What Is a Mutual Fund?
A mutual fund serves as a financial tool that pools resources from multiple shareholders to invest in a diversified portfolio of securities, including stocks, bonds, money market instruments, and other assets. These funds are professionally managed by experienced money managers who strive to generate capital gains or income for the investors. The composition of a mutual fund’s holdings is carefully designed and maintained in accordance with the investment objectives outlined in its prospectus.
By investing in mutual funds, individual or small-scale investors gain access to expertly managed portfolios that comprise various equities, bonds, and securities. Each shareholder in the mutual fund holds a proportional stake, thereby participating in the fund’s gains or losses. Mutual funds typically invest in a broad range of securities, and their performance is commonly measured based on the overall market capitalization of the fund, which reflects the collective performance of its underlying investments.
Many mutual funds are affiliated with prominent investment companies like Fidelity Investments, Vanguard, T. Rowe Price, and Oppenheimer. Within a mutual fund structure, there exists a fund manager, often referred to as an investment adviser, who bears a legal responsibility to act in the best interests of the mutual fund’s shareholders.
KEY TAKEAWAYS
- A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities.
- Mutual funds give small or individual investors access to diversified, professionally managed portfolios.
- Mutual funds are divided into several kinds of categories, representing the kinds of securities they invest in, their investment objectives, and the type of returns they seek.
- Mutual funds charge annual fees, expense ratios, or commissions, which may affect their overall returns.
- Employer-sponsored retirement plans commonly invest in mutual funds.
How Are Mutual Funds Priced?
The value of a mutual fund is determined by the performance of the securities it invests in. When an investor purchases a unit or share of a mutual fund, they are essentially acquiring a portion of the portfolio’s value and its corresponding performance. It is important to note that investing in mutual fund shares differs from investing in individual stocks, as mutual fund shares do not grant voting rights to their holders. Instead, a mutual fund represents investments in a diversified selection of stocks and other securities.
The price of a mutual fund share is commonly referred to as the net asset value (NAV) per share, sometimes expressed as NAVPS. The NAV of a fund is calculated by dividing the total value of the securities held in the portfolio by the total number of shares outstanding. Outstanding shares include those held by all shareholders, including institutional investors, company officers, and insiders.
Mutual fund shares can typically be bought or sold at the fund’s current NAV, which is determined at the end of each trading day. Unlike stock prices, the NAV of a mutual fund remains constant during market hours and is updated once the NAVPS is settled.
One of the advantages of investing in mutual funds is the inherent diversification they provide. Unlike an investor who solely holds shares of a single company, a mutual fund investor benefits from a portfolio that includes various securities. This diversification helps offset potential gains and losses of individual stocks, as the performance of one company within the fund is balanced by the performance of other companies held in the portfolio.
How Are Returns Calculated for Mutual Funds?
Returns for mutual funds are calculated based on the change in value, known as the total return, of the investor’s shares in the fund. These returns are typically reported on a quarterly or annual basis.
Mutual fund investors earn returns through three primary sources:
- Income: Mutual funds generate income from dividends on stocks and interest on bonds held within the fund’s portfolio. The fund distributes a significant portion of this income to its shareholders in the form of dividends. Investors have the option to receive the dividend payments in cash or reinvest them to purchase additional shares in the fund.
- capital gain: If the mutual fund sells securities that have appreciated in value, it realizes capital gains. These gains are typically passed on to the investors in the form of capital gain distributions. Similar to dividends, investors can choose to receive the distributions in cash or reinvest them in the fund.
- Price Appreciation: When the net asset value (NAV) of the mutual fund increases, the value of the investor’s shares also rises. If the investor sells their mutual fund shares at a higher price than their initial investment, they can realize a profit.
The total return of a mutual fund reflects the combined effect of these income distributions, capital gain distributions, and price appreciation. Investors should consider the total return when assessing the performance of a mutual fund.
