What are Mutual Funds?
Many people realize there’s a way to get what they want—but can’t get on their own—simply by pooling resources with other like-minded people. For this reason, vacation time-shares have become popular with travelers and, now, even "toy-shares" exist for those who don’t want to foot the whole cost of various recreational vehicles.
Similar to time-shares or toy-shares, mutual funds make it possible for an individual to invest in assets that were once only available to the wealthy. Mutual funds are shared pools of money from many investors used to purchase a specific mix of investments. Today, investors can choose from a wide selection of readily available funds from different fund families, a far cry from when the first mutual funds were organized during the 1920s. Nearly every available asset class has one or more corresponding mutual funds—stocks, bonds, real estate, commodities—you name it. Want to purchase a portion of every stock in the S&P 500? Not a problem. Mutual Funds allow you to broadly diversify your account instantly even if you normally could not afford to do so.
What exactly is a mutual fund?
Each mutual fund investor receives "shares" of the pooled money. The value of each share is based on the collective value of the individual assets owned by the fund. At the end of each day, each fund’s shares are given a net asset value, or NAV. Think of the NAV as the price or value of a mutual fund. Of course, the idea is to purchase funds that are expected to rise in value.
There are three primary types of mutual funds: open-end, closed-end and exchange-traded funds (ETFs). Open-end funds are purchased from a fund company. There is no limit on the number of shares outstanding and they are given a price at the end of each day.
Closed-end funds issue a limited number of shares that trade like stocks. Instead of dealing with a fund company, investors can trade closed-end fund shares with other investors just as they would with stocks.
ETFs are technically classified as open-end funds, but they are traded like shares of stock and prices are determined during the buy/sell process.
How do mutual funds gain value?
Profiting from a mutual fund is much like owning a stock and offers value in a few different ways. By selling mutual fund shares at a higher NAV price than their purchase price, a profit—or capital gain—is realized. Also, when the fund manager decides to sell one of the fund’s individual holdings at a profit, that money is distributed to shareholders. It is also required that dividend earnings from the fund’s holdings are to be passed on to shareholders. You can receive those payments in cash or use the money to buy additional shares of the fund.
When considering a fund’s history know how profits are calculated. The performance of an individual mutual fund is measured by any gain or decline in share price, and assumes the reinvestment of income dividends and capital gains distributions.
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Why invest in mutual funds?
Diversification is probably the most common reason for investing in mutual funds. By spreading your capital over dozens of investments, a mutual fund can diversify its holdings and avoid the risks associated with purchasing a single security. The individual investor typically can’t afford to diversify as well as mutual funds do. And, even if possible; the fees for buying and selling dozens or hundreds of individual investments would be substantial.
Another common reason investors choose mutual funds is for access to a professional fund manager. Making decisions every day for each investment or future investment in a fund, the fund manager is dedicated to understanding all aspects of each managed fund. Decisions are based on extensive, ongoing research and analysis of economic factors, individual companies and current issues. Mutual fund managers work to determine which investments they believe will outperform in the near and distant future. They then adjust the fund’s positions to accommodate for changing conditions.
Mutual funds are also largely selected for their transparency and convenience. Not only is it easy to see exactly where your money is going, but a fund’s past performance is also audited for accuracy. Mutual funds offer a wide variety of choices to fit each investor’s objectives. It’s just a matter of finding the right one for you.
How do you select a mutual fund?
With mutual funds, it is common to have a mixture of stocks and bonds, large-cap and small-cap companies, and domestic and international holdings. Be sure to check each fund’s top holdings to avoid too much overlap of the same investments.
Once you’ve determined your allocation, it’s time to look at the past performance of the fund and its manager. Don’t just pick funds with the highest annual returns in previous years. It is possible for results to be skewed by one extraordinarily successful or volatile year. Look for a fund that performs better than its index a majority of the time. Also, consider how funds have performed during bad years. Many funds will do well during good times, but fail miserably in a bear market. Stick with funds that have profited, held steady, or even lost less in bad years. While past performance is helpful to keep in mind, remember that it is not indicative of future performance.
Don’t forget to consider fees. The benefits of a mutual fund come with some costs. There can be a sales charge, or commission, for the advisor and broker who sell you the fund (load funds). Generally, you should always choose a no-load fund over a fund that charges a load, or a commission, to the broker or financial advisor. Management fees are also common and typically range from .25 percent to 1.5 percent.
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While no one likes to pay fees, some extra expense may be worthwhile if a fund consistently generates returns above those by its competition. When selecting a mutual fund, keep in mind its past performance. And, equally important, its fund manager’s past performance. Yet, again, although past performance is important to consider, it is not a guarantee of future performance.
Ask for help if you need it. Schedule an appointment with your investment advisor and cover any questions you may have.
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What to do next
- Consider what you would gain from investing in a mutual fund and whether it makes sense for you.
- When choosing a mutual fund, first determine your asset allocation.
- Don’t forget to consider fees—know the ‘what’ and the ‘why’ of what you’re paying.
- Ask questions and seek answers. Schedule an appointment to sit down with your investment advisor to find the answers to all of your questions.