the investment risk across multiple assets. In summary, when investing in a mutual fund, investors are essentially acquiring exposure to a diversified portfolio, and the value of their shares reflects the overall performance of that portfolio.
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How Are Returns Calculated for Mutual Funds?
When an investor purchases Apple stock or invests in a mutual fund, they are essentially acquiring partial ownership or a share of the company or mutual fund’s assets, respectively.
Investors typically earn a return from a mutual fund in three ways, and these returns are often distributed on a quarterly or annual basis:
- Income: This is earned from dividends on stocks and interest on bonds that are held in the mutual fund’s portfolio. The income is distributed to fund owners in the form of a payment. Investors usually have the option to receive the payment as a check or reinvest it to acquire additional shares of the mutual fund.
- Capital Gain: If the fund sells securities that have increased in price, it realizes a capital gain, which is also passed on to investors in a distribution.
- Increase in Share Price: When the value of the mutual fund’s shares rises in the market, investors can sell their mutual fund shares for a profit.
When researching the returns of a mutual fund, investors will encounter the term “total return,” which represents the change in the investment’s value, either positive or negative, over a specific period. The total return includes any interest, dividends, or capital gains generated by the fund, along with the change in its market value over that period. Total returns are commonly calculated for one, five, and ten-year periods, as well as since the fund’s inception date.
Types of Mutual Funds
There are several types of mutual funds available for investment, though most mutual funds fall into one of four main categories which include stock funds, money market funds, bond funds, and target-date funds.
Stock Funds
This type of fund, known as an equity fund, primarily invests in stocks or equity. Equity funds can be further categorized based on various factors. Some are named according to the size of the companies they invest in, such as small-cap, mid-cap, or large-cap. Others are named based on their investment approach, like aggressive growth, income-oriented, or value funds. Additionally, equity funds are classified based on whether they invest in domestic (U.S.) stocks or foreign equities.
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To understand the different types of equity funds, a style box is commonly used as a visual representation. The style box helps investors see where a particular fund falls in terms of size and investment style.
Value funds focus on investing in high-quality companies with lower growth potential that are currently not favored by the market. These companies typically have low price-to-earnings (P/E) ratios, low price-to-book (P/B) ratios, and high dividend yields. On the other hand, growth funds target companies with strong earnings, sales, and cash flow growth. These companies usually have high P/E ratios and do not pay dividends. A “blend” style refers to companies that don’t fit strictly into the value or growth category and are considered somewhere in between.
Equity funds can also vary based on the market capitalization of the companies they invest in. Large-cap companies have high market capitalizations, typically over $10 billion, and are often well-established blue-chip firms. Small-cap companies have market caps ranging from $250 million to $2 billion and tend to be newer and riskier investments. Mid-cap stocks fall between small- and large-cap in terms of market capitalization.
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A mutual fund may combine its investment strategy by considering both the investment style and company size. For example, a large-cap value fund would focus on financially stable large-cap companies whose share prices recently declined, represented in the upper left quadrant of the style box (large and value). Conversely, a small-cap growth fund would invest in promising startup technology companies, placed in the bottom right quadrant (small and growth).
Bond Funds
A mutual fund that ensures a minimum return is classified as a fixed income fund. This type of mutual fund primarily focuses on investments that offer a predetermined rate of return, such as government bonds, corporate bonds, or other debt instruments. The fund’s portfolio generates interest income from these investments, which is then distributed to the shareholders.
These funds are commonly known as bond funds and are actively managed. They aim to purchase relatively undervalued bonds with the intention of selling them at a profit. As a result, fixed-income mutual funds may offer higher returns, but they do come with some level of risk. For instance, a fund specializing in high-yield junk bonds poses more risk than a fund that invests in government securities.
Since there is a wide variety of bonds available, bond funds can differ significantly depending on their investment choices. It’s important to note that all bond funds are subject to interest rate risk, meaning their returns can be influenced by changes in interest rates.
Index Funds
Index Funds are a type of investment that puts money into stocks matching a major market index like the S&P 500 or the Dow Jones Industrial Average (DJIA). This approach involves less research from analysts and advisors, leading to lower expenses for shareholders. Index Funds are often tailored for cost-sensitive investors.
Balanced Funds
Balanced funds are a type of investment that combines different asset classes, such as stocks, bonds, money market instruments, or alternative investments. These funds, also known as asset allocation funds, aim to reduce risk by diversifying across various asset classes.