It’s important to note that mutual fund returns can fluctuate over time, and past performance does not guarantee future results. Investors should carefully review a fund’s prospectus, including its historical performance, fees, and investment strategy, to make informed decisions about investing in a particular mutual fund.
Types of Mutual Funds
There are several types of mutual funds available for investment, though most mutual funds fall into one of four main categories which include stock funds, money market funds, bond funds, and target-date funds.
Stock Funds
Stock funds are investment vehicles that primarily allocate their assets to equity or stocks. Within this category, there are several subcategories based on different criteria. Some equity funds are classified according to the size of the companies they invest in, such as small-cap, mid-cap, or large-cap. Others are categorized based on their investment approach, such as aggressive growth, income-oriented, or value-focused strategies. Equity funds can also be distinguished by whether they invest in domestic (U.S.) stocks or foreign equities. To gain a comprehensive understanding of equity funds, investors often use a style box, which provides a visual representation of the fund’s investment characteristics.
Funds within the stock category can be further classified based on both the size of the companies they invest in (market capitalization) and the growth prospects of the stocks in their portfolios. A value fund follows an investment style that seeks out high-quality companies with lower growth rates that are currently undervalued by the market. These companies typically exhibit low price-to-earnings (P/E) ratios, low price-to-book (P/B) ratios, and high dividend yields.
In contrast, growth funds focus on companies that have demonstrated strong growth in earnings, sales, and cash flows. These companies often have higher P/E ratios and reinvest their profits rather than paying dividends. Blend funds strike a balance between value and growth strategies by investing in companies that fall between the two categories.
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Market capitalization is another factor used to categorize stocks within equity funds. Large-cap companies have high market capitalizations, generally exceeding $10 billion. They are often well-established, widely recognized firms referred to as blue-chip companies. Small-cap stocks , on the other hand, have market capitalizations ranging from $250 million to $2 billion. These companies are typically newer and carry higher investment risk. Mid-cap stocks fall between small-cap and large-cap stocks in terms of market capitalization.
Mutual funds have the flexibility to blend investment styles and company sizes in their strategies. For instance, a large-cap value fund would focus on financially sound large-cap companies whose share prices have recently declined, placing it in the upper left quadrant of the style box (large and value). Conversely, a small-cap growth fund would invest in promising technology startups with strong growth prospects, positioning it in the bottom right quadrant (small and growth).
Bond Funds
A mutual fund that generates a minimum return is part of the fixed income category. A fixed-income mutual fund focuses on investments that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments. The fund portfolio generates interest income, which is passed on to the shareholders.
Sometimes referred to as bond funds, these funds are often actively managed and seek to buy relatively undervalued bonds in order to sell them at a profit. These mutual funds are likely to pay higher returns and bond funds aren’t without risk. For example, a fund specializing in high-yield junk bonds is much riskier than a fund that invests in government securities.
Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest and all bond funds are subject to interest rate risk.
Index Funds
Index Funds invest in stocks that correspond with a major market index such as the S&P 500 or the Dow Jones Industrial Average (DJIA). This strategy requires less research from analysts and advisors, so there are fewer expenses passed on to shareholders and these funds are often designed with cost-sensitive investors in mind.
Balanced Funds
Balanced funds invest in a hybrid of asset classes, whether stocks, bonds, money market instruments, or alternative investments. The objective of this fund, known as an asset allocation fund, is to reduce the risk of exposure across asset classes.
Some funds are defined with a specific allocation strategy that is fixed, so the investor can have a predictable exposure to various asset classes. Other funds follow a strategy for dynamic allocation percentages to meet various investor objectives. This may include responding to market conditions, business cycle changes, or the changing phases of the investor’s own life.
The portfolio manager is commonly given the freedom to switch the ratio of asset classes as needed to maintain the integrity of the fund’s stated strategy.
Money Market Funds
The money market consists of safe, risk-free, short-term debt instruments, mostly government Treasury bills. An investor will not earn substantial returns, but the principal is guaranteed. A typical return is a little more than the amount earned in a regular checking or savings account and a little less than the average certificate of deposit (CD).
