How Do Mutual Funds Work?

Posted on Friday, December 21st, 2018 MarketBeat Staff

Summary - Mutual funds are investment instruments that allow a variety of securities from a particular asset class to be combined into a portfolio, which is typically referred to as a fund family. There are more mutual funds than there are individual stocks. A mutual fund investment can take many forms including stock funds, bond funds, and money market funds). Investors can even get a more curated investment by choosing funds that target their investment objective or risk profile. Some investors like to invest in mutual funds that target industries in which they have some expertise. Others may choose to look at companies that have a similar market capitalization. Mutual funds are actively managed which means, unlike an index fund or exchange-traded fund, they employ a fund manager who is in charge of selecting and trading the securities that are in the fund. While the idea of a fund manager may theoretically enhance a fund’s performance, every investor should take care to read the prospectus for a fund carefully. In addition to professional management, the primary benefits to owning a mutual fund are diversification, minimum (and in many cases no) initial purchase requirements,  the ability to make small transactions, the ability to automatically reinvest earnings back into the fund, and the ease in which shares can be bought and sold.

The key metric for determining a fund’s performance, and benefit to an investor, is its total return. Different funds charge different management fees, advertising and marketing fees (known as 12b-1 fees) and have varying expense ratios. All of these can eat into a potential return and should be looked at closely. Although no-load funds are very common and are usually the best bet for most investors, some fund families only offer funds that charge a sales load (i.e. a sales charge) that is either paid for at the time the shares are purchased (called a front-end load) or when the shares are redeemed (a back-end load).

Introduction

Mutual funds are sort of like having a personal shopper. For people that don’t like the hassle of going to stores in search of the perfect item or maybe feel that they lack the discipline or knowledge to be a good shopper, the personal shopper takes care of all of that. They do the searching for you, they find the best deals for your budget and your tastes and bring the items to you. In investing, mutual funds play a similar role. Many investors lack the time or the expertise that investing in individual stock or bond offerings requires. Investing in mutual funds gives them access to professional portfolio management by experts who choose which funds will help an investor best meet their investment goals and match their risk tolerance.

Although a relatively new investment instrument, mutual funds outnumber individual stocks in terms of selection. Funds are divided into many categories including by sector (technology, energy, biotech, etc.), by investment objective (aggressive growth, growth, growth and income, etc.), by company size (i.e. market capitalization), and by fund type (balanced funds, equity funds, growth funds, etc.). This is another reason that many investors, particularly more inexperienced investors prefer to work with mutual funds because – in many cases – they can provide professional portfolio management to help ensure proper fund selection.

In this article, we’ll break down mutual funds including answering questions like how they work, how safe they are, what are the benefits of owning mutual funds and how mutual funds are similar to and different from owning stocks?

What are mutual funds?

Every mutual fund is a company that combines money from multiple investors and invests those funds into securities that are dictated by the fund’s prospectus. For example, some mutual funds are exclusive to stocks, others to bonds, others to U.S. Treasuries, etc. The total money invested in the fund (i.e. the combined holdings from every investor) is known as the fund’s portfolio.

How do mutual funds work?

Mutual funds work essentially the same way as buying shares of stock. When an investor purchases a share of stock, they are buying a piece of the underlying company. That’s why a mutual fund is a company. When an investor buys into a mutual fund, they are buying shares of that company and – like ownership in stock – they are entitled to their portion of the income it generates. They also assume the risk that comes should the portfolio decrease in value. Just like investing in stocks, investing in mutual funds carries a potential risk of losing money in the fund.

Mutual funds are different from index funds or exchange-traded funds (ETFs) in that they are actively managed funds. This means that there is a fund manager who is involved with actively picking and trading the stocks that are included in the fund. This means that every mutual fund will involve fees of some sort to compensate those managers. We’ll review the fees a little later in the section titled “What costs come with a mutual fund?”

What is a good rate of return for a mutual fund?

For mutual fund investors, the most important metric for determining the success of one fund over another is its total return. Total return is simply the total wealth generated by an initial investment over the length of time you are measuring. Total return includes not only appreciation in share value but dividends and interest as well as capital gains distributions and securities that the fund sells for a profit. It’s important to understand total return because it will be different for every investor.

