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What is a Mutual Fund?

You may be new to investing and are starting to research the best investments. One of the most popular investment terms you may have heard of or read about is a “Mutual Fund”. A “Mutual Fund” is an investment program that pools money from investors. It then invests money in various securities such as bonds, stocks, short term debt, etc. The combined holdings within a Mutual Fund are what is known as a portfolio.

Investors buy shares in a mutual fund, with each share representing part ownership in that fund and the outcome generated. The price of a mutual fund share is known as the net asset value (NAV), sometimes referred to as NAVPS. The PS is representing “per share” in that term. This is a very basic understanding of what a Mutual Fund is. With that being said, we can begin to ask if there are different types and. More importantly, how can I get started investing in one?

How Do Mutual Funds Work?

Mutual Funds are an SEC-registered investment company that pools funds from a plethora of investors and invests the money into many different securities. Such securities could be stocks, bonds, short-term money-market instruments (CDs, treasury bills, repurchase agreements, etc.). 

The combination of these securities or assets that is owned by the Mutual Fund is known as the portfolio, as mentioned previously. This is managed by an investment advisor who is SEC-registered (Securities and Exchange Commission). Every share of the Mutual Fund represents the proportionate ownership, by an investor, of the fund’s portfolio and income generated.    

How to Invest in a Mutual Fund?

Investors in Mutual Funds buy and sell their shares to the Mutual Fund itself. You can purchase Mutual Fund shares via the fund directly, or you can work through a broker. It is best to work with a financial advisor if you are unsure how to get started. They can guide you if you just need guidance on which Mutual Funds to get into.  

Before you invest in Mutual Funds you should consider the following:

  • Determine what your financial goals and risk tolerance are. With investing, it comes down to each individual and what their end goals are. You need to understand what your personal strategy is and what your risk tolerance is prior to making decisions on which Mutual Fund to invest in
  • Beware of investment risks. Risk is inherent in investing, this should be known from the start. You are susceptible to market fluctuations when you make any type of investment. Generally the market returns somewhere around 7% historically. However, any given year you can potentially lose money if a fund does as well
  • Ask a professional financial advisor. It may be in your best interest to enlist the help of a professional when first starting off investing. You of course are welcome to research individual Mutual Funds yourself. Using a financial advisor may be a more prudent choice as they are well versed in investment strategies 

Why Do People Invest In Mutual Funds? 

It is a popular choice with investors because they offer many features such as:

  • Professional management: Managers of the fund perform research and select the securities for you. They monitor the performance of the mutual fund and act accordingly
  • Liquidity: Investors in Mutual Funds can redeem their shares easily if they so choose at any moment. They can withdraw the current net asset value (NAV), but this will be accompanied by redemption fees (amongst others)
  • Diversification: A Mutual Fund is extremely diversified in nature. They invest in a range of companies and different industrial sectors. This lowers the risk if one particular company fails. It will not make a major impact on the fund as a whole
  • Affordability: Most Mutual Funds have a low startup cost for initial investment, as well as any follow on purchases 

Mutual Fund Fees

Similar to a business, a mutual fund costs money to run. Mutual funds pass these costs on to the investors by charging fees and other expenses (depending on how it is managed). The fees and expenses will vary depending on who is managing it and how they operate. Funds with high costs are expected to have a higher performance than lower cost funds in order to provide the same type of returns. 

Shareholder’s Fees

Types of fees that you will see in the “Shareholder’s Fees” table on a fund’s prospectus include:

  • Sales Loads: Funds that use brokers to sell their shares may compensate the brokers by imposing a fee on the investors. This is known as a “sales load”, which is paid to the broker making the sale. Sales loads are a commission that investors pay when they purchase securities from a broker. Generally, there are two types of sales loads. 
    • Front-end sales load: Investors pay a fee upon purchase of fund shares
    • Deferred sales load: Investors pay a fee when they redeem their shares
  • Redemption Fee: A fee when shareholders redeem their shares. It is deducted from the redemption proceeds, similar to the deferred sales load. They are not considered to be the same though. The difference is that the redemption fee is used typically to defray fund costs associated with the redemption. It is not paid to the broker, but directly to the fund instead
  • Exchange Fee: A fee that many funds will put on shareholders if there is an exchange from one fund to another within the same fund group
  • Account Fee: A fee that some funds place on investors in association with maintaining their account. For example, if you do not meet a certain dollar threshold, there may be an account maintenance fee on the account
  • Purchase Fee: A fee that is charged when shareholders purchase their shares. It is not considered to be a front-end sales load however. The fee is typically to defray fund costs associated with the purchase. It is not paid to the broker, but directly to the fund instead

