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What Is A Mutual Fund? Definition & FAQs

Written by Than Merrill

Over the past couple of decades, investing has gotten harder to understand. There are so many assets you can invest in! Stocks, bonds, commodities, futures, real estate, mutual funds, and cryptocurrency are only some examples. We won’t be able to talk about all of those things today. Instead, we’ll be focusing on mutual funds.

Mutual funds are a great way to diversify your portfolio. But what is a mutual fund, how do they work, and how do they align with your financial goals? Let’s take a closer look!

What Are Mutual Funds?

A mutual fund consists of a pool of money from several investors. This money is managed by a money manager, who invests it in various assets. These could be stocks, bonds, real estate, or almost any other asset. Funds can be targeted towards certain industries, or they can be incredibly diversified. It all depends on the fund’s investment objectives.

This gives individual investors access to the types of services that used to cost a lot of money. Professional money managers command substantial salaries, and your average person could never afford to hire one. But by investing your money in a pool, you’re able to reap the rewards of their services.

A mutual fund’s value depends on the value of all its investments. That said, when you buy shares of a mutual fund, you’re not buying any of the underlying shares. You’re buying a share of the mutual fund itself, although that share does not come with voting rights like a regular stock does.

Because of this unique investment arrangement, the price of a mutual fund is called the net asset value (NAV). This is sometimes written as NAV per share, or NAVPS. Unlike a stock, NAV has an objective value, and does not fluctuate during trading hours. The NAV is equal to the total value of the fund’s investments, divided by the total number of outstanding shares, and is calculated every weekday at close of market.

The main advantage of a mutual fund is the ability to diversify your investments, even if you’re a small investor. If you only invest in one asset, you’re exposed to more risk. The average mutual fund invests in more than 100 different assets, so you’re less exposed to risk from any individual asset.

THE BASICS:

  • Mutual funds are investment vehicles for individuals to pool their money and invest in stocks, bonds, and other assets.

  • Mutual funds provide “big money” services to “small money” investors.

  • Mutual funds can specialize in certain investments, or spread their investments across many asset types.

  • Mutual funds charge annual fees and sometimes commissions, which are paid out of your returns.

  • The vast majority of 401(k) money is invested in mutual funds.


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mutual funds

How Do Mutual Funds Work?

There are many ways to invest in a mutual fund. You can purchase shares through a bank, a brokerage, or even an investment app like Robinhood. If you’re saving for retirement with a 401(k), there’s a good chance that most of your retirement savings is already in mutual funds.

Mutual funds can earn you money in three different ways: dividend payments, capital gains, and NAV. Here’s a quick explanation:

  • Dividend payments: When a mutual fund invests in dividend-paying stocks, those dividends are paid back to the fund. The fund then passes some of that on to the investor. When you invest in a fund, you can choose whether to take a check for the payments, or reinvest the money back into the fund.

  • Capital gains: Capital gains are any money you make by selling an asset for selling a security for more than you paid for it. When the fund sells a security for profit, it earns capital gains; these funds are sent back to the fund’s investors in an annual payment.

  • Net asset value: When a fund’s NAV increases, you don’t get a direct payout. But if you sell your shares, you’ll earn a profit.

Keep in mind that different funds will make different types of investments depending on their investment strategy. Before you invest, make sure to find a fund whose philosophy aligns with yours.

Example Of Mutual Funds

One of the most prestigious mutual funds is the Fidelity Managements Magellan Fund (FMAGX), founded in 1963. Between 1977 and 1990, under the management of money manager Peter Lynch, the fund’s assets increased in value from $18 million to $14 billion. In the year 2000, It would rise to $110 billion. Since then, its performance has either matched or exceeded that of the S&P 500.

What Are The Types Of Mutual Funds?

Mutual funds come in several different varieties, each with its own benefits and drawbacks. Let’s go over the types of funds you might encounter:

Equity Funds

Equity funds are the most common type of mutual fund, and they invest primarily in stocks. These funds fall into several categories depending on their investment strategies and the size of company they invest in. In addition, some equity funds focus on U.S. stocks, while others invest in foreign stocks.

When it comes to investment strategy, equity funds fall into three categories. First, there are value funds, which invest in slow-growing companies that nonetheless represent a safe investment. These stocks also tend to have high dividend yields. On the other hand, growth funds invest in companies they believe have strong potential for growth. These companies rarely, if ever, pay dividend, but have high price-to-earnings ratios. Blend funds invest in both value and growth stocks.

Company size also comes in three different categories. Large-cap mutual funds invest in companies with a market cap of more than $10 billion. Market cap is the sum of the value of all outstanding company shares. Small-cap funds invest in companies with a market cap between $250 million and $2 billion. Mid-cap stocks have a market cap of $2 billion to $10 billion.

