The role mutual funds play in the financial industry has increased drastically over the years. Between 2011 and 2020, the number of open-ended funds in the United States increased by 40%. But what exactly is a mutual fund?
In simple terms, it’s a giant pool of capital sourced from hundreds or even thousands of different investors. An investment manager then invests this money into various types of financial assets to establish a winning diversified portfolio.
Some of the most prominent asset managers in the world include BlackRock, Vanguard, and State Street Global Advisors.
How do mutual funds work?
Investors in a mutual fund buy shares similar to investing in stocks. As usual, these shares represent an investor’s claim over the pool of capital. Therefore, the more shares someone owns, the larger their claim.
Unlike buying and selling stocks, mutual fund shares are purchased and sold directly from and to the issuing fund rather than from another investor. The money used to purchase shares is added directly to the fund’s pool of available capital. Similarly, the money is taken out of the capital pool when shares are sold.
Fund managers usually leave a certain percentage of the fund’s available capital as cash to return to investors selling their shares. However, suppose a large number of investors decide to sell. In that case, the fund manager may be forced to sell some of the investment positions inside the fund’s portfolio to satisfy investor orders.
The share price of a mutual fund is not based on market capitalisation but rather on the Net Asset Value (NAV). This is equal to the total value of all the securities and cash inside the fund divided by the total number of shares outstanding.
Because buy and sell orders for mutual fund shares are processed at the end of a trading day, the NAV, and therefore share price, is updated only once per day.
Using the collective resources of all shareholders who bought shares, a fund manager invests in a diverse range of financial assets and instruments to build a portfolio. But typically, bonds and stocks are the popular choices.
Mutual funds are often placed into one of two groups:
- Active – This type is actively managed by the fund manager in an attempt to outperform a benchmark index such as the FTSE 100 or S&P 500.
- Passive – Unlike active funds, passive funds managers aim to reproduce the performance of an underlying benchmark index.
What are the different types of mutual funds?
There are multiple different types of mutual funds to cater to almost every type of investor. And each usually offers an active and passive variant.
A stock fund is also known as an equity fund, and as the name implies, these invest exclusively in equities. Each fund usually lays out a specific strategy that the fund manager will follow. For example, a large-cap stock fund will focus only on large-cap stocks. Similarly, an income stock fund will only invest in companies that provide ample dividends.
Some examples of stock funds include:
- Fidelity ZERO Large Cap Index (FNILX)
- Schwab S&P 500 Index Fund (SWPPX)
- Shelton NASDAQ-100 Index Direct (NASDX)
- Halifax UK FTSE 100 Index Tracking Fund (GB0001359685)
A bond fund is also known as a debt fund. This type of mutual fund is principally invested in various kinds of bonds, including government, municipal, corporate, and sometimes convertible.
The investment manager may also explore more unique debt instruments, such as mortgage-backed securities. However, the ultimate goal is typically to generate a reliable and consistent monthly income for investors. These are typically lower risk than stock funds.
Some examples of bond funds include:
- Lord Abbett Income Fund (LAGVX)
- Calvert Income Fund (CFICX)
- Invesco Corporate Bond Fund (ACCBX)
A balanced fund is a type of mutual fund that invests in both stocks and bonds. It serves as an easy way for investors to gain exposure to both the stock market and bond market in a single investment.
The balance between debt and equity is not always 50/50. Depending on the strategy outlined by the fund manager, the balance could be more aggressive with a higher concentration of stocks or vice versa.
Some examples of balanced funds include:
- Fidelity Balanced Fund (FBALX)
- Vanguard Balanced Index Fund Admiral Shares (VBIAX)
- T. Rowe Price Balanced Fund (RPBAX)
Money Market Funds
Money market funds are a special type of bond fund. The fund manager focuses exclusively on short-lived debt instruments. These are typically assets with a very short maturity date, such as Treasure Bills, Commercial Papers, and Certificates of Deposits.
The returns generated on these types of investments are typically relatively low. However, the performance is usually slightly ahead of the interest offered by depositing money in a bank. And due to the highly liquid nature of these debt instruments and their low risk, it is an ideal temporary parking spot for investors with lots of cash.