Annual Fund Operating Expenses

Types of fees that you will see in the “Annual Fund Operating Expenses” table on a fund’s prospectus include:

  • Management Fees: Fees associated with managing the fund’s investment portfolio, which is paid out of the funds assets
  • Distribution Fees: These are fees that cover distribution expenses and perhaps shareholder service expenses. These are paid out of the funds assets
  • Other Expenses: Examples of other fees could be accounting, legal, transfer agent, custodial expenses, etc.
  • Total Annual Fund Operating Expenses: This fee is a total of all of the fund’s annual operating expenses. It is expressed as a percentage of the average net assets for the fund within this table

Mutual Fund Fee Example

They may seem small, but tiny differences in fees can mean huge ramifications with your returns over time. Below is a basic breakdown of an original investment, with a fixed return but different operating expenses.

Example: If you had invested $100,000 in a fund that has an 8% return, and let’s say a 1.5% operating expense on an annual basis. You would have approximately $352,346 after 20 years. 

If you had invested that same $100,000 in a fund that had the same 8% annual return. If the operating expense was 0.75% (half of the previous expense) as well. You would have approximately $405,458 after 20 years. 

If you just change the operating expense and have all of the factors the same — you are seeing a difference of over $50,000! The fees may seem trivial at a first glance. However, the expense ratio is a very important factor when deciding which fund to invest in.  

Types of Mutual Funds

There are many different flavors of Mutual Funds, that all serve a different purpose for the investor. Some invest in more conservative securities, while others take on a much riskier approach. Let’s look into the different types that you can invest in. 

Equity (Stock) Funds

Equity Funds or Stock Funds are types of Mutual Funds that invest primarily in stocks, as the name implies. Stock, or commonly referred to as equities, fund values can rise or fall drastically over a short term basis. 

However, they have a better long term performance over many other types of investments. Other types can include corporate bonds, government bonds or treasury securities. There is a greater amount of risk that is associated with Equity Funds as well due to the Market Risk. 

Money Market Funds

Money Market Funds are Mutual Funds that are relatively low risk. In accordance with the law, they invest in high-quality, short-term securities that are issued by the federal, state or local governments. 

Investor losses are rare in this type of Mutual Fund, but they certainly are still possible. A risk that is common with this type of fund is Inflation Risk. Inflation Risk is the risk that inflation will outpace the performance of the investment returns over time. 

Fixed Income (Bond) Funds

A Fixed Income Fund is a Mutual Fund that invests primarily in bonds and other types of debt securities. This can be a riskier investment than, let’s say, a Money Market Fund. The SEC does not have rules to restrict bond funds to short-term or higher quality investments. Some risks that accompany Bond Trusts are:

  • Credit Risk: Possibility that companies whose bonds are owned by the fund could fail to pay their debts — includes debt that is owed to holders of their bonds
  • Interest Rate Risk: Chance that the market value of the bonds will be reduced when interest rates creep up — investors can potentially lose money on any bond fund because of this
  • Prepayment Risk: There is a chance that a bond could be paid off early — if interest rates fall, the issuer of the bond could pay off the debt and issue new bonds which would pay a lower rate. The fund may possibly couldn’t reinvest proceeds into an investment with as high of a yield as the original bond

Balanced Funds

A Balanced Fund is a Mutual Fund that invests in stocks, bonds and in some cases money market instruments. This is done as an attempt to reduce the investors risk while still being able to provide income and capital appreciation. The allocation of funds will differ from fund to fund. The main purpose is to reduce risk by diversifying amongst the investment categories.

Index Funds

An Index Funds is a Mutual Fund (or Exchange Traded Fund) that is designed to track an underlying securities index and achieve returns that correlate closely to the returns of that index. Generally, Index Funds have lower expenses and fees than an actively managed fund. They’re known as having a passive investment strategy. 

International Funds

An International Fund is a Mutual Fund that invests in companies that are anywhere in the world. This would be outside of it’s investors’ resident country, obviously. International Funds are sometimes referred to as “Foreign Funds” as well. 

Are Mutual Funds Safe?

Mutual Funds come in different shapes and sizes, some of which are safer than others. There are varying levels of risk that are inherent to particular types of sectors and by proxy, the Mutual Funds that accompany them. It is best to review all of your options with a financial advisor. They can help you determine which Mutual Funds you would like to invest in, so that you know all of the risk associated with them.