What is a mutual fund?
A mutual fund is an investment that holds a variety of securities in order to provide diversification to investors. There are thousands of mutual funds, each created to target a specific investment type or strategy.
If you’re at all familiar with modern investment strategy, then you are surely aware that the concept of diversification is among the most basic principles one should follow when building his or her portfolio.
Naturally, having too many eggs in one basket is no way to build lasting wealth. It presents far too much risk without a significant reward in the form of a higher return.
One key problem with diversifying investments, whether they be stocks or bonds, or real estate, is the sheer difficulty of keeping up with and managing enough investments to be properly diversified while also implementing an appropriate asset allocation and investment strategy.
In other words, diversification can be a lot of work.
Thankfully, in 1924 the first modern mutual fund was created providing investors with the opportunity to make one investment purchase and receive, among other things, instant diversification.
A mutual fund is a financial product that pools assets from its shareholders in order to allow fund participants the opportunity to invest in a variety of securities in order to generate capital gains or income.
Even though it wasn’t until the late 80s or early 90s that mutual funds really caught on for the average investor, their existence has provided an exceptional opportunity to simplify investing without sacrificing returns.
Talk to me Like I’m Five, Curt
In simple terms, investment banks and other fun companies create mutual funds for clients in order to execute a specific investment strategy in an asset class, or security type, or even to target a specific retirement date.
These investment houses appoint a fund manager to control the fund’s assets. As shareholders approach the investment company to invest, the fund manager buys more securities according to the strategy of the fund.
This strategy is written in a fund prospectus which is a written document declaring how the fund will operate.
For example, let’s say Freddy Fund Manager is managing a mutual fund based on the S&P 500 stock market index. Freddy has $10 million to invest on behalf of the fund’s shareholders.
Per the fund prospectus, Freddy will buy shares of all the stocks listed in the S&P 500 index using the invested money from shareholders, holding a small portion in a cash reserve to cover expenses and any sudden need to buy or sell stock for those who enter or exit the fund.
As more people buy shares of the fund, Freddy will buy proportionally more S&P 500 stocks. As people leave the fund, he will sell them off proportionally.
Unlike stocks, which are issued in finite quantities, open-ended mutual funds* keep selling shares as long as people want to buy them. Since the pool of money in the fund is growing at the same rate shareholders invest in the fund, the overall value is neither concentrated nor diluted based on purchases or sales.
The overall value of the fund is mostly affected by the increase or decrease in the value of the securities held by the fund and by any expenses incurred in the day-to-day operation of the mutual fund.
So, in Freddy’s case, as the S&P 500 goes up, so goes the value of his mutual fund. The inverse is also true.
(*we’re mostly covering open-ended mutual funds in this post, but there is an explanation of the differences between open-ended and closed-ended mutual funds below.)
How Are Mutual Funds Priced?
The price of a mutual fund is set by its Net Asset Value (NAV) which is calculated at the end of each trading day.
The fund’s NAV is basically the value of all the assets in the fund minus any liabilities owed by the fund. It is expressed in a per-share amount by dividing the net assets by the number of shares outstanding.
The fund prospectus will outline exactly how the NAV will be calculated.
Because the NAV is calculated at the end of each trading day, all purchases and sales are executed after the end of the next full trading day.
This means if you decide to sell you mutual fund after the market opens on Tuesday, you’ll have to wait until the market closes Wednesday for the trade to actually occur.
Since most people purchase mutual funds for long-term investing, this isn’t often a significant concern. Exchange Traded Funds (ETF’s) exist as an alternative if you wish to enjoy many mutual fund features, but also want the ability to trade instantly while the market is open.
Typically, mutual funds will require a minimum initial investment which can be prohibitive if you don’t have much cash available.
Most investment companies offer index funds or target date funds that have friendlier initial investment minimums than some actively managed funds.
Types of Mutual Funds
Now that you have a basic understanding of what a mutual fund is, let’s talk about the different types.
There are thousands of mutual funds available today and they cover countless strategies. It is not feasible to account for all of them in this post, but we’ll hit the high points so you have a pretty broad idea of what’s out there.
Stock Funds
Stock funds own stocks.
That is obvious enough, but within this category, there are scores of strategies regarding which stocks to own.
Some stock funds strategically buy equities based on the size or market capitalizations of a group of companies. These size groups of stocks are known as small caps (for small companies), mid caps, large caps, and mega caps.
Stock funds can also purchase groups of stocks based on their perceived growth trajectory. Growth stocks are stocks that are expected to grow quickly while value stocks are seen as slow growing but undervalued by investors. Blend stocks describe companies that are neither growth nor value, but are perceived to be somewhere in the middle.
Bond Funds
Bond funds are known for holding fixed-income assets like government bonds, corporate bonds, or other forms of debt.
Even though bond funds are typically bought to provide a bit of stability against the volatility of stocks, they are not without risk.
All bonds are subject to interest rate risk and if you’re reading this in 2022 then you know how much damage rising interest rates can cause in bond markets.
Additionally, not all bond funds exist to provide stable, low-volatility returns to their investors. Some bond funds actively buy and sell bonds, looking for undervalued bonds they can buy and sell at a profit.
Also, some bonds hold higher-risk debt, known as junk bonds, which pay higher returns but could also fall into default rendering them nearly worthless.
In summary, not all bond funds are created equal. Be sure to do your research before selecting a bind fund that aligns with your investing strategy.
Target Date Funds
Target date funds are the quintessential “set it and forget it” investment product.
As investors age, they normally desire to reduce investment risk in their portfolios. Typically, this is done by reducing the percentage of stocks in a portfolio and buying bonds in their place.
