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Saturday, May 25, 2024

What are mutual funds?

What are mutual funds?

As an investor, you no doubt have an overall objective of building a diverse investment portfolio that lets you reach your current and future financial goals. For many investors, both new and advanced, adding mutual funds to your portfolio is a common option.

While not for everyone, these funds often come with lower risk factors and require a lower-than-average minimal investment. These factors can help encourage new or conservative investors to consider this form of investment.

Before you start investing in these funds, however, it’s important to understand exactly what mutual funds are and how they work. This guide covers mutual funds in detail, provides a look at the different types of funds available, and lists both the potential advantages and disadvantages of this type of investment.

Defining mutual funds

Mutual funds are a type of investment that pools money from numerous shareholders to invest in a variety of securities, such as stocks, bonds and money markets. These funds are an integral part of many investors’ wealth management strategies. These investments are combined into one portfolio, which is managed by a designated portfolio manager. Most investors purchase mutual funds through a brokerage agency, but you can also purchase them directly through the fund.

While fund managers are legally bound to work in the interest of the investors, they must also adhere to the goals and objectives set forth in the mutual funds’ prospectus. Before investing in any mutual fund, it’s important to review the fund’s prospectus – or disclosure document – which provides information about the fund’s goals and objectives and includes other valuable information, like fund disbursement information, the number of shares issued, offering price and any risk factors. The rules also require mutual funds and brokers to provide you with this information free of charge and prior to investing.

Unlike purchasing stock, owners of shares in a mutual fund do not have voting rights. However, when investing in shares of a mutual fund, you’re not investing in just one company but rather a full portfolio of stocks and other securities.

Mutual funds pricing

Mutual funds prices are based on the current performance of the fund. Naturally, those funds that are performing well will have a higher price point than funds that aren’t performing as well. Shares in a mutual fund are typically sold at the Net Asset Value, or NAVPS, amount, which represents the value of the fund per stock.

To calculate the NAVPS, you must divide the combined value of all the investments in the portfolio by the number of outstanding shares. For example, if a mutual fund’s investment portfolio has a value of $1 million and it also has 10,000 outstanding shares, the NAVPS is $100 per share.

$1 million / 10,000 = $100 per share

You can then calculate your investment by multiplying the NAVPS amount by the number of shares you want to purchase. For instance, if you want to purchase 30 shares of the mutual fund used in the example above, your total value would be $3,000 ($100*30).

It’s important to note the NAVPS for mutual funds changes on a daily basis, but it doesn’t fluctuate during market hours. Instead, the value of the fund is calculated daily at the close of the market. Additionally, the IRS taxes profits from mutual funds as a capital gain, which – depending on your income and tax bracket – could help you minimize your tax burden.

How do mutual funds make money?

You can earn money through a mutual fund from dividends on stocks, interest on bonds or through the sale of various securities within the fund. Many funds give investors the option of receiving a cash payout for these profits or reinvesting any proceeds back into the fund. It’s important to read the fund’s prospectus for more information regarding fund distributions. You can also earn money by selling your shares in mutual funds that have increased in value.

The 9 types of mutual funds

One of the prime benefits of investing in mutual funds is the diversification of investment options it offers. While stocks, bonds and money market funds are the top three types of mutual funds1 available, there are a number of various options. For example, here’s a look at the nine types of mutual funds available.

1. Stock funds

Stock funds are probably the most common and well-known mutual fund investment option available. In basic terms, stocks represent part ownership in a specific company. As mentioned above, owning stock through a mutual fund doesn’t give you any voting rights with the company, as does owning individual stocks. This factor is due to the fact that stock funds are not owned by an individual but rather by a group of shareholders.

Typically, mutual funds break stock funds down into different classifications based on the size of the company, its growth potential or its market cap. For example, value funds focus on undervalued stocks that still have potential, while growth funds focus on stocks that are growing faster than industry standards.

Many mutual funds include a variety of different stock options to create a diversified stock portfolio. However, the type and number of stocks included in the mutual fund must also be in alignment with the fund’s goals and objectives.

2. Bond funds

Many investors in mutual funds include bond funds, such as corporate and government bonds, in their overall portfolios because it’s a fixed-income option. This means that shareholders can expect to earn bond interest at a set rate of return on a regular basis. These funds also invest in bonds with the primary purpose of selling them for a profit. Fund managers actively search for undervalued bonds that they believe they can sell later at a higher rate. As with all investments, bond funds are not without risk. First, fluctuating interest rates can impact the value of bonds. Additionally, the value of the bond can decrease, which can result in profit loss.

3. Index funds

Index funds track major market indexes, such as the Dow Jones, Nasdaq 100 and S&P 500. These funds typically come with a lower risk factor due to diversification. These funds also often have lower administrative fees because it requires less research and fund management.

4. Balance funds

Many investors refer to balance funds as hybrid funds because they combine investments of two or more fund categories, such as stocks, bonds and money markets. The goal of balance funds is to minimize the risk factor by spreading investments over multiple types. Some balance funds have a fixed allocation strategy that fund managers must adhere to, but other funds allow the portfolio manager to adjust the ratio of investments in the balance funds to provide the highest returns for clients.

5. Money market funds

Money market funds invest in short-term debt securities, such as term certificates of deposit and treasury bills. These investment options come with a guaranteed principal, which is very appealing to some investors. However, returns on money market funds are often not nearly as substantial as other investment options.

6. Income funds

Income funds are an ideal option for conservative investors, such as new investors and seniors, who prioritize short-term versus long-term gains. These funds include government and quality corporate debt. Once these bonds reach maturity, they can provide investors with a steady stream of income for a set number of years.