The fund’s strategy will be a combination of these factors. For example, a small-cap value fund would look for smaller companies that nonetheless have strong brand recognition and are undervalued. A high-cap growth fund would invest in companies like Tesla or Amazon, which have seen huge gains in recent years. A blended mid-cap fund would invest in all types of companies, and so on.

Fixed-Income Funds

Fixed-income funds are another particularly common type of mutual fund. These funds invest in investments like bonds and other types of debt, which pay a set interest. This interest is then passed on to the fund’s shareholders, or reinvested in more bonds.

Some fixed-income funds, called bond funds, are actively-managed. These funds buy bonds they believe are undervalued, in the hope of selling them at a profit. These funds can often provide high returns, but they can also be risky. A fund might invest in junk bonds, for example. This can be incredibly profitable if the “junk” bonds’ issuer makes a comeback, but the bonds could also be literally worthless.

Index Funds

Index funds are actually a type of equity fund, but they’ve become popular enough that they’ve become a category of their own. Instead of being actively managed, they build a passive strategy that’s designed to track a particular stock index like the S&P 500 or the Dow Jones. These funds cost far less to manage, and they’re based on a simple observation: actively managed equity funds tend to underperform the market over the long run. With an index fund, you’re not going to beat the market – but you’ll at least perform as well as the market, which tends to go up over time.

Balanced Funds

Balanced funds invest in a variety of asset classes. They spread their investments across stocks, bonds, and many other types of investments. This reduces your risk if any one kind of asset goes down. For example, a recession could cause the stock market to go down, but bonds go up in value as interest rates go up.

Some balanced funds use a fixed allocation strategy. The fund maintains a particular percentage of their assets in each asset class with this strategy. Other funds use a dynamic allocation strategy, and adjust the proportions of their investments as market conditions change. Fixed allocation funds tend to have lower risks and lower returns, while dynamic allocation funds tend to have higher risk and higher returns.

Money Market Funds

Money market funds invest in short-term debt instruments that are considered risk-free. These funds invest mostly in short-term Treasury bonds, which are possibly the world’s safest investment. Keep in mind, though, that low-risk also means low-reward. Money market funds will outperform a savings account, but not many other kinds of investments. Even so, they remain a viable way to keep your money growing during a recession.

Income Funds

Income funds are designed to provide a consistent stream of income to their shareholders. They invest primarily in government bonds, as well as in top-rated corporate bonds, and hold those bonds until they mature. As the interest payments come in, they’re passed on to the investors. As such, these funds are a popular choice for retirees, who require a stream of income and can’t afford any risky investments. The interest payments count as regular income, not as capital gains, which can be good or bad depending on your tax situation.

International & Global Funds

International funds, sometimes called foreign funds, invest in assets outside the country in which the fund is listed. For a U.S. fund, that’s anywhere outside the United States. Some international funds focus on areas like Asia, Europe, or emerging markets, while others are more generalized. Global funds invest their money across many companies around the world, both inside and outside the U.S.

Different funds have different philosophies, and different regions and markets have their own risks and opportunities. As a result, there’s no way to make a general statement about how international and global funds perform.

Specialty Funds

Specialty funds are another popular subset of equity fund. But while most equity funds strive for diversification, specialty funds focus on a particular market sector. This could be any sector, from the financial sector, to healthcare, manufacturing, or the tech industry. These funds tend to be more volatile than other funds, since stocks in the same sector are normally subject to the same market conditions. You can see large gains during good years, but there’s also the risk that an entire sector collapses. For example, mutual funds that specialized in the financial sector suffered massive losses during the 2008-2009 financial crisis.

Socially-responsible funds, sometimes known as ethical funds, are tailored to people with various ethical concerns. Some funds are environmentally conscious, and won’t invest in petroleum and other polluting industries. Some are designed for people with particular religious beliefs. Others will not invest in industries they deem socially irresponsible, like alcohol or tobacco. The objective is to provide comparable performance to other, similar funds, while ensuring that shareholders’ money is invested in accordance with their personal convictions.

Exchange-Traded Funds (ETFs)

Exchange-traded funds (ETFs), aren’t technically mutual funds, but they have many similar features. Both of them are ways for people to pool their resources and invest in an array of stocks, bonds, and other investments. That said, ETF shares also have more in common with stocks than with mutual fund shares. They can be bought and sold throughout the day, and their value fluctuates with the market. You can short sell ETFs, buy them on margin, and trade on ETF options markets. Not only that, but ETFs usually have lower fees than mutual funds, and they have some tax advantages.

What Are Mutual Fund Fees?

Mutual funds charge two main types of fees: operating fees and shareholder fees. Operating fees range from 1% to 3% of the fund’s value, and are taken out of the fund itself. These fees cover the cost of managing and administering the fund.

