Mutual funds explained
A mutual fund consists of money from a large number of investors. The assets under management (AUM) of the fund get invested in stocks, bonds, money market instruments, and other assets. An example of a mutual fund would be an index fund which track the performance of a specific index of assets.
Mutual funds are overseen by fund managers. These fund managers are tasked with researching, selecting and monitoring the performance of the securities that the fund invests in. Under Securities and Exchange Commission (SEC) law, a manager must do this in accordance with the fund’s investment prospectus. This means that 80% of the fund’s AUM must match what the fund has laid out in its prospectus.
It has been estimated that about 100 million Americans were invested in mutual funds as of the year 2017. According to ICI, the U.S. held the largest mutual fund industry worldwide with $18.7 trillion in total net assets. With the high demand in the fund investment field, understanding how they work can help you to decide if mutual funds can help you reach your financial goals.
How do mutual funds work?
Mutual funds invest their AUM in a variety of companies in different industries in an effort to reduce risk in the event that one company or sector underperforms. Since there is a possibility of that occurring, investor funds remain liquid and can be easily withdrawn. The total amount of money managed by a mutual fund is referred to as AUM while the total value of those assets is called its net asset value or NAV.
Why should I invest in a mutual fund?
There are many reasons people choose to invest in mutual funds. Among them are advantages like dividend payments, capital gains distributions and increased NAV. When comparing investments, mutual funds are a great option.
The fund will pay most income from stock dividends directly to shareholders. Any capital gains earned from selling securities at a higher price than they were bought are also paid to investors. And as the market value of a fund’s AUM rises, so too does the initial investment held by all who invest in the fund.
With mutual funds, there is always some amount of risk involved. Securities owned by the fund can go down in value, resulting in investors taking a loss. Dividend or interest payments can fluctuate according to the market value of a fund’s AUM. Most funds opt to reinvest dividends back into the fund’s asset pool, increasing the NAV of the fund.
When evaluating a mutual fund, it is important to consider the fact that past performance does not always indicate future returns. Even though a fund’s net asset value has increased over time does not mean it will continue to be profitable. It is important to look at a fund’s volatility over time, as higher volatility often indicates higher risk. For short-term investments higher volatility may be okay, but for long-term investments stability is preferred.
Types of mutual funds
Mutual funds take a multitude of different forms. Depending on the investments involved and how the fund operates, funds are called by slightly different names. Funds are generally not short-term investments but that can depend on the investor’s preference.
Money market funds
Money market funds are low risk investments. This is due to the fact that, by law, they have to invest in high-quality investments issued by corporations and governments in the U.S. High-risk assets are not allowed. All the assets under management (AUM) of a money market fund are thought to be conservative because of the reputation of the issuers.
Bond funds hope to gain higher returns but involve higher risk. The risk of a bond varies according to its rating, with “junk bonds” being the riskiest. Still, some bond funds might invest in junk bonds for the small chance of earning huge gains. Because of the varying risk/reward ratio of bonds, no two bond funds are alike in terms of their risk and reward.
Equity funds invest only in corporate stocks. They are can also be referred to as stock funds. These funds tend to focus on larger companies and can take several different forms.
Growth funds come with greater potential for high rewards but might not pay out dividends to investors. Income funds invest only in stocks that do pay regular dividends. As mentioned earlier, index funds track the performance of a particular market index, like the S&P 500. While sector funds focus investment in a specific industry.
Hybrid funds invest in multiple types of investment vehicles. A hybrid fund might be invested in many different asset classes including, but not limited to, stocks, bonds, gold, and more. This is one of many strategies that can reduce risk and increase NAV.
Open and closed-end funds
Open-end funds have a share price based on net asset value or NAV. This may allow investors to enter the markets by having the flexibility as to purchasing shares. By contrast, closed-end funds have a share price dictated by supply and demand, making it more volatile. The price per share is often offered at a discount to NAV and usually is bought or sold through a broker.
Load and no-load funds
Load funds require the investor to pay a sales commission on top of the NAV. No-load funds, on the other hand, require no sales commission and have the possibility of resulting in higher returns. The reasoning is due to the fact that the investor is able to purchase the shares directly through the investment company and not a secondary party.
What is a mutual fund share class?
There are three “share classes” associated with mutual funds. These include class A, class B, and class C shares. It is important to know the differences of each classification because of the fees associated with each one.
Class A shares
Class A shares come with two fees at the time of purchase. One of them is a commission fee for the financial representative involved. The other is an asset-based sales charge, an indirect fee taken from the fund’s net assets in order to cover its operating costs.
Class B shares
Class B shares only charge fees when the fund is sold. However, this fee is usually higher than that of class A shares. Some class B shares convert to class A shares automatically in a given time frame.
Class C shares
Class C shares come with a small fee when sold within one year of the purchase date. Class C shares do not convert to class A and may have high asset-based sales charges associated with them.