Income Funds
Income funds are named for their purpose: to provide current income on a steady basis. These funds invest primarily in government and high-quality corporate debt, holding these bonds until maturity to provide interest streams. While fund holdings may appreciate, the primary objective of these funds is to provide steady cash flow to investors. As such, the audience for these funds consists of conservative investors and retirees.
International/Global Funds
An international fund, or foreign fund, invests only in assets located outside an investor’s home country. Global funds, however, can invest anywhere around the world. Their volatility often depends on the unique country’s economy and political risks. However, these funds can be part of a well-balanced portfolio by increasing diversification, since the returns in foreign countries may be uncorrelated with returns at home.
Specialty Funds
Sector funds are targeted strategy funds aimed at specific sectors of the economy, such as financial, technology, or healthcare. Sector funds can be extremely volatile since the stocks in a given sector tend to be highly correlated with each other.
Regional funds make it easier to focus on a specific geographic area of the world. This can mean focusing on a broader region or an individual country.
Socially responsible funds, or ethical funds, invest only in companies that meet the criteria of certain guidelines or beliefs. For example, some socially responsible funds do not invest in “sin” industries such as tobacco, alcoholic beverages, weapons, or nuclear power. Other funds invest primarily in green technology, such as solar and wind power or recycling.
Exchange Traded Funds (ETFs)
An alternative to mutual funds is the exchange-traded fund (ETF). While not classified as mutual funds, ETFs adopt strategies similar to mutual funds. They are structured as investment trusts and are traded on stock exchanges, offering additional features associated with stocks.
ETFs provide the advantage of being bought and sold throughout the trading day, offering flexibility in timing. They can be sold short or purchased on margin, allowing investors to engage in various trading strategies. Additionally, ETFs generally have lower fees compared to equivalent mutual funds. Many ETFs also benefit from active options markets, enabling investors to hedge or leverage their positions.
One notable advantage of ETFs over mutual funds is their tax efficiency. ETFs tend to offer greater cost-effectiveness and liquidity when compared to mutual funds.
Mutual Fund Fees
A mutual fund has annual operating fees or shareholder fees. Annual fund operating fees are an annual percentage of the funds under management, usually ranging from 1–3%, known as the expense ratio. A fund’s expense ratio is the summation of the advisory or management fee and its administrative costs.
Shareholder fees are sales charges, commissions, and redemption fees, that are paid directly by investors when purchasing or selling the funds. Sales charges or commissions are known as “the load” of a mutual fund. When a mutual fund has a front-end load, fees are assessed when shares are purchased. For a back-end load, mutual fund fees are assessed when an investor sells their shares.
Sometimes, however, an investment company offers a no-load mutual fund, which doesn’t carry any commission or sales charge. These funds are distributed directly by an investment company, rather than through a secondary party. Some funds also charge fees and penalties for early withdrawals or selling the holding before a specific time has elapsed.
Classes of Mutual Fund Shares
Currently, most individual investors purchase mutual funds with A-shares through a broker. This purchase includes a front-end load of up to 5% or more, plus management fees and ongoing fees for distributions, also known as 12b-1 fees. Financial advisors selling these products may encourage clients to buy higher-load offerings to generate commissions. With front-end funds, the investor pays these expenses as they buy into the fund.
To remedy these problems and meet fiduciary-rule standards, investment companies have started designating new share classes, including “level load” C shares, which generally don’t have a front-end load but carry a 12b-1 annual distribution fee of up to 1%.
Funds that charge management and other fees when an investor sells their holdings are classified as Class B shares.
Pros of Mutual Fund Investing
There are a variety of reasons that mutual funds have been the retail investor’s vehicle of choice with an overwhelming majority of money in employer-sponsored retirement plans invested in mutual funds.
