How Do Mutual Funds Work: An Investor’s Guide

Key Takeaways


Investing has gotten a lot more accessible in the last decade, with the proliferation of user-friendly brokerages, funds, and trading applications. However, there are countless investment vehicles made available to today’s investors: real estate, stocks, bonds, commodities, and mutual funds (to name a few examples). Today’s discussion will help bring investors up to speed on the latter. These investment vehicles have proven they belong in diversified portfolios, which begs the question: How do mutual funds work? Better yet, how can investors take advantage of them to secure their financial future? The answers to these questions—and many more just like them—will be addressed below.

What Is A Mutual Fund?

Mutual funds are a great addition to any diversified portfolio, but what is a mutual fund? A lot of investors have heard about them, but even more are confused by what they are. In their simplest form, mutual funds are collective pools of money that have been invested by individuals. Money managers take these funds and invest them in different securities, in a way that focuses on either long-term growth or high pay-offs while minimizing risk as much as possible. Because these funds are a collective, each shareholder will benefit or lose equally. However, those who select a mutual fund investment over individual stocks or bonds typically enjoy less exposure to risk, as they are diversified between different types of securities.

To invest in a mutual fund, you can typically buy shares through a mutual fund company, brokerage, or bank—many of which are available online. Many individuals will use their 401(k) provided through their workplace to invest in mutual funds, as a way to save up for retirement. If you fall into this category, be sure to avoid these common retirement investing mistakes. Once you have purchased your shares, your dividends and interest are typically reinvested on your behalf, unless you specify otherwise. You also have the option of earning capital gains by selling your shares for more than you paid for them.

Earlier, we mentioned that the mutual fund manager will make investment decisions based on the nature of the investment fund type. Be sure to review the different types of mutual funds below, so that you can select one that best aligns with your investment goals.


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How Do Mutual Funds Work?

Investing in mutual funds has proven—time and time again—to be a worthwhile endeavor. At the very least, professional money managers tend to have a better grasp of the market than novice investors. Having said that, what are these investment vehicles doing that traditional traders aren’t? How do mutual funds work? How do you make money from a mutual fund? For a better idea of the process (from beginning to end), here’s an overview of what investors can expect when they choose to invest in a mutual fund themselves:

  1. Determine A Mutual Fund Deserves Your Money: Before investing in a mutual fund, investors will need to determine if there are better growth vehicles for their money. If, however, all avenues have been explored and investors are comfortable with how they operate, mutual funds can be a great way to increase wealth passively. Consequently, investors who prefer a more hands-on approach may want to look elsewhere.

  2. Pick A Mutual Fund With An Appropriate Benchmark: Each mutual fund has its own goal, otherwise known as a benchmark. The benchmark is what the asset management company hopes to be able to achieve. Some benchmarks are set higher (representing more risk), and others are lower (suggesting they are risk-averse). As a result, anyone considering investing in a mutual fund needs to pick one that meets their own investment goals and risk tolerance.

  3. Choose How Much To Invest: Not unlike every other investment strategy, mutual funds will require a finely tuned allocation strategy. Investors will need to determine how much they want to invest in a mutual fund, and at which rate. Contributors may choose to invest one lump sum or execute a systematic investment plan (SIP), which will have them put in smaller amounts over time; this allows investors with almost any sort of budget to pool their money too.

  4. Contributors Will Receive Unites: Upon contributing to a mutual fund, investors will receive units in return for their money invested. Each unit is representative of a portion of their initial investment and will be used to determine how much money they are owed when the mutual fund returns profits.

  5. The Fund Will Invest In Diversified Assets: The money pooled together by the fund is invested into a diversified portfolio. To avoid market volatility, money managers will invest in several industries. For example, it is common for fund managers to invest the money in debt funds and equities (doing so may benefit from the growth of equity investments and the stability of debt funds). Proper diversification tends to make stock investing less risky and enables funds to reach their predetermined benchmarks easier.

  6. Assets Produce Income: Fund benchmarks are set with the intentions of generating income by capitalizing on interest, dividends, and growth. When any of the assets a fund invests in an increase in any of these areas, contributors can expect to realize returns. The income is then paid to the mutual fund, who will disperse profits based on the number of units each contributor has.

  7. Investors May Either Reinvest Or Cash Out: Investors may choose to chase out and trade all of their units for profits or they may choose to reinvest their profits back into the fund and potentially compound their earnings over years (if not decades).

