Mutual funds are an investment vehicle characterised by investors pooling their money together to invest in a wide variety of financial instruments. Conceptually, they’re very much like ETFs, though the two kinds of funds are structured somewhat differently.
One of the main advantages of investing in a mutual fund, as opposed to picking stocks yourself, is that an experienced fund manager oversees the investments the mutual fund makes on behalf of its members. Depending on the type of fund, most if not all of these investments will usually be in stocks and bonds, resulting in returns that are in line with the market in general.
These fund managers don’t work for free, of course: investors pay fees to put their money in a mutual fund. For most people, this is still preferable to investing directly for themselves due to mutual funds two main advantages:
- Allowing a professional to manage your investments.
- Achieving more diversification than individual investments allow.
Contents: How mutual funds work
- How do mutual funds work?
- How are these funds managed?
- How are mutual funds traded?
- Making money with mutual funds
- Minimum investment
- Fees
- Taxes
- Open vs close-ended funds
- FAQs
How do mutual funds work?
Practically speaking, the first step in investing in a mutual fund is to buy a “unit” in it, corresponding to a share in an Exchange-Traded Fund (ETF). Technically, though, this unit does not give you even theoretical ownership of part of that mutual fund; instead, it gives you the right to withdraw your capital and any returns it might have generated on a future date.
How are these funds managed?
Any mutual fund is administered by an asset management company (AMC), a concept explained in detail by the SEC’s guide to mutual funds, usually part of a large financial firm. Though we often speak of fund managers as individuals, they are in reality supported by a dedicated team that provides functions like investment research, compliance with securities law, marketing, and so on.
When deciding which investments to make with members’ pooled money, the object is not just to maximise profits but to adhere closely to the fund’s stated strategy and achieve its investment objectives. Both of these are clearly spelt out in the fund’s investment prospectus, allowing potential investors to make an informed choice as to which mutual fund suits them best.
An actively-managed equity fund, for instance, invests mainly in stocks and tries to provide returns in excess of those of the stock market as a whole. Debt funds, on the other hand, focus on fixed-income securities like government and corporate bonds, resulting in slower but more dependable growth.
Active vs passive management
The majority of mutual funds practise an active investing style: fund managers buy and sell stocks and bonds relatively frequently, hoping to outperform the market as well as their competitors. Index funds, by contrast, are passively managed. They hold a basket of investments made to reflect an index – a kind of average of the stock market as a whole. If such a fund is designed to track the British FTSE 100, for example, it would simply own shares in the 100 largest companies on the London Stock Exchange.
You may wonder why anyone who’s investing for the long term, during which market wobbles and surges tend to balance one another out, would accept index funds’ lower but more stable returns. Part of the answer comes down to overhead costs: how much it costs to actually running an active vs passive fund. Passively managed funds require fewer staff, translating into a lower salary bill, and don’t buy and sell securities very frequently, meaning lower transaction costs. These savings are passed on to the fund’s members as lower fees. An index fund may have an expense ratio (defined later) of only 0.1%, while an aggressively managed active fund may go as high as 2%.
How are mutual funds traded?
ETF shares can be bought and sold at any time during stock exchange business hours. Mutual funds’ units are only transferred once a day, after regular trading has closed and a set unit price, known as the NAV, can be determined. (A broker can initiate a transaction at any time, but these are only processed in a daily batch.)
Speaking of NAV, this is an acronym for Net Asset Value or, more simply, what each fund unit costs. Compared to some financial metrics, it’s pretty easy to calculate: the value of all the securities in the fund’s portfolio is divided by the number of units. In other words, a fund’s NAV changes every day. A passive fund’s NAV movements will closely mirror those of the index to which it is tied, while an active fund’s figure reflects its alpha: the degree to which the fund manager’s investment decisions outperform the market as a whole. Obviously, in either case, fun members want to see the NAV increase over time, as this represents their primary return on investment.
Making money with mutual funds
Mutual funds pay their members in two ways. In the first place, units in the fund can be sold once their value has grown, representing a capital gain. Secondly, funds may also enact periodic distributions, enabling members to earn some money without having to sell out. These distributions are financed from sources like dividends on shares the fund owns, interest payments, and profits the fund has made by selling securities. Both capital gains and distributions come with tax implications; these should be carefully weighed as part of the decision to invest in a mutual fund.