Diversification
Diversification, or the mixing of investments and assets within a portfolio to reduce risk, is one of the advantages of investing in mutual funds. A diversified portfolio has securities with different capitalizations and industries and bonds with varying maturities and issuers. Buying a mutual fund can achieve diversification cheaper and faster than buying individual securities.
Easy Access
Trading on the major stock exchanges, mutual funds can be bought and sold with relative ease, making them highly liquid investments. Also, when it comes to certain types of assets, like foreign equities or exotic commodities, mutual funds are often the most feasible way—in fact, sometimes the only way—for individual investors to participate.
Economies of Scale
Mutual funds also provide economies of scale by forgoing numerous commission charges needed to create a diversified portfolio. Buying only one security at a time leads to large transaction fees. The smaller denominations of mutual funds allow investors to take advantage of dollar-cost averaging.
Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions. A mutual fund can invest in certain assets or take larger positions than a smaller investor could.
Professional Management
A professional investment manager uses careful research and skillful trading. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments. Mutual funds require much lower investment minimums so these funds provide a low-cost way for individual investors to experience and benefit from professional money management.
Variety and Freedom of Choice
Investors have the freedom to research and select from managers with a variety of styles and management goals. A fund manager may focus on value investing, growth investing, developed markets, emerging markets, income, or macroeconomic investing, among many other styles. This variety allows investors to gain exposure to not only stocks and bonds but also commodities, foreign assets, and real estate through specialized mutual funds. Mutual funds provide opportunities for foreign and domestic investment that may not otherwise be directly accessible to ordinary investors.
Transparency
Mutual funds are subject to industry regulation that ensures accountability and fairness to investors.
Pros
- Liquidity
- Diversification
- Minimal investment requirements
- Professional management
- Variety of offerings
Cons
- High fees, commissions, and other expenses
- Large cash presence in portfolios
- No FDIC coverage
- Difficulty in comparing funds
- Lack of transparency in holdings
Mutual Funds: How Many is Too Many?
Cons of Mutual Fund Investing
Liquidity, diversification, and professional management all make mutual funds attractive options, however, mutual funds have drawbacks too.
No Guarantees
Like many other investments without a guaranteed return, there is always the possibility that the value of your mutual fund will depreciate. Equity mutual funds experience price fluctuations, along with the stocks in the fund’s portfolio. The Federal Deposit Insurance Corporation (FDIC) does not guarantee mutual fund investments.9
Cash Drag
Mutual funds require a significant amount of their portfolios to be held in cash to satisfy share redemptions each day. To maintain liquidity and the capacity to accommodate withdrawals, funds typically have to keep a larger portion of their portfolio as cash than a typical investor might. Because cash earns no return, it is often referred to as a “cash drag.”
High Costs
Mutual funds provide investors with professional management, but fees reduce the fund’s overall payout, and they’re assessed to mutual fund investors regardless of the performance of the fund. Since fees vary widely from fund to fund, failing to pay attention to the fees can have negative long-term consequences as actively managed funds incur transaction costs that accumulate over each year.
“Diworsification” and Dilution
“Diworsification“—a play on words—is an investment or portfolio strategy that implies too much complexity can lead to worse results. Many mutual fund investors tend to overcomplicate matters. That is, they acquire too many funds that are highly related and, as a result, lose the benefits of diversification.
Dilution is also the result of a successful fund growing too big. When new money pours into funds that have had strong track records, the manager often has trouble finding suitable investments for all the new capital to be put to good use.
The Securities and Exchange Commission (SEC) requires that funds have at least 80% of assets in the particular type of investment implied in their names. How the remaining assets are invested is up to the fund manager.10 However, the different categories that qualify for the required 80% of the assets may be vague and wide-ranging. A fund can, therefore, manipulate prospective investors via its title. A fund that focuses narrowly on Congolese stocks, for example, could be sold with a far-ranging title like “International High-Tech Fund.”