Some balanced funds have a fixed allocation strategy, meaning the investor knows the predetermined exposure to each asset class, providing predictability. Other funds follow a dynamic allocation approach to adapt to different investor objectives and market conditions. This may involve responding to changes in the business cycle or the investor’s life stages.
The portfolio manager of the balanced fund has the flexibility to adjust the ratio of asset classes as necessary to maintain the fund’s stated strategy and ensure its overall performance.
Money Market Funds
The money market is a collection of secure and low-risk short-term debt instruments, primarily government Treasury bills. Investors in the money market can expect to earn modest returns, but their principal is guaranteed. The returns typically exceed those of a regular checking or savings account, but are slightly lower than the average certificate of deposit (CD).
Income Funds
Income funds are funds designed to generate regular income for investors. They achieve this by investing mainly in government and high-quality corporate debt and holding these bonds until they mature, thereby providing a steady stream of interest payments. Although the fund holdings may also appreciate in value, the main goal of income funds is to offer a consistent cash flow to investors. As a result, these funds are popular among conservative investors and retirees who seek reliable income from their investments.
International/Global Funds
An international fund, also known as a foreign fund, focuses on investing in assets located outside an investor’s home country. On the other hand, global funds have the flexibility to invest anywhere in the world. The volatility of these funds often depends on the economic and political risks of the specific countries they invest in. However, including these funds in a well-balanced portfolio can enhance diversification because returns from foreign countries may not be closely related to returns in the home country. This can be beneficial for managing risk and potentially improving overall portfolio performance.
Specialty Funds
Sector funds are specialized funds that focus on specific sectors of the economy, such as finance, technology, or healthcare. These funds aim to capitalize on the potential growth and performance of companies within those sectors. However, sector funds can be highly volatile because the stocks they invest in are closely related to each other, which means their performance is influenced by sector-specific factors.
Regional funds, on the other hand, allow investors to concentrate on a particular geographic area of the world. This could involve focusing on a broader region, like Asia or Europe, or on an individual country, like China or Brazil. By investing in regional funds, investors can take advantage of the economic trends and opportunities in those specific areas.
Socially responsible funds, also known as ethical funds, have an investment strategy based on specific guidelines or beliefs. These funds only invest in companies that meet certain criteria related to social, environmental, or ethical considerations. For instance, some socially responsible funds avoid investing in industries like tobacco, alcoholic beverages, weapons, or nuclear power due to ethical concerns. Others may prioritize investments in environmentally friendly businesses, such as those involved in green technology like solar and wind power or recycling initiatives. By choosing socially responsible funds, investors can align their investments with their personal values and principles.
Exchange Traded Funds (ETFs)
A variation of the mutual fund is the exchange-traded fund (ETF). While not classified as mutual funds, ETFs utilize strategies similar to mutual funds. ETFs are structured as investment trusts and are traded on stock exchanges, providing additional features associated with stocks.
One advantage of ETFs is that they can be bought and sold throughout the trading day, providing flexibility for investors. Additionally, ETFs can be sold short or purchased on margin, offering potential opportunities for more sophisticated trading strategies. Moreover, ETFs typically have lower fees compared to equivalent mutual funds, which can be appealing to cost-conscious investors.
ETFs also benefit from active options markets, allowing investors to hedge or leverage their positions, thereby potentially enhancing their investment approach. Furthermore, ETFs enjoy certain tax advantages compared to mutual funds, making them a tax-efficient investment option.
Overall, ETFs tend to be more cost-effective and offer greater liquidity than mutual funds, making them an attractive choice for many investors.
Mutual Fund Fees
A mutual fund comes with certain fees that investors should be aware of. The first type is the annual operating fee, also known as the expense ratio, which is a percentage of the total funds managed, usually ranging from 1% to 3%. The expense ratio is the sum of the advisory or management fee and administrative costs.
Additionally, there are shareholder fees, which are charges paid directly by investors when buying or selling the funds. These fees include sales charges, commissions, and redemption fees. Sales charges or commissions are often referred to as “the load” of a mutual fund. If a mutual fund has a front-end load, fees are applied at the time of purchase, while a back-end load means fees are applied when an investor sells their shares.
However, some investment companies offer no-load mutual funds, which do not carry any commission or sales charge. These funds are distributed directly by the investment company, avoiding intermediary fees. Some mutual funds may also impose fees and penalties for early withdrawals or selling holdings before a specific time has passed. Being aware of these fees is essential for making informed investment decisions.