  8. The Fund Will Take Its Cut: Funds have proven to be a valuable part of many portfolios. However, their benefits come at a price. To have professional money managers make investment decisions based on investors’ behalf, the fund will take a percentage of the profits they make for contributors. Otherwise known as an expense ratio, mutual funds will typically cost between 1.0% and 3.0% of the investor’s profits.

The answer to “how do mutual funds work” doesn’t need to be overly complicated. By breaking the process down into these simple steps, investors who would have otherwise been left out may not partake in a great wealth-building opportunity.

Types Of Mutual Funds

Mutual funds have become synonymous with diversification. In addition to investing in multiple types of equities, money managers have also developed a reputation for branding out across several industries. As a result, it is safe to say there is a fund for just about every investor and investment strategy. Let’s take a closer look at the type of mutual funds today’s investors can expect to come across:

  • Money Market Funds: This type of fund is a great fit for investors who don’t mind having a lower potential return, in exchange for safe investments. Money market funds typically invest in government bonds, treasury bills, certificates of deposit, and other short-term fixed-income securities.

  • Fixed Income Funds: Government bond, investment-grade corporate bond and high-yield corporate bond investments are known to pay out a fixed rate of return, mostly through interest. It should be noted that funds that invest in high-yield corporate bonds tend to be riskier than government and investment-grade bonds.

  • Equity Funds: Equity funds invest in stocks to help your investments grow faster than they would with money market or fixed-income funds. However, there is always a higher risk associated with funds that focus on higher yields or faster growth. Investors can choose between growth stocks, which do not pay dividends and are focused on long-term growth, or income funds, which do pay dividends.

  • Balanced Funds: Those who wish to earn higher returns but still want to minimize risk as much as possible should consider balanced funds. These funds invest in a mix between equities and fixed income securities by following a special formula, and are associated with less risk than pure equity funds.

  • Index Funds: Index funds will go up and down based on the performance of a specific index, such as the S&P Index. Because the manager for this type of fund does not have to actively research or make investment decisions, these funds typically come at a lower cost.

  • Specialty Funds: Investors who are interested in specific niches, such as real estate, certain commodities, or even socially responsible investing might consider a specialty fund.

  • Funds-Of-Funds: A fund-of-funds will invest in a way that is similar to balanced funds by allocating assets and diversifying in a way that minimizes risk but still focuses on higher returns. These funds are unique because they invest in other mutual funds. Because the portfolio manager is required to perform intensive research, these funds typically have higher costs and fees.

If you have ever asked yourself “how do mutual funds work” you aren’t alone. Since there are several types of mutual funds it can get a bit confusing. However, use this list to break things down into a simple, digestible format.

ETF Vs Mutual Fund

When researching different types of money managers, you will likely come across the term “ETF.” These two investment types are often grouped because they both involve pools of cash that are invested in varieties of assets. However, there are some important distinctions between the two, which begs the question: How do mutual funds work compared to ETFs?

ETFs, or exchange-traded funds, track a particular index of the stock market and are traded throughout the day. In contrast, mutual funds are traded at the end of the day at their net asset value.

Both ETFs and mutual funds have unique advantages and disadvantages that will cause an investor to choose one option over the other. For example, one investor might choose an ETF if they prefer to have more control, as they can trade throughout the day and place a variety of orders. Also, ETFs are generally associated with lower investment minimums and fees.

However, an investor who prefers to trade without paying commission, and prefers a fund that is actively managed, might opt for a mutual fund instead. Ameritrade offers a great side-by-side comparison of ETFs vs mutual funds, as well as a discussion of the pros and cons of each.

Mutual Fund Shares

Investing in a mutual fund is not all that different from investing in traditional stocks. Stock investors purchase shares of companies with the hopes of realizing growth or dividend income. Mutual fund investors, on the other hand, pool their money (along with other investors) into a large fund to invest in a diverse portfolio of equities. When all is said and done, mutual fund contributors are investing in the same companies as traditional traders, only their money is being managed by a professional. Therefore, mutual funds are just as dependent on the performance of shares as traditional investors.

Mutual fund shares are similar to their stock counterparts, in that they are divided into classes. Stock classes typically indicate whether or not a shareholder gets to exercise voting rights. Mutual fund classes have more to do with fees and incurred expenses. While there are seven classes of shares found in mutual funds, there are three which deserve more attention than the others: A, B, and C shares.