Costs associated with funds
Some funds charge transaction fees or commissions for every buy or sell order that customers place. Some common fees that mutual funds might charge include the following:
- Redemption fees – for selling shares shortly after purchasing them
- Operation fees – to cover the cost of operating the fund
- Account fees – to cover costs associated with opening and maintaining new accounts
Taxes and mutual funds
Whenever you purchase or sell shares in a mutual fund, each transaction has to be included on your next tax return. This is no different than trading stocks, index funds or currencies. The specific tax treatment of your fund depends on several factors including but not limited to the type of investment, how long you hold the investment in your portfolio and the way the net assets of the fund are distributed to investors.
For mutual funds or index funds that are not held in tax-advantaged accounts, the following types of taxes may apply:
- Dividend income – this most often counts as ordinary income and is taxed as such
- Capital gains – for shares held for 364 days or less, short-term capital gains tax applies. Shares held for one year or more fall under long-term capital gains.
ETF vs mutual fund
An exchange-traded fund (ETF) is an investment vehicle that allows investors to gain exposure to a group of stocks or bonds in a single investment vehicle. An ETF stock is traded like any other stock but involves a group of different securities.
ETFs are traded on major stock exchanges like the New York Stock Exchange (NYSE) and the Nasdaq. An ETF stock will let you start investing with smaller minimums than mutual funds and provide real-time pricing every time you buy or sell. The price of an ETF stock will change throughout the day, whereas a fund is only priced once per day.
However, ETFs are less liquid than mutual funds. This means you cannot simply sell shares as soon as you want to, and you cannot set up automatic investments or withdrawals.
ETFs are similar mutual funds in several ways. They both have professional management teams that research the investments involved. Each investment type attempts to minimize risk via diversification strategies.
And, ETFs and mutual funds offer a variety of different investment choices.
Many smaller investors prefer ETFs or index funds due to the fact that they require smaller amounts of capital to get started. Though, mutual funds come with several advantages that ETFs do not. While the ETF vs mutual fund comparison is not always straightforward, there are a few general differences to determine which one is right for you.
Advantages of a mutual fund
Mutual funds tend to require a larger minimum investment than ETFs or index funds. Mutual funds also give investors more options as they tend to hold higher net assets. You can choose between growth investing, value investing, developed or emerging markets, etc. With an ETF or an index fund, you are limited to whatever securities are included in the grouping or tracked by the index.
Limitations of mutual funds
There are a few key limitations to holding mutual funds in your portfolio that you should keep in mind. First, funds can be volatile, meaning the net asset value of securities held can fluctuate quite a lot. Also, Federal Deposit Insurance Corporation (FDIC) does not cover mutual fund investments.
Many funds tend to hold a significant sum of their net assets in cash, meaning that some of the money you invest will just be sitting there rather than being invested for a potential return. This fact, in addition to the various fees involved, add up to reduce returns.
Perhaps most concerning for some investors will be the fact that up to 20% of the investment strategy utilized by any given firm will be unknown to investors. This is because by law only 80% of the strategy has to be made public. The portfolio of a fund can, therefore, be hard to analyze, making judging which fund to purchase even more difficult.
Finally, funds are priced only once daily, rather than the price changing countless times over the course of a trading day like an index fund. They cannot be traded during regular stock market hours, which makes funds even less liquid.
Fraud and funds
Fraudulent investments are commonplace in the financial world. Since the potential payoff can be great, criminals often prey upon unsuspecting or inexperienced investors who do not know how to invest in mutual funds, ETFs, or index funds.
Fortunately, it is easy to avoid fraud when knowing what to look for in a mutual fund. Every fund has to file a prospectus with the SEC and all associated investment advisors must be registered with the SEC.
Be sure to always read the prospectus provided by any fund you are interested in. Check that the advisors are registered with the SEC and read thoroughly the shareholder reports that are released.
How to invest and sell a mutual fund
When looking for a mutual fund to buy, there are a few things to keep in mind. First, seek out a fund with high net assets, a well-defined strategy and a fund manager that acts in line with that strategy.
Read the prospectus in detail before deciding to invest in a fund. Here you will find all the information you need with regard to the fund’s plan. Make sure to check that the fund’s advisors are registered with the SEC.
Finally, be mindful of your risk tolerance. It is hard to know how to invest without determining the level of risk you want to take on.
Generally speaking, the younger you are and more time you have left until planning to retire, the higher your risk should be. It is okay to take on greater risk for potential greater reward since you will have time to catch up if you fall behind.
If you are closer to retirement, a more conservative portfolio is recommended. You need more short-term investments and low-risk investments as the need access to the cash in your portfolio increases.
Selling a mutual fund is simple. It is similar to selling shares of any other security. Shares can be redeemed at any time, and funds usually send payment within 5 – 7 business days. Remember to report the sale on your taxes and plan for any tax consequences you may have.
Investing in a mutual fund is one of the many options* in investing today.
*This article is for educational purposes. M1 Finance does not currently support mutual funds. Learn more about securities we support on M1.