Shareholder fees can be charged when you buy or sell shares in the fund. These sales charges are referred to as the load of the fund. Front-end loads are charged when shares are purchased, and back-end fees are charged when shares are sold. In addition, some funds charge a penalty for selling shares before a set time has elapsed. Some financial institutions offer no-load funds, so you pay nothing to buy and sell shares.

What Are The Classes Of Mutual Fund Shares?

Mutual fund shares come in three different classes, depending on the type and size of their fees. Most shares available to individual investors are what’s known as Class A shares. Class A shares are purchased through a broker, and come with a front end load of at least 5%, oftentimes more. They also come with annual operating fees of 1% to 3%. Class B shares are similar to Class A shares, but the load is charged on the back end instead of at the front end.

These shares are becoming less popular, because they’re expensive, and they come with a conflict of interest. Financial advisors could be tempted to steer their clients towards higher-load funds to boost their commissions. As a result, some mutual funds are now offering Class C shares. These shares come with no front-end load, although you’ll still have to pay for operating costs.

Benefits Of Mutual Funds

So, why would you want to invest in a mutual fund? Here are some of the benefits:

  • Diversity: With the exception of specialty funds, your investments will be spread across all kinds of assets, reducing your risk.

  • Ease of access: Unlike some other financial instruments, you can invest in mutual funds via a smartphone app, online brokerage, or even through your bank. Even if you only have a little bit of money to invest, you can get access to the same diverse portfolio.

  • Liquidity: Some assets, like real estate, can tie up your money for months or years. Others, like 401(k) funds, charge an early withdrawal penalty. Mutual funds can be bought and sold on demand, without any penalty.

  • Money management: The main benefit of a mutual fund is that it’s managed by people who know what they’re doing. Instead of constantly buying and selling your own individual stocks, the money manager makes sure your investment is being properly taken care of.

  • Passive income: Once you’ve made your investment, you don’t have to do anything else. You’ll receive annual distributions from the fund. You can hold your shares for years without selling, and still make a passive income.

  • Accountability: Money managers are subject to strict legal and ethical requirements. The fund’s board of directors also have a vested interest in the fund’s performance, and will hold the manager accountable.

Drawbacks Of Mutual Funds

Of course, mutual funds also have some downsides. Here are a few:

  • High fees: Mutual funds charge higher fees than most other types of investment. If you’re paying a 5% front-end load, for example, you’re taking a significant haircut right off the bat.

  • Large cash positions: Mutual funds need to have enough cash on hand to pay any investors who want to sell there shares. Because a large investor might want to cash out at any time, this means a large percentage of the fund’s money is held in cash, instead of being invested.

  • Market risk: Ultimately, mutual funds are subject to the same fluctuations as any other stock-based investment. You can sometimes beat the market, but you can also take a loss.

  • Excessive diversification: If you prefer an aggressive investment strategy, you may be frustrated with a money manager who makes conservative investments.

How To Invest In Mutual Funds

You can invest in a mutual fund through a brokerage, app, online service, or through your own bank. But regardless of how you make your investment, the process remains similar. Let’s walk through it.

  1. Choose a mutual fund that meshes with your investment needs and philosophy.

  2. Choose a fund with an appropriate benchmark. A higher benchmark means higher risk, but more potential for reward. A lower benchmark means less risk and less reward potential.

  3. Decide how much to invest. You can either invest a lump sum all at once, or invest smaller amounts of money over time.

  4. Receive your units. A unit represents a single share of the fund, and investors with more units will receive larger distributions.

  5. The fund invests your money.

  6. The fund’s assets produce income, which is distributed to shareholders annually.

  7. The fund collects their operating costs.

  8. Decide what to do with your portion of the annual distribution. You can keep the money, or reinvest it in your fund.

Real Estate Vs. Mutual Funds

Instead of mutual funds, many investors opt to invest in real estate. So, why might someone prefer one over the other? Here’s a quick comparison.

  • Your rate of return on mutual funds will normally track with market conditions. The rate of return on real estate is far less predictable.

  • The risk/reward factor is more controversial. Mutual funds are more diverse than real estate, so they’re less exposed to losing value. That said, real estate can still be used for rentals or other purposes, even if it’s not being used optimally.

  • For mutual funds, you pay taxes on your annual distribution and any capital gains you earn when you sell your shares. With real estate, you pay sales tax for selling the property, property tax when you’re holding it, and income tax on any rental income.

  • With a mutual fund, you’re hoping that a small amount of money will grow in the long term. With real estate, you can use a small amount of money as leverage to mortgage a more valuable property.

  • With a mutual fund, the money manager controls your investment. With real estate, you’re in charge.

Summary

What is a mutual fund? 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.

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.


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