Some examples of money market funds include:
- Fidelity Money Market Fund (SPRXX)
- Vanguard Federal Money Market Fund (VMFXX)
Target Date Funds
Target date funds are popular amongst investors seeking to build a nest egg for retirement or saving for a large expense in the future. With this type of mutual fund, the manager is usually free to explore any kind of financial instrument to maximise investor returns by a specific date.
Some examples include:
- BlackRock LifePath® Index Retirement Fund (LIRAX)
- Fidelity Freedom® Income Fund (FHAHX)
What are the advantages of mutual funds?
Mutual funds are a popular investment vehicle due to their convenience and ability to offload the investing process to a professional.
The main advantages of investing in a mutual fund are:
- Instant diversification – Each type of mutual fund has a diverse investment portfolio in which investors can buy a piece within a single transaction. While it’s possible for an investor to manually diversify their portfolio by investing in the various financial instruments directly, this would rack up considerably more commission fees on each transaction.
- Gain a professionally managed portfolio – Professionals manage these funds. And for investors with little experience, investing in a mutual fund allows a professional to handle all investment decisions more cost-effectively than hiring a personal investment manager.
- Investments are put on autopilot – Because the fund manager makes all the decisions, shareholders in a mutual fund do not have to perform any research or portfolio rebalancing. It essentially puts investments on autopilot.
What are the disadvantages of mutual funds?
While mutual funds provide a lot of benefits, they do have their drawbacks as well. Just like any investment, there is no guarantee of positive returns and the fund manager may not be as talented as initially anticipated.
The main disadvantages of investing in a mutual fund are:
- Zero control over decision-making – Having investments managed by a professional can be a blessing and a curse. Investors have no say in where their capital gets put to work. And there is no guarantee that it will be invested in areas that match the investor’s values. For example, someone who doesn’t like tobacco stocks may end up owning shares through a mutual fund without realising it.
- Fees can be expensive – Mutual funds charge various management fees that are used as compensation for the fund manager and their team. While passive funds are usually low-cost, active funds can get quite expensive. And even if terrific performance is delivered, the net gains on an investment may be mediocre after fees are considered.
- Performance can be disappointing – Even with a professional at the helm, there is no guarantee that the fund manager will be able to deliver on expectations. Most active mutual funds fail to deliver consistent market-beating returns. And if an investment manager makes a series of poor decisions, shareholders may lose money rather than gain it.
What factors should I consider before investing in mutual funds?
When deciding whether to invest in a mutual fund, there are a few things investors should consider.
What are the fees for mutual funds?
The fee structure for each mutual fund is different. And some are more expensive than others. Beyond an annual management fee, there can be additional costs, such as an entry fee to pay when buying shares and an exit fee when selling shares.
In other words, investors could be charged money for withdrawing their money. Therefore it’s paramount to understand precisely how much an investment in a mutual fund actually costs and whether the price is worth the potential reward.
How much money do you need for a mutual fund?
In many cases, mutual funds do not require a minimum investment. And the few that do often set the threshold relatively low at around £100 or £500. Of course, there are exceptions, and minimum investment thresholds can extend to £10,000 or even higher.
Can you lose money in mutual funds?
As with any investment, there is no guarantee of positive returns. Buying shares in a historically well-performing mutual fund does not mean it will continue to deliver good returns in the future. Therefore, it’s entirely possible for an investor to lose money in a mutual fund.
Do you have to pay taxes on mutual funds?
Capital gains and dividends received through a mutual fund are subject to standard capital gains and dividend taxes when held inside a standard investment account. However, British investors can bypass these expenses by using a tax-efficient account like a Stocks and Shares ISA or Self-Invested Personal Pension (SIPP).
The bottom line
Today there are over 450 listed investment funds with over $320bn in market capitalisation in the United Kingdom on the London Stock Exchange alone. Needless to say, mutual funds make up a large portion of the financial markets. And given their popularity, this shouldn’t be a surprise.
Mutual funds make it easy for investors to gain a diversified portfolio. And since investments are handled by a professional, investors aren’t required to understand the intricate details of the financial instruments a fund is investing in. This makes them incredibly beginner friendly.
Having said that, investors still need to take precautions and research a mutual fund and its manager before buying any shares.
Continue Reading: How to invest in mutual funds
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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.
Prosper Ambaka does not have a position in any of the financial instruments mentioned in this article. The Money Cog does not have a position in any of the financial instruments mentioned in this article.