Investors can look online to get a quote for their mutual fund’s price. However, the price that’s shown is only for a moment in time. It may be helpful to give a general sense of what direction the fund is moving in, but it’s only one piece of the total return equation.

For example, if an investor were to purchase shares in the ABC fund at a cost of $10 share and six months later, the fund’s share price has grown to $15 per share. The fund’s management decides to sell some of the underlying stocks for a profit and give back to its shareholders $5 per share. They do this to keep the net asset value of the fund at $10 (they want to attract other investors). But investors are left with the choice to take the $5 per share as a cash distribution or to re-invest it in the fund.

To see why that decision is important to understanding a fund’s total return, let’s say the fund continues to increase in value. A year after the initial purchase, shares in the ABC fund are up to $20 per share. That would be a 100% increase, but only if you don’t count the $5 per share distribution. But as part of the fund’s total return you have to. So that means the funds has actually grown from $10 to $25 – a total return of $150%. The fund would calculate its total return with the assumption that every investor reinvested the $5 per share distribution. This means that for every share that was purchased at $10, they received an extra one-half share. If individual shares are worth $20 at the end of the year, 1 ½ shares would be worth $30 which represents a $200 total return on the original $10 investment.

How much risk is involved with investing in mutual funds?

Mutual funds are generally considered to be less risky than individual stocks because they divide the risk of any one stock into dozens or hundreds of similar stocks. However, no mutual fund is without risk. Every mutual fund, like a stock, is assigned a beta value. The beta is a measure of how volatile the fund is when compared to the market as a whole. A fund with a beta of 1 will be expected to perform in a very close correlation to the overall market. In attempting to assess the risk associated in a fund, investors can look at a separate volatility index that ranks stocks on a scale of 1-9. In this case, a rating of 9 (which is rare) would indicate the highest risk.  A rating of 5 indicates average risk.

What are the benefits of mutual funds?

They offer expert professional management – The management structure of every mutual fund company includes the hiring of experts who make investment decisions for the fund. This is what makes mutual funds an ideal option for new investors who may be uncertain about their ability to select individual securities. In exchange for this expertise, there is a management fee associated with every mutual fund. We’ll review a little later when we look at the costs associated with mutual funds.

  • They provide diversification – Diversification is fundamental to a successful portfolio because it spreads the risk associated with a single security. Mutual funds, by definition, do this automatically because an investor buys ownership into all the securities that make up the fund. The idea is, of course, that while some securities are declining, there are more than enough that are rising to act as an offset. This is a feature of mutual funds that make them particularly attractive to investors in employer-sponsored retirement plans such as a 401(k). Many of these investors only have modest amounts of money to put at risk and mutual funds can be a good way of managing that risk – even if they choose an aggressive fund.
  • They are easy to buy and sell – With electronic trading, it’s easier than ever for individual investors to buy and sell shares in mutual funds, and securities law requires funds to buy back shares when you want to sell them. Most funds are called open-end funds which means that new shares are regularly being issued and old ones are being bought back. Closed-end funds by contract are more like an initial public offering (IPO) in that a fixed number of shares are offered and they are usually not bought back. For the most part, investors will purchase shares based on the Net Asset Value (NAV) price at the close of trading on the day the order is placed. This is one of the risks associated with buying mutual funds. If an investor is looking to trade out of a volatile fund, they may receive far less for their shares than they were expecting. On the other hand, they could wind up paying a higher price (and therefore receiving fewer shares) than they were expecting.
  • They allow small minimum purchases – When an investor buys stocks, they typically are required to do so in blocks of 100 shares. That can make purchasing shares of a stock like Facebook or Google out of the reach of most individual investors. However, with a mutual fund you can invest far less. Some funds have no minimum initial investment requirement and others will only charge a modest amount. Once an investor is in the fund, they can invest very small amounts. That’s another reason these investments are popular for employer-sponsored retirement plans. For as little as 1% of their net income, they can buy shares every pay period and get the benefits of dollar-cost averaging.
  • Earnings are automatically reinvested – A mutual fund generates earnings from events such as a stock paying a dividend, a bond receiving interest or a fund recording a capital gain because they sell shares. When this happens, mutual fund investors can choose to have those earning reinvested to buy more shares automatically. Reinvested earnings can be an important factor in the growth of a long-term investment plan.

