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What is a Mutual Fund?
Looking for long-term investment that includes built-in diversification? Mutual funds could be just the ticket.
Whether you’re saving for the future, prefer to have financial guidance, want a varied portfolio (or all of the above) — mutual funds can be an enticing investment option.
Want to learn more? In this post, we’ll delve into the world of mutual funds: what they are, how they work, and why they’re worth considering.
Download a PDF version of this post as PDF.
What Is a Mutual Fund?
Mutual funds are basically a variety of securities rolled into one investment vehicle. They’re funded by many different investors.
At the helm of the fund is a professional manager who’s responsible for allocating the funds. That can be a good thing or a bad thing. You’re counting on their expertise to create a balanced portfolio that maximizes gains.
Mutual funds are like snowflakes: no two are exactly the same. Each mutual fund has a prospectus that details its specific objectives.
How It Works
Mutual funds are pretty easy to understand. Let’s break it down …
An investor buys shares in the mutual fund. Each fund share represents a portion of ownership in the assets owned by the fund.
A fund’s assets can include commodities, real estate, stocks, and bonds — just to name a few examples.
Mutual fund shares can be purchased or redeemed as needed at the fund’s current net asset value (NAV) per share.
How do you calculate the NAV? Divide the number of securities in the portfolio by the total amount of shares outstanding.
Primary Structures of Mutual Funds
A mutual fund can be structured in a number of ways. Here’s just a few …
- Open-End Funds: These funds buy back (‘redeem’) or sell their shares every day at the NAV computed that day, based on the prices of the securities owned by the fund.
- Closed-End Funds: These funds issue shares to the public only once, when they’re created through an initial public offering (IPO). The shares are then listed on a stock exchange. Investors can sell their shares to another investor in the market — they cannot sell their shares back to the fund.
- Unit Investment Trusts: UITs are issued to the public only once: when they’re created. Investors redeem shares directly with the fund at any time or wait to redeem them upon the trust’s termination.
A UIT doesn’t have a professional investment manager. Its portfolio of securities is locked at the creation of the UIT.
Types of Mutual Funds
Mutual funds are normally classified by their principal investments. Let’s look at a few examples:
- Bond Funds: These funds invest and actively trade in various types of fixed income or debt securities.
- Money Market: These funds invest in short-term (less than one year) securities representing high quality, liquid debt, and monetary instruments.
- Stock Funds: Also referred to as equity funds, these invest in common stocks.
- Hybrid Funds: Hybrids invest in both bonds and stocks — or in convertible securities.
Mutual Funds vs. ETFs and Stocks
- Investors buy mutual fund shares from the fund itself or through a fund broker, rather than from other investors, as with stocks and ETFs.
- The minimum investment for stocks and ETFs is just one share. A mutual fund might require an investment of $1,000 to $5,000.
- Mutual funds can only be traded once a day after the markets close. Stocks and ETFs can be traded at any point during the trading day.
- A mutual fund’s NAV is determined at the end of the trading day. Stocks and ETFs fluctuate throughout the trading day.
Why Invest in a Mutual Fund?
Here are a few big draws for investing in mutual funds …
- Increased Diversification. A mutual fund holds many securities. That diversity can decrease overall risk. So even if one asset suffers, the others may be able to cover the losses over time.
- Daily Liquidity. Since investors can easily redeem their shares at any time, there’s a daily liquidity inherent to mutual funds.
- Professional Management. A mutual fund is managed. That means you can take advantage of the manager’s expertise in hopes of making the best choices with the fund.
Mutual Fund Fees
Like anything you invest in, there are costs and fees that come with mutual funds. You must consider the fees before buying into a mutual fund. These fees are detailed in the prospectus under the heading ‘Annual Fund Operating Expenses and Shareholder Fees.’
In general: Mutual fund fees can be broken down into two broad categories …
- Expense Ratio. Also known as management expense ratio (MER), this is an ongoing annual fee to keep you invested in the fund. After all, a fund can’t run itself. Administrative fees cover operating expenses. Management fees pay the portfolio manager. And 12-b1 fees go to brokerage commissions and advertising or marketing costs.
- Load and Shareholder Fees. When you buy or sell shares in a fund, you’re gonna pay fees. That includes the sales load, or the broker’s commissions on sale and purchase. There’s also the redemption fee or the fund’s fee on a sale. And, of course, the purchase fee, which is the fund’s fee for every purchase.
Guidelines to Pick a Mutual Fund
Think you’re ready to buy? First, you need to pick the best mutual fund to suit your personal needs. Consider the following …
- Calculate costs. Use a mutual fund cost calculator to compute the costs of different mutual funds over time and how they’ll eat into your returns.
- Vet the management. Evaluate the portfolio managers and their results on the reg. To avoid fraud, always check that the investment advisor is registered — before investing.
- Compare. Comparing fund returns across a number of metrics is key. How does the fund perform over time? How does it compare to its benchmark or to other funds in its peer group?
- Anticipate. Always look at how well the mutual fund is poised for future success, not just how it performed in the past.
- Read. Before you invest, you gotta read. That includes the prospectus and the required shareholder reports.
- Research. Do your homework! Use online services like MorningStar, Yahoo Finance, MSN Money to thoroughly research the fund.
A Brief History of Mutual Funds
Mutual fund, this is your life! Here are some important dates from the history of mutual funds.
- 1772-73: In the Netherlands, a Dutch merchant named Adriaan van Ketwich forms a trust named Eendragt Maakt Magt (“unity creates strength”) to increase the appeal of investments to smaller investors with minimal capital.
- 1849: In Switzerland, an investment trust launches.
- 1880: In Scotland, similar vehicles are created.
- 1890: In Boston, MA, the Boston Personal Property Trust is formed as the first closed-end fund in the U.S.
- 1907: In Philadelphia, the Alexander Fund is formed. It features semi-annual issues and allows investors to make withdrawals on demand.
- 1924-28: In Boston, the Massachusetts Investors’ Trust launches, along with the Wellington Fund.
- 1934: The U.S. Securities and Exchange Commission (SEC) is created. Mutual funds are now required to register with the SEC and provide disclosures as part of a prospectus.
- 1970: The first index fund is established by William Fouse and John McQuown of Wells Fargo.
- 2000s: There are 10,000+ mutual funds, in spite of the 2003 mutual fund scandals and the global financial crisis of 2007-08.
Today: Mutual fund assets top $40 trillion. The countries with the largest mutual fund industries include the U.S., Brazil, Ireland, France, Germany, the UK, Luxembourg, China, Japan, and Australia.
Mutual funds offer investors the opportunity to diversify their portfolios — all within a single investment vehicle that’s professionally managed.
Mutual funds can offer reliability and reduced risk. But it’s all about the pros and cons. That means you gotta do your research! Some can come with high fees. Some cannot be traded as freely as stocks or ETFs.
Interested in investing in a mutual fund? Read the prospectus and research everything about the fund: past performance, the manager, and any associated fees.
Have you invested in mutual funds? Share your experience in the comments!