While there’s plenty to be said for cash in your pocket, it’s generally wise not to actually withdraw these distributions. Mutual funds, by and large, are long-term investments, so compound interest is the ball you’ll want to keep your eye on. The majority of mutual funds allow you to reinvest these distributions automatically, meaning that they’ll be applied to buying more units of the fund instead of being paid out.
Minimum investment
Though mutual funds are organised in terms of units, it is also possible to buy a fraction of one unit. If you have $200 to invest and your chosen fund has a NAV of $45, your broker will be happy to let you buy 4.44 units. That having been said, many funds require new investors to deposit at least a certain amount of money. Minimum investment requirements tend to be in the region of $500 to several thousand dollars. Investors with a smaller amount of capital to invest still have plenty of options, though they will be restricted from accessing some of the more sought-after mutual funds.
Less wealthy investors should still consider mutual funds as one of their best options, though. One of the benefits of using these to grow your nest egg is the ability to set up regular automatic payments into the fund. Mutual funds and pension schemes have a long shared history, so it makes sense that they make it easy to earmark some portion of each paycheck you receive for investing. These recurring transactions typically incur no transaction fees; the only variable involved is the NAV on the day the payment is made to the fund.
Fees
Before the rise of online trading and a multitude of low-cost ETFs, mutual funds charged fees that seem high in retrospect. However, increased indirect competition has worked well in making investing in mutual funds more economical. To generalise a little, using a passive mutual fund costs about the same as investing in an index ETF.
This doesn’t mean that either investment vehicle is free, though. Mutual funds charge their members both transaction and operating fees.
In a mutual fund, transaction fees are generally charged for selling but not buying units, i.e. these charges should be covered by your investment’s appreciation. These are also known as redemption fees and are specified as a percentage of the NAV, or equally the transaction amount.
Operating fees are usually expressed as an expense ratio. This is just the cost of running the fund divided by the assets under management. This amount is deducted from the value of each unit annually. Expense ratios are reported in the fund’s prospectus; figures of between 0.5% and 1.5% are common, depending on the type of fund.
The reasoning behind calculating expenses as a ratio rather than a flat rate leads to an interesting thought: larger funds tend to cost more to run. Some of these expenses are variable and grow in line with a fund’s activities and number of members: custodial services, administration, recordkeeping, legal expenses, and so forth. However, the biggest line item is normally the fund manager’s compensation, along with that of their staff. This strongly implies that larger, actively-managed funds enjoy better supervision by more skilled managers – though this belief isn’t necessarily born out by funds’ performance in any particular quarter or year.
Taxes
Those who choose to invest in mutual funds rather than other vehicles like ETFs often face a more onerous tax bill. The reason is simple: mutual funds pay capital gains distributions to their members, typically once per year, and these are subject to capital gains tax.
Other income from the fund, such as stock dividends passed on to members, is also taxable. How all of this affects you depends on the amounts involved, the law in your country or state, as well as how long the fund has held the stock paying out the dividend. It is highly recommended that you consult an expert both before investing a large sum of money and when considering cashing out.
Open- vs closed-ended funds
Mutual funds can also be categorised based on the structure of its membership and the way units of the fund are distributed. As the terms “open-ended” and “closed-ended” imply, the main difference lies in how accessible funds are to new investors.
Open-ended mutual funds have no set limit on the number of members. Every time an existing or new investor buys into the fund, the appropriate number of new units is created with the stroke of a pen. The total number of units in circulation is theoretically infinite, and issuing more does not appreciably affect the current NAV (as that is what new units are sold for).
Closed-ended funds, by contrast, issue a specific number of units when they are formed and create no new ones. Once all of these have found buyers, new investors cannot be accommodated until existing investors sell their units back to the fund.
FAQs
Here are some brief answers to some questions a lot of people have about mutual funds.
What is an investment fund company?
An investment firm like Vanguard or BlackRock generally runs several different types of investment funds, including mutual funds and ETFs. Their business is to professionally manage other people’s money for a fee.
What is an investment fund in stocks?
These are more commonly called equity funds; tehy are simply mutual funds that invest primarily or exclusively in shares. There are also debt funds that keep all or most of their assets in bonds, as well as hybrid funds that don’t prioritise either.
What is a fund manager?
A fund manager is a fiduciary (i.e. a legally responsible person) who oversees and directs the investments made by a mutual fund. Successful fund managers are always in high demand, though their past track record doesn’t necessarily guarantee future returns.