What costs come with a mutual fund?

A mutual fund is only going to be as successful as the knowledge and expertise of the fund managers who select and manage the securities. But this experience comes with a cost – actually several costs. As an investor, it’s important to understand the different costs and how they affect the fund’s performance and your total return.

Sales charges– this is commonly referred to as a fund being a load or no-load fund. Load funds are sold through a broker or investment advisor and charge investors a commission every time shares are purchased. No-load funds can be purchased directly from the fund company and don’t charge a commission. Some people will argue that investors should never buy a fund that charges a load. However, not all funds are managed in the same way. If the total return of a load fund exceeds that of a similar no-load fund, it may be a prudent investment. However, in general, it is best to choose a no-load fund. Whether a fund is a load or no-load fund does not have any bearing on how the stocks are selected. That expertise is paid for through a management fee (that we’ll describe a little later).

Loads take many forms. Front-end loads are paid up-front. These are often charged on a sliding scale depending on how much money is being invested. An investment of $1,000 that carries a load of 5.75% would mean that only $942.50 would be allocated towards buying shares in the fund. That means that of the dollars that actually went towards buying shares, an investor has paid a 6.1% commission. If an investor’s primary interest is growth, they may be better off with a front-load fund because they will pay a smaller amount on the front end.

Back-end loads which are sometimes called redemption fees are sales charges that are taken out when shares are redeemed. This means that an investor will have less profit or a greater loss should they need to sell shares. Income investors may prefer a back-end load because more of their initial investment goes to work earning interest and rear-end loads tend to be slightly less than front-end loads.

Some funds may charge deferred loads which act as a contingency to discourage investors from jumping in and out of funds.  A deferred load will reduce in value provided investors hold shares in a fund for a specified period of time.

Management Fees– these are the fees that an investor pays to compensate the managers and take care of other fund management costs. Whereas a sales charge is often avoidable, a management fee is not. A typical fee may be one-half to one percent of a fund’s assets. In many cases, this fee is based on a sliding scale, so the more an investor contributes and keeps in a fund, the lower the fee will be. When you consider that a 0.5% fee on a $50,000 portfolio is $250, these fees can eat into a fund’s total return quickly.

Marketing Fees– these are fees, called 12b-1 fees, that are associated with the advertising and marketing of a fund. These funds have come into question in recent years and some funds have eliminated them while others have greatly reduced them.

Expense Ratios– these represent the cost of operating the fund and is expressed as a percentage of the fund’s assets. An expense ratio will include 12b-1 fees and management fees, but it does not include sales charges. These expenses are subtracted from the fund’s net assets and then factored into the percentage gain or loss reported by the funds. The higher the ratio, the less money the fund has left to pay its shareholders from its earnings.

The bottom line on mutual funds

Mutual funds are a popular investment for investors of all risk profiles and income levels. One of the reasons for this is that, while everyone has a common objective to make money from their investments, many investors lack the time or the inclination to pick their own stocks and read the prospectus for each individual stock. Investing in mutual funds gives them the ability to have a series of securities selected and managed by investment professionals.

When selecting a mutual fund, investors should ask the following questions to decide on which fund is right for them.

Does the fund’s investment objective match mine? For example, if an investor is looking for aggressive growth, they would want to avoid income funds that would provide more conservative investments.

Does the fund have a good performance record? Investors should be looking at not only how the fund performs against the overall market, but how it performs against similar funds. Total return is the metric that is considered the most important.

How risky is the fund? No fund is without risk but looking at a fund’s beta score or volatility ranking can help match a fund to an investor’s risk level.

Does the fund charge a load? And if it does what kind is it? In general, investors should avoid funds that have loads, but some can provide exceptional returns.

What is the fund’s expense ratio? A fund’s earnings ratio show what percentage of potential earnings will get absorbed by the costs of running the fund. This is more important for bond and money-market funds.

Overall, investing in mutual funds is a safe way for many investors – particularly those that are new to investing – to develop good investing habits.

Enter your email address below to receive a concise daily summary of analysts' upgrades, downgrades and new coverage with MarketBeat.com's FREE daily email newsletter.

Yahoo Gemini Pixel