7. International/global funds

International and global funds are those related to investments held outside the United States. These funds come with added risks that are based on the economic and political landscape of the location of the investment. On the other hand, international funds can help investors build a robust investment portfolio that is outside the limits of the economic and political landscape of the United States.

8. Specialty funds

Specialty funds include investments and securities that are related to a specific sector, region or purpose, such as socially responsible funds. Investing solely in specialty funds can increase your risk factor. For example, if a specific sector or investment begins to decrease in value, the value of the entire fund is likely to fall because all investments are in just one specific area.

9. Exchange-traded funds (ETFs)

ETFs are not technically mutual funds, but they do have some similar qualities. Like mutual funds, ETFs combine a variety of investments into one. Unlike mutual funds, ETFs can be traded throughout the day, which means the value can fluctuate significantly. ETFs also come with a higher risk factor than some other mutual fund options but can be a great addition to any investor's portfolio.  

Fees when investing in mutual funds

There are a number of fees associated with managing mutual funds, including:

  • Operating fees: Operating fees, also referred to as management fees, are paid to the mutual fund manager out of the mutual funds. These fees cover research and administrative costs incurred by the fund manager.
  • Distribution fees: Distribution fees cover the costs of distributing funds to shareholders. These fees are also known as 12b-1 fees, due to the SEC rules that allow mutual fund companies and brokers to collect these fees upon the withdrawal of funds. It’s important to note that not all funds and brokers charge these fees.
  • Sales load fees: When working through a broker, you typically incur sales load fees when purchasing and selling securities. Some mutual fund companies also charge these fees. There are two primary types of sales load fees, including front-end load fees, which you incur when purchasing a security, and back-end load fees, which you incur when selling the security.
  • Redemption fees: Redemption fees are additional costs that you may incur when selling a security. Unlike sales load fees that go directly to the broker, redemption fees go to the mutual fund.
  • Exchange fees: Some funds also charge exchange fees when shareholders make transfers between funds.
  • Purchase Fees: Just as with the redemption fees, you may incur purchase fees when buying securities. These fees go directly to the fund.

Advantages of mutual funds

There are a variety of reasons why you may want to add mutual funds to your overall investment portfolio.

Professional management

One of the advantages of investing in mutual funds is that you have a professional advisor managing these funds. These fund managers use their investment expertise and analytical data to determine which securities to add to the mutual fund portfolio as well as when to sell these securities to provide the greatest benefit to the investors.

By law, these managers must make investment decisions that are in the interests of their investors, so you can feel secure in knowing that they will manage your investment as well as they can. This makes mutual funds a great option for new investors and investors who lack the time or ability to track and manage their investments on their own.

Liquidity

While mutual funds don’t come without risks, they are liquid investments. This means that you can sell your investment in any mutual fund at any time. Of course, because mutual funds aren’t sold during stock market hours, you will need to wait until the market closes to sell your stock. This level of liquidity gives you instant access to your cash funds if you need them.

Minimal investment requirement

Unlike some investment options, you can typically invest in mutual funds with very little upfront investment. While the typical minimum investment requirement is around $2,500, some funds allow investors to participate with as little as $100. These low minimal requirements are possible because investors pool their money together to invest in these funds.

Disadvantages of mutual funds

Clearly, there are numerous benefits to investing in mutual funds. However, before you make your final decision as to whether to invest in these funds or not, it’s important to also understand the various disadvantages of investing in mutual funds.

Variety of fees

One of the clear disadvantages of investing in mutual funds is the number of fees involved in managing, trading, buying and selling securities in the fund. These fees can eat away at your overall earnings and should be considered when choosing a mutual fund to invest in. It’s important to carefully review the portfolio’s prospectus and other documentation to understand exactly what fees are involved in managing the fund. Comparing these fees within different plans can help you determine which options are right for you.

Lack of transparency

Once you choose a mutual fund to invest in, you have no control over what investments the fund manager chooses to purchase or sell in the portfolio. Instead, you put your trust in the fund manager to make investment decisions that are in your interests. Because these investments can change on a daily basis, you have limited access to see exactly what securities are a part of your investment portfolio at any given time.

High costs

If you’re not careful about which mutual funds to invest in, you could incur a high expense ratio, which results in lower profits. When comparing funds, try to find a mutual fund that has a 1% expense ratio or lower. You should also be leery of mutual funds that implement sales charges or 12b-1 fees. Not all funds have these additional fees, so you may be able to save some costs by choosing a fund that doesn’t have these charges.

Our take

Mutual funds are a good investment for some investors and can be an ideal addition to your overall portfolio. Due to the number of differences between various mutual funds that can impact your returns, you may want to consider consulting a financial professional before making this type of investment. An expert can examine your specific situation and review your overall financial goals and objectives to help you determine which mutual funds are right for you.

1 SEC, “Mutual funds and ETFs: A Guide for Investors.”

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Alex Graesser, CFP®, ChFC®

Contributor

Alex Graesser is a Senior Financial Professional at Empower. A Certified Financial Planner (CFP®) professional and Chartered Financial Consultant (ChFC®), he is responsible for developing enduring relationships with his clients by providing expert guidance for a lifetime of financial security.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. No part of this blog, nor the links contained therein is a solicitation or offer to sell securities. Compensation for freelance contributions not to exceed $1,250. Third-party data is obtained from sources believed to be reliable; however, Empower cannot guarantee the accuracy, timeliness, completeness or fitness of this data for any particular purpose. Third-party links are provided solely as a convenience and do not imply an affiliation, endorsement or approval by Empower of the contents on such third-party websites. 

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