As perhaps the most common mutual fund shares, Class A shares charge investors a commission. Otherwise known as a front-end load, the commission is taken out of the initial investment and paid to the fund in return for their services. Breakpoint discounts are awarded to investors who put in more money upfront, which means Class A shares are usually best for those who intend to invest a lot of money into a single fund. The more money an investor puts in, the more money they stand to save at each breakpoint discount. Investors who submit an official letter of intent to buy a certain amount of Class A shares may also be awarded a discount at the time of the initial investment. It is worth noting, however, that the upfront fees associated with Class A shares are not well suited for short-term investments.

Much like their Class A counterparts, Class B shares are typically best reserved for long-term investors. While Class B shares don’t charge front-end fees, the longer the fund is held, the smaller the sales charge will be. If held long enough, Class B shares convert to Class A shares, which bodes well for investors with longer investment windows. When the conversion takes place, the newly minted Class A shares will coincide with a lower yearly expense ratio. If, however, the investor sells their Class B shares before they convert, they will ensure back-end loads (fees at the time of a sale). As a result, Class B shares are tailor-made for investors with little cash on hand and a long-term investment window.

Class C shares are referred to as level-load funds, meaning they come complete with an annual fee to cover distribution and marketing costs. Unlike the previous classes, Class C shares are best reserved for investors with short-term investment windows. Short term investors appreciate that there are no front-end fees, and back-end loads are only incurred if funds are withdrawn in the first year. In exchange for lower fees, however, Class C shares have higher expense ratios.

Mutual fund shares give investors another level of optionality. In addition to enabling investments in multiple equities, they also allow investors to capitalize on long and short-term strategies.

Benefits Of Mutual Funds

How do mutual funds work? Why would someone want to put their capital in one? Hopefully, the benefits listed below will answer these questions for most investors:

  • Diversification: The nature of a mutual fund is to gain exposure to several equities. To meet the benchmark set by most funds, a lot of money managers will hedge their bets and reduce risk exposure. In doing so, money managers will diversify their portfolios with equities from different industries.

  • Access: Mutual funds grant just about everyone access to diversified portfolios. With several types of shares, both investors with a lot of money and those who are just starting can invest in mutual funds and optimize their holdings. What’s more, funds can be bought and sold with relative ease, making them accessible to even the newest of investors.

  • Liquidity: Investing in mutual funds allows contributors to maintain a liquid position. Whereas some investments, like real estate, tie up funds for extended periods, money managers allow investors to buy and sell with ease, granting access to money almost immediately.

  • Professional Management: As perhaps the single greatest benefit, professional money managers are in charge of allocation. While some investors are completely comfortable investing in the stock market without any help, others will appreciate the expertise of fund trustees. If for nothing else, professional money managers have a proven track record of realizing returns, or at least more so than novice investors.

  • Passive Profits: Mutual funds are fairly passive investments, meaning most investors don’t need to do anything. Outside of choosing a fund, investors aren’t required to do anything. Provided they invest in a good fund, investors can do nothing and watch the income pile up.

  • Transparency: All money managers are heavily regulated, which means investors can rest assured that their money is in good hands. Accountability and trustees make sure money managers work in the best interest of investors.

Mutual Fund Disadvantages

There’s no doubt these investment vehicles can reward patient investors with attractive returns, but it’s important to remember no wealth-building vehicle is perfect. In addition to the benefits of mutual funds, investors also need to look at their disadvantages:

  • High Fees: In exchange for enlisting the services of a professional money manager, investors will have to pay fees depending on the types of shares they buy into. Fees may be incurred at the beginning, middle, and end of an investment, but they are all to compensate for the fund. That said, investors are essentially paying for someone else to manage their money, which (in the right fund) could be very worthwhile

  • Large Cash Positions: Funds pool together money from a lot of individual investors, which means capital is constantly on the move. On any given day, someone may choose to enter or leave the fund, which means a large cash position is required. While that may not sound bad at first, the money isn’t being put to work and could end up costing investors over the long run.

  • Inconsistent Returns: Mutual funds make no guarantee they will be able to realize returns, which begs the question: Can you lose your money in a mutual fund? Since they are subject to market fluctuations, just like every other stock, funds can lose money. While funds are typically good at beating the market, investors need to be prepared for the possibility of a net loss.

  • Over-Diversification: Money managers are usually fairly risk-averse, but sometimes diversification can go too far. It is entirely possible to be too diversified. Hedging too much can mean investors aren’t maximizing their returns.

Mutual Fund Fees

How do mutual funds work if contributors aren’t actively managing their money? The answer is simple: they pay someone to do it for them. Investing in mutual funds coincides with several fees. In exchange for enlisting the services of a professional money manager, investors will pay fees. More often than not, those fees can be classified in one of two ways: annual operating fees and shareholder fees.