Classes of Mutual Fund Shares
Currently, many individual investors purchase mutual funds through brokers, typically opting for A-shares. These A-shares come with a front-end load, which can be as high as 5% or more, along with ongoing management fees and distribution fees known as 12b-1 fees. Some financial advisors may recommend higher-load offerings to earn commissions. In this arrangement, the investor pays these expenses at the time of buying into the fund.
To address these issues and adhere to fiduciary-rule standards, investment companies have introduced new share classes, such as “level load” C shares. Unlike A-shares, C shares do not have a front-end load, but they carry an annual distribution fee of up to 1% (12b-1 fees).
On the other hand, funds that charge management and other fees when investors sell their holdings fall under the category of Class B shares.
Pros of Mutual Fund Investing
There are a variety of reasons that mutual funds have been the retail investor’s vehicle of choice with an overwhelming majority of money in employer-sponsored retirement plans invested in mutual funds.
Diversification
Diversification is an essential strategy in investing that involves spreading your investments across various assets within a portfolio to lower risk. Mutual funds offer this advantage as they hold a mix of investments, including securities from different industries, varying bond maturities, and securities with different capitalizations. By investing in a mutual fund, you can achieve diversification more efficiently and at a lower cost compared to purchasing individual securities. This approach helps in managing risk and increasing the potential for long-term growth.
Easy Access
Mutual funds are highly liquid investments that can be easily bought and sold on major stock exchanges. They provide convenience in trading and allow investors to access various assets like foreign equities or exotic commodities that might otherwise be difficult for individual investors to participate in. Mutual funds offer an accessible and practical avenue for individual investors to diversify their portfolios and invest in a wide range of assets without facing the complexities of direct investing in these specialized markets.
Economies of Scale
Mutual funds offer cost-saving benefits through economies of scale. By pooling money from multiple investors, mutual funds can create diversified portfolios without incurring numerous commission charges associated with buying individual securities. This eliminates the need for investors to pay large transaction fees when purchasing securities one by one. Additionally, the smaller denominations of mutual funds enable investors to benefit from dollar-cost averaging.
Since mutual funds make bulk purchases of securities, their transaction costs are lower compared to individual investors buying securities in smaller quantities. This advantage allows mutual funds to invest in certain assets or take larger positions that may not be feasible for individual investors due to higher transaction costs. As a result, mutual funds provide an efficient and cost-effective way for investors to access a diversified portfolio and leverage their investment opportunities.
Professional Management
A mutual fund allows small investors to access the expertise of a professional investment manager who conducts thorough research and skillful trading. This investment manager makes and monitors investments on behalf of the fund. Compared to other options, mutual funds are relatively inexpensive and have much lower investment minimums. As a result, individual investors can benefit from professional money management without having to invest significant amounts of money. Mutual funds provide a cost-effective way for small investors to experience and benefit from the expertise of professional fund managers.
Variety and Freedom of Choice
Investors have the freedom to explore and choose from a diverse range of fund managers, each with their own investment styles and goals. Some managers focus on value investing, others on growth investing, and there are also those who specialize in developed markets, emerging markets, income generation, macroeconomic strategies, and more. This wide variety of fund managers allows investors to access specialized mutual funds that provide exposure to various assets, including stocks, bonds, commodities, foreign assets, and real estate.
Mutual funds offer opportunities for both foreign and domestic investments, giving ordinary investors access to assets and markets that might otherwise be difficult to directly invest in. Through mutual funds, investors can diversify their portfolios and take advantage of specialized investment strategies, providing greater flexibility and opportunities for their financial goals.
Transparency
Mutual funds are subject to industry regulation that ensures accountability and fairness to investors.
Pros
- Liquidity
- Diversification
- Minimal investment requirements
- Professional management
- Variety of offerings
Cons
- High fees, commissions, and other expenses
- Large cash presence in portfolios
- No FDIC coverage
- Difficulty in comparing funds
- Lack of transparency in holdings
Cons of Mutual Fund Investing
Liquidity, diversification, and professional management all make mutual funds attractive options, however, mutual funds have drawbacks too.
No Guarantees
Investing in mutual funds carries certain risks, and there’s no guarantee of returns. The value of your mutual fund can go down, and this is because the prices of the stocks in the fund can fluctuate. It’s important to note that mutual funds are not insured by the Federal Deposit Insurance Corporation (FDIC). For more information about whether a specific investment is insured or not, you can refer to the FDIC’s guidelines.
