Mutual Funds Guide: What Are They?

A mutual fund is an investment vehicle that is made up of money contributed by many people for the purpose of investing in stocks, bonds, real estate or other kinds of investment vehicles including money market instruments.

Mutual funds are operated by money managers who make the actual investment decisions and who attempt to provide capital gains and income to the investors.

One of the main advantages of mutual funds is that they give small investors access to professionally managed, diversified portfolios of equities, bonds and other securities, which would be quite difficult (if not impossible) to create with a small amount of capital.

When a mutual fund sells a security like a stock or bond or collects income such as a dividend or interest payment these are passed along to the shareholders of the fund.

Passive vs. Active Mutual Funds

A passive mutual fund invests in a portfolio that mirrors the component of a market index. For example, an S&P 500 index fund is invested in the 500 stocks of Standard & Poor’s 500 Index. There is no attempt made to try to determine which stocks are expected to do well and which are not.

Actively managed funds are managed by an individual manager, co-managers, or a team of managers. The mangers try to buy stocks that they think will outperform the market.

The costs associated with passive investing are lower than the costs of active management. Active managers attempt to justify their higher costs by doing better in either up or down markets.

Cost Structure

Sales Charges

Some funds (load funds) sold by brokers, insurance agents or investment advisors have a front-end sales charge which is paid by the investor and passed along to the seller for his services. The charge is deducted from the amount being invested.

Other mutual funds (no load funds) are offered directly to the investing public by fund companies, or they are offered to investors by financial intermediaries who have a compensation arrangement (hourly, flat fee or a percentage of assets) with the purchaser. In this case, a sales charge is not involved, and the investor fully invests his or her available money into funds sponsored by a no-load fund company.

There are several other arrangement by which load mutual fund companies compensate sales people that are less obvious than front end sales charges in a variety of fund share classes – A, B and C. Many fund families offer special no-load share classes (F-1, F-2) for fee-based advisors who want to use their funds but do not want their clients to pay a sales charge. Before anyone invests in a mutual fund it is important that the investor understands how the broker, salesperson or investment advisor is compensated.

Expense Ratio

A mutual fund’s expense ratio is the amount of money that the fund charges for running the fund. It is usually shown as a percentage of the fund assets. All mutual funds charge investors a fee for their services. In general, passively managed index funds have a lower expense ratio than actively managed funds and bond funds have a lower expense ratio than stock funds.

Redemption Fee

Many mutual funds are charging a fee if the investor withdraws his money from a fund within a certain specified time of making an investment. This is designed to discourage market timing which can complicate the process of managing a fund.

Popular Mutual Funds

There are more mutual funds that there are stocks on the NY stock exchange. To make sense of the variety here are some of the most common fund types.

• Money market funds. These are funds that invest in very short term, liquid securities that offer a safe place to put cash. They offer a very low rate of return but try to maintain a net asset value of $1 per share.

• Bond funds invest primarily in fixed income securities. These could be government bonds, corporate bonds, municipal bonds, convertible bonds or mortgage backed securities.

• Stock funds (equity funds) invest primarily in stocks. They are subdivided into many categories according the size of the companies they invest in (large cap, small cap), the investment style (growth, value) and geography (US, Foreign).

• Balanced funds combine the features of stock and bond funds.

• Specialty funds may invest in certain industries (technology, drugs), countries (Britain, Korea) or real estate (REITs).

Well balanced portfolios frequently include funds from many of these categories in proportions appropriate to the risk tolerance of the investor.

Traditional Funds vs. ETFs

When people think about traditional mutual funds they typically think about funds known as “open ended funds.” They are the most commons funds. Shares of the fund are bought or sold though the fund company. There are no limits to the number of shares that can be issued and shares prices are determined once a day, after the market closes. At that point the total value of the assets in the mutual fund are determined and divided by the number of shares. This is the “net asset value” (NAV) and everyone who buys a share on that day pays the same price and everyone who sells also gets the same price, not matter what time of the day the order to buy or sell has actually been entered.

“Exchange Traded Funds” (ETFs) are newer but have become popular because they are bought and sold like a stock and are traded on major exchanges. The price of the shares can fluctuate during the day and the price that an investor pays for the shares can be different from minute to minute, just like the price of a stock will fluctuate during the day. That means that an ETF can be bought in the morning and sold in the afternoon for a profit or a loss depending on the change in value. The market price of an ETF is kept near the NAV by large institutional investors who will detect any difference between the NAV and the actual share price and use “arbitrage” to make that difference go away.

Because ETFs are more flexible in terms of trading strategy, they have become very popular with many active investors and speculators. In addition, because many ETFs are “passive” funds they often have lower expense ratios than many traditional mutual funds.

There are a number of other issues that an investor should be aware of with ETFs such as liquidity, commissions to trade, the bid-asked spread, and the viability of any specific ETF.

Final Thoughts on Mutual Funds

That wraps up our guide on mutual funds, what they mean, the most popular types of mutual funds, and traditional funds vs ETFs.  As always, consult your investment advisor for more information. You can also contact us through our contact page.

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