In this week’s post, I explain the basics of mutual funds.
Mutual funds are investment companies that pool investors’ money and then buy a variety of securities, such as stocks and bonds. Owners of mutual fund shares can benefit in a variety of ways, including increased diversification and having a professional manager select the underlying investments. Mutual funds commonly make up the primary investment options in many workplace retirement plans – so you may own mutual funds whether you realize it or not.
As I have continued to emphasize, remember that investment securities, such as mutual funds, are distinct from the type of investment account in which they are held, as we covered in a post from several weeks ago. Each type of security has its own characteristics that are separate from the rules and tax treatment of the investment account. This post will explore some of the characteristics of mutual funds.
Mutual funds are investment companies that pool investors’ money and then buy securities
Mutual funds are investment companies that pool investors’ money and then buy a variety of underlying securities. A professional manager decides what securities to buy and sell within the fund, according to the objective of the fund. Individual units of the mutual fund are called “shares,” but remember that mutual funds do not solely own stocks - they can own bonds or other non-stock securities.
There are two primary types of mutual fund structures: open-end funds and closed-end funds. With an open-end fund, the fund company can create and destroy shares as investor demand changes. Whereas closed-end funds have a specific number of shares and if an investor wishes to buy or sell, they must do so on the open market. Open-end funds are much more common than closed-end funds, so this post will focus on open-end funds.
Here is a visual on the basic mutual fund structure. As mentioned, the fund is split into different shares. In this example, there are four shares. The manager of the fund then selects the assets that the fund will own in accordance with the fund’s objectives. In this example, the manager decides that the fund will own shares of stock in six different companies (A through F):
How is the price of a mutual fund determined?
The price of a mutual funds’ shares is the value of all assets the fund owns, minus any liabilities. This value is called the fund’s “net asset value” or “NAV.” The net asset value of a fund is calculated every day, after the stock and bond markets close. Investors in the mutual fund can only buy and sell shares of the fund at the daily NAV – even if an investor puts in an order to buy or sell early in the morning, the transaction will not be executed until the end of the day at the NAV. Exchange-traded funds (ETFs), which we will discuss in a future post, are similar to mutual funds, but allow for transactions throughout the day.
In the example above, the total NAV of the fund is $900. This is calculated by adding up the values of all the underlying assets ($100 + $50 + $250 + $200 + $50 + $250). This value is then divided by the number of shares to arrive at the NAV per share, which is $225 ($900 / 4). Any changes to the value of the assets of the fund will impact the NAV. For example, if company D goes bankrupt and its value falls to $0, the NAV of the fund will fall to $700. This will result in a NAV per share of $175.
Do mutual funds have fees?
Mutual funds have yearly management fees that pay for the administration of the fund and compensate the fund’s manager. These fees can vary dramatically from less than 0.10%/year to over 1.5%/year.
Some mutual funds will also have certain commissions built into the expenses of the fund. These commissions compensate the salesperson who sells the mutual fund to the investor. Some of these commissions can also take the form of a large, upfront payment, instead of a yearly fee. A full explanation of mutual fund sales commissions will likely be the subject of a future post.
What are the benefits of mutual funds?
There are several benefits to owning shares of mutual funds, namely diversification and professional management:
Diversification – Diversification is “not putting all your eggs in one basket,” or spreading ownership over many assets so that poor performance of one asset does not destroy the whole portfolio. Because mutual funds typically buy many different securities, this gives the investor easy access to diversification that would be hard to replicate on their own.
Professional management – The manager of the mutual fund will select which underlying securities the fund will own. Managers are typically investment professionals with many years of experience. Although professional management can be viewed as a benefit, there is evidence that actively picking stocks does not produce better returns (after fees) over time. We will discuss active investment management in a future post.
Do different mutual funds all have the same objective?
Different mutual funds have many different objectives and hold many different types of securities. Here are some examples:
Some funds passively try to follow a benchmark, while others actively try to beat a benchmark through security selection. We will discuss active vs. passive investing in a future post.
Funds will focus on owning a certain type of underlying security: US stocks, bonds, international stocks, emerging market stocks, etc.
Funds will focus on a certain sub-segment of the market, such as stocks of companies in a certain industry, or companies with certain characteristics.
There are also special mutual funds, called target date funds, that are designed to change over time to become less aggressive and more conservative as the investor gets closer to retirement.
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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