Cash Drag
Mutual funds need to keep a substantial amount of cash in their portfolios to meet daily requests from investors who want to redeem their shares. This helps them have enough money on hand to handle withdrawals. As a result, mutual funds tend to hold more cash than an individual investor normally would. However, keeping cash in the portfolio means it doesn’t earn any returns, which is why it’s often called a “cash drag.”
High Costs
Mutual funds offer professional management to investors, but it’s essential to be aware that fees can impact the overall return of the fund. These fees are charged to investors regardless of how the fund performs. Since fees can differ significantly between funds, it’s crucial to pay attention to them to avoid potential negative consequences in the long run. Actively managed funds, in particular, may incur transaction costs that accumulate each year, affecting the final returns.
“Diworsification” and Dilution
“Diworsification” is a term used in the investment world to describe a strategy where investors complicate their portfolios with too many similar funds, leading to worse outcomes. This happens when mutual fund investors acquire multiple funds that are highly related, causing them to lose the benefits of diversification.
Another aspect related to dilution is when a successful fund becomes too large. When a fund’s performance attracts a lot of new investments, the fund manager may struggle to find suitable opportunities to utilize all the new capital effectively.
To protect investors, the Securities and Exchange Commission (SEC) requires funds to invest at least 80% of their assets in the type of investment implied in their names. However, the categories that qualify for the 80% requirement can be broad and vague, allowing funds to potentially manipulate prospective investors through misleading titles. For instance, a fund that primarily focuses on Congolese stocks might be sold under a misleading title like “International High-Tech Fund.”
End of Day Trading Only
With a mutual fund, you have the option to convert your shares into cash whenever you want. However, unlike individual stocks that can be traded throughout the day, mutual fund redemptions usually happen only at the end of each trading day.
Taxes
When a fund manager sells a security, it activates a capital-gains tax. To reduce the impact of taxes, investors can opt for tax-sensitive funds or hold non-tax-sensitive mutual funds in tax-deferred accounts like a 401(k) or IRA. This allows them to potentially lower their tax liabilities and retain more of their investment returns. For more detailed information, you can refer to the U.S. Securities and Exchange Commission’s guide on Mutual Funds and ETFs, specifically pages 36-37.
Evaluating Funds
Researching and comparing mutual funds can be challenging for investors. Unlike stocks, mutual funds don’t provide straightforward metrics like price-to-earnings (P/E) ratio, sales growth, or earnings per share (EPS) for direct comparison. While a mutual fund’s net asset value can be a useful point of reference, the diversity of fund portfolios makes it tough to compare them directly, even if they have similar names or stated objectives. Index funds tracking the same markets are generally the most comparable, as they follow specific benchmarks, making their evaluation more straightforward.
Example of a Mutual Fund
One of the most well-known mutual funds is the Fidelity Magellan Fund (FMAGX), launched in 1963 with a primary goal of achieving capital appreciation through investments in common stocks.
During the years from 1977 to 1990, the fund experienced significant success under the management of Peter Lynch. Under his leadership, Magellan’s assets under management grew remarkably from $18 million to an impressive $14 billion.
Fidelity’s performance remained strong, leading to further growth in assets under management, reaching nearly $110 billion by the year 2000. However, due to its substantial size, the fund was closed to new investors in 1997 and remained so until it reopened in 2008.
As of March 2022, the Fidelity Magellan Fund holds assets totaling nearly $28 billion and has been managed by Sammy Simnegar since February 2019.
Over time, the fund’s performance has generally tracked or slightly surpassed that of the S&P 500 index, which is a widely-used benchmark for the overall stock market.
Are Mutual Funds a Safe Investment?
All investments involve some degree of risk when purchasing securities such as stocks, bonds, or mutual funds. Unlike deposits at FDIC-insured banks and NCUA-insured credit unions, the money invested in securities typically is not federally insured
Can Mutual Fund Shares Be Sold at Any Time?
Mutual funds are considered liquid assets and shares can be sold at any time, however, review the fund’s policies regarding exchange fees or redemption fees. There may also be tax implications for capital gains earned with a mutual fund redemption.
What Is a Target Date Mutual Fund?
When investing in a 401(k) or other retirement savings account, target-date funds, or life-cycle funds, are a popular option. Choosing a fund that is dated around retirement, like FUND X 2050, the fund promises to rebalance and shift the risk profile of its investments, commonly to a more conservative approach, as the fund approaches the target date.