Well, some folks forget to provide adequate attention to this as they age until a sharp market decline refreshes their memory. By then, the damage is done, and, out of fear, these older investors shift their asset allocation in favor of bonds at the worst possible time.
As a result, their overall portfolio value is reduced and their shift to a conservative asset allocation assures them that recovery will take longer than it would have otherwise.
Target date funds seek to avoid this by gradually shifting fund assets toward a more conservative allocation as the fund approaches the target retirement date set by the fund prospectus.
For example, a target date 2045 fund will have a higher percentage of stocks compared to a target date 2035 fund. However, as the 2045 fund approaches 2045, the assets in the fund will shift into lower-risk, fixed-income investments to decrease volatility and market risk.
Normally providers of target date funds will hold stock or bond funds already offered by their company in the target date funds they sell.
For example, as I’m writing this, Vanguard’s Target 2050 Fund is currently comprised of Vanguard’s Total Stock Market Index Fund (VTIVX 53.5%), Vanguard’s Total International Stock Index Fund (VGTSX 36.1%), Vanguard’s Total Bond Market II Index Fund (VTBIX – 7.1%), and Vanguard’s Total International Bond II Index Fund (VTILX 3.3%).
Index Funds
Index Funds track with major market indexes like the Dow Jones Industrial Average, the S&P 500, or the Russell 2000 Index, but can also hold an even broader selection of securities.
The real draw of index funds is their low cost.
Because these mutual funds follow pre-established market indexes, there isn’t as much work for a fund manager or team to do in the day-to-day operation of the fund.
As a result, expense ratios for index funds are typically very low; some as low as 0.03%. This basically means for every $1M the fund has under management it will spend only $300.
That’s pretty cheap.
It’s also one reason that index funds have exploded in popularity over the last 40 years.
Another is the fact that the seemingly small difference in cost between actively managed funds and passively managed index funds has consistently led to better overall performance by index funds.
In other words, not only are index funds cheaper than actively managed funds, they produce better returns.
This is not advice, but I only own index funds and there are many people like me who don’t bother paying more for funds that are actively managed. The largest mutual funds and ETFs in the industry are all index funds.
Money Market
Money market funds hold short-term debts like treasury bills. They do not produce much in the way of an investment return; perhaps a little more than one might get from a standard savings account.
The draw of money market funds is the preservation of principal. They are virtually guaranteed not to decrease in value.
International
International mutual funds hold stocks and assets from businesses based in countries other than the United States.
One variety of international funds is known as emerging market funds. These funds invest in countries with economies that are emerging in terms of technology and economic power. A few examples include Brazil, India, China, and Malaysia.
Specialty Funds
Specialty funds cater to very specific or niche groups of investors.
Recently, ESG funds (Environmental, Social, Governance) have emerged to appeal to those who desire to invest with companies that have high standards for environmental or social justice initiatives.
Some mutual funds are specialized to accommodate varying moral and ethical points of view on topics like gambling, abortion, or alcohol.
If there is a specific concern you have regarding how your invested dollars are used, chances are there is a specialty fund to accommodate it. It may require some time and effort to research, however.
Finally, specialty funds can also focus on specific market segments like technology, health care, or communications.
Expenses & Fees
Mutual funds are not free to own. The fund provider and management team incur costs for operating the fund. Regular costs are rolled up into the fund’s expense ratio which is withheld from the assets of the fund and the costs are recovered evenly from all shareholders.
Expense ratios can vary greatly, even for mutual funds with similar strategic focus. Vanguard and Fidelity tend to provide exceptionally low-cost funds.
You should be able to locate good mutual funds with expense ratios below 1% for most fund classes (some specialties excluded). Generally, international funds will have higher expense ratios while domestic index funds are regularly below 0.10%.
Some mutual funds charge commissions and fees called “loads” which may be collected upon the purchase of a fund (a “front-end” load) or when it is sold (the “back-end.”) Most funds are no-load funds, but you should keep an eye out for this as you select mutual funds.
Taxes
It’s important to understand how frequently a fund manager makes trades within a fund because every sale will trigger capital gains taxes, assuming there’s a gain. If a fund manager trades too often, it will erode the returns shareholders receive from their investments.
(Note, this is another reason actively managed funds tend to underperform index funds.)
It is equally important to note the regular dividend yields produced by the equities within a mutual fund. These dividends are subject to dividend taxes and can create an unpleasant tax surprise if a shareholder isn’t planning for this event.
One way to avoid tax problems with mutual funds is to own them in tax-advantaged accounts that do not create capital gains or dividend taxes for the shareholders since they are in a tax-efficient envelope.
Open vs Closed
Open-end mutual funds can generate or terminate shares of the fund as shareholders enter or exit the fund.
Closed-end mutual funds are issued in a specific number of shares which does not fluctuate based on investor demand. Closed-end funds are initially sold by the fund creator, then traded on an exchange like a stock.
Unlike an open-end fund, closed-end funds are not priced based on their NAV. Instead, the price is determined by market forces and can trade above or below the calculated NAV.
Conclusion
Mutual funds are great. They make diversification so much easier for investors who simply don’t have the time to bother with creating their own diversified collection of equities.
If you aren’t already familiar with the nuances of mutual funds, I’d encourage you to look one up and start digging through the details of how it’s managed and what strategic goals it has.
Run comparisons between funds to see how the expenses and yields compare.
In many cases, once the homework is done many people stay in a mutual fund for decades. They are certainly a “long view” financial instrument and have a place in nearly every portfolio.