End of Day Trading Only
A mutual fund allows you to request that your shares be converted into cash at any time, however, unlike stock that trades throughout the day, many mutual fund redemptions take place only at the end of each trading day.
Taxes
When a fund manager sells a security, a capital-gains tax is triggered. Taxes can be mitigated by investing in tax-sensitive funds or by holding non-tax-sensitive mutual funds in a tax-deferred account, such as a 401(k) or IRA.11
Evaluating Funds
Researching and comparing funds can be difficult. Unlike stocks, mutual funds do not offer investors the opportunity to juxtapose the price to earnings (P/E) ratio, sales growth, earnings per share (EPS), or other important data. A mutual fund’s net asset value can offer some basis for comparison, but given the diversity of portfolios, comparing the proverbial apples to apples can be difficult, even among funds with similar names or stated objectives. Only index funds tracking the same markets tend to be genuinely comparable.
Example of a Mutual Fund
One prominent mutual fund in the investment landscape is the Magellan Fund (FMAGX) offered by Fidelity Investments. Established in 1963, the fund’s primary objective is to achieve capital appreciation through investments in common stocks. The fund experienced significant success during the period between 1977 and 1990 when it was managed by Peter Lynch. Under Lynch’s leadership, the fund’s assets under management surged from $18 million to an impressive $14 billion.
Fidelity’s strong performance continued, leading to substantial growth in assets under management, reaching nearly $110 billion by 2000. Due to its substantial size, the fund was closed to new investors in 1997 and remained closed until 2008.
As of March 2022, the Fidelity Magellan Fund holds approximately $28 billion in assets and has been managed by Sammy Simnegar since February 2019. The fund’s performance has closely tracked or slightly exceeded that of the S&P 500 index, showcasing its consistent performance in relation to the broader market
Are Mutual Funds a Safe Investment?
All investments carry inherent risks, including those associated with purchasing securities such as stocks, bonds, or mutual funds. Unlike deposits made in FDIC-insured banks or NCUA-insured credit unions, the funds invested in securities generally do not benefit from federal insurance coverage.
Can Mutual Fund Shares Be Sold at Any Time?
Mutual funds are considered liquid assets and shares can be sold at any time, however, review the fund’s policies regarding exchange fees or redemption fees. There may also be tax implications for capital gains earned with a mutual fund redemption.
What Is a Target Date Mutual Fund?
When individuals invest in a 401(k) or similar retirement savings account, they often consider target-date funds or life-cycle funds as a viable option. These funds are designed to align with a specific target date, typically corresponding to an individual’s anticipated retirement year, such as FUND X 2050. The key feature of these funds is their ability to automatically adjust the investment allocation and risk profile as the target date approaches.
Target-date funds offer a convenient investment strategy by gradually shifting the asset allocation from a more aggressive stance to a more conservative one over time. The intention behind this approach is to reduce the portfolio’s exposure to higher-risk investments as retirement nears, aiming to protect accumulated wealth and potentially provide more stable returns.
These funds employ a systematic process of rebalancing, where the investment manager periodically adjusts the mix of stocks, bonds, and other assets within the fund. This rebalancing ensures that the portfolio remains in line with the target-date fund’s predetermined asset allocation strategy.
As the target date approaches, the fund typically shifts its focus towards capital preservation and income generation rather than aggressive growth. This adjustment is aimed at providing investors with a more stable investment experience and mitigating the potential impact of market volatility as retirement draws nearer.
Investors should be aware that target-date funds, like any investment, carry inherent risks. While they offer a convenient and simplified approach to retirement investing, the performance of these funds is still subject to market conditions and the performance of the underlying assets.
In summary, target-date funds or life-cycle funds are popular choices for individuals investing in retirement savings accounts like a 401(k). These funds automatically adjust their asset allocation and risk profile as the target date approaches, aiming to provide a more conservative investment strategy and potential capital preservation. However, investors should carefully assess the specific fund’s objectives, risks, and performance to ensure it aligns with their individual retirement goals.