Annual operating fees, otherwise known as the expense ratio, are an annual percentage of the funds under management. In other words, the more money the fund manages, the more the annual operating feel will be. It is common for the expense ratio to range between 1.0% and 3.0%. Funds will typically use this money to pay advisory or management fees and administrative costs.

Shareholder fees, as their names suggest, are incurred when shareholders decide to either buy or sell. These actions aren’t free and may be applied either at the purchase or sale of assets (depending on the shares’ class. Fund contributors will incur sales costs, commissions, and redemption fees anytime they buy or sell.

How Do You Buy Mutual Funds?

Traditional stocks are usually purchased through a brokerage, but mutual funds award investors a few more options. While many brokerages do offer the ability to buy into mutual funds, investors may also choose to invest in them through 401(k)s, pensions, and individual retirement accounts (ROTH or traditional). There are always exceptions, but most employee-sponsored retirement accounts will grant access to mutual funds. If all else fails, investors may go directly to the source. Nothing is stopping interested investors from going to the company that created the actual fund. Vanguard, Fidelity, or American Funds all provide access to their mutual funds, thought the options may be limited.

Real Estate Vs Mutual Funds: Factors To Consider

Now that you have a better grasp of how mutual funds work, you have a big decision to make: Will you invest in mutual funds or real estate? There are a variety of benefits of investing in real property. For starters, you are building equity in something tangible, an investment secured by a physical asset. Furthermore, during any type of economic downturn, you have equity built-in and can keep earning cash flow from rental properties. Also, don’t forget about the added appreciation you get to factor in. If you’d like to get started in real estate investing, here’s a beginners guide to everything you need to know.

On the other hand, there is a myriad of unique benefits associated with mutual funds, some of which you have hopefully gleaned throughout this piece. Here are some important factors to consider when making your decision:

  • Rate Of Return: One of the main considerations for investors is the rate of return on their investments. Funds and brokerages will provide projected rates of return for the various products they offer. Calculating the rate of return on real estate investments can be trickier, as you won’t necessarily know your return until the property is sold or rented. Here are tips on how to calculate your return on investment (ROI) and cash-on-cash return for real estate.

  • Risk Factor: The performance of both real estate and mutual funds are dependent on the economy. Some may argue that mutual funds are less risky due to portfolio diversification, but they are still subject to economic downturns. Others will argue that individuals have more control over real estate risk by minding their due diligence. Also, they can still build equity and earn rental income even if the economy takes a turn.

  • Taxation: You should always consider your potential tax liabilities before making any investment decisions. Unless you hold your mutual fund in a tax-advantaged account, you will be subject to capital gains tax when you sell or exchange your shares at a profit, or when you receive dividend income. When investing in real estate, your yields can be taxed after indexation, which lessens the burden by taking inflation into account. For real property, property taxes and rental income tax will be assessed, although deductions can be made.

  • Leverage: When you choose to invest in stocks, funds, or act as a private lender, you’re investing your cash or retirement savings. When purchasing real estate, you get to leverage your investments, meaning you use your cash to make a down payment to purchase real estate of much higher value.

  • Control: With funds and stocks, you are often relinquishing much of your decision making to a portfolio manager. When purchasing real estate, you have full control over conducting market research, selecting a property, and choosing the financing method and debt structure. The question here might be if you prefer to take a more active or passive role towards your investments.

Summary

How do mutual funds work? It’s a simple question, but one that weighs on the minds of novice investors. If for nothing else, being introduced to Wall Street and its countless wealth-building vehicles is intimidating. Adding one more avenue to go down can seem like a huge task, but it doesn’t need to. Mutual funds are only as intimidating as investors make them out to be. When all is said and done, they are relatively simple and worth looking into.

The merits of both investing in real estate and mutual funds are tough to ignore. If you are still feeling torn between investing in real estate or mutual funds, perhaps you may want to consider investing in real estate investment trusts (REITs), which allow investors to invest in real estate without actually purchasing physical assets. If this is of interest to you, check out this beginner’s guide to REIT investing.

As always, mind your due diligence by performing thorough research and by consulting a financial professional before making any investment decisions. Regardless of your decision, the important thing to recognize is that you are taking steps toward powerfully growing your wealth.

What are your favorite types of investments and why? Please feel free to share your thoughts in the comments below:

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REITs & Stock Investing
REITs & Stock Investing
REITs & Stock Investing
REITs & Stock Investing
REITs & Stock Investing
REITs & Stock Investing