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What are Mutual Funds and Mutual Fund Terms

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what are mutual fundsMutual funds are a big part of our investing landscape, and frequently it is forgotten that not everyone understands these basic investment tools.  Here we take a look at what a mutual fund is so that you can continue learning how to invest without wondering what all these terms mean!

A mutual fund is not an asset itself; instead it is an investment vehicle to hold other assets.  Consider it like a shopping bag, when you go to the store you put your groceries in it to make it easier to get stuff home, but you don’t consider the bag your groceries just the actual stuff inside the bag.  The mutual fund is the bag and the stocks/bonds/etc are the groceries.  The mutual fund simply carries your assets in one place to make it easier to manage.

You pool your money together with other investors into a mutual fund to create a larger pile of money to purchase assets.  A professional manager manages the money and decides where to invest those funds that you put in the bag.  Your share of the gains and losses are distributed proportionality to the amount of money you have invested.

Types of Assets in Mutual Funds:

Mutual funds can hold just about any investment, including bonds, equities, commodities, and money market instruments.  The fund company will let you know  what each fund is intended to invest in so you are not stuck guessing what assets you will be buying.  This information is found in the prospectus and sometimes you can determine that from their name also.  A fund named Andrea’s Growth Stocks you know will invest in stocks that are growing, yet Andrea’s Fund could invest in anything so you would need to check to see if it is bonds, stocks, etc.

Structures of Mutual Funds:

Mutual funds have two legal structures: open ended and closed ended.

Open ended funds have unlimited shares that you can purchase.  You trade directly with the management company for the mutual fund. The fund company may “close” the fund if too much money is coming into the fund for them to manage, but they can reopen it at anytime they feel things are under control.  Even if the fund is closed to new money you can still redeem shares as normal.  This structure allows you to reinvest dividends so that you continue to grow your asset base.

Closed end funds have a set number of shares and you trade the shares on the stock market.  Technically these are not real mutual funds and are a category of their own.  When deciding to purchase these, there are things you take into consideration beyond just what you look at for in mutual funds, stocks, or even ETF’s.  In fact Morningstar has a separate category and screener for these instruments.

The rest of this article focuses only on open ended funds.

Mutual Fund Management Types:

The management team for a mutual fund can either actively select the where the money is invested or they can track an index.

Active management means the fund manager is analyzing and picking individual investments based on the funds goals, category and their own investing guidelines.  They are trying to beat the indexes and the overall market.

Index funds are designed to follow a specific tracking index.  Index examples might be S&P 500, Russell 2000 or the Barclays US Agg Bond.  The fees on index funds are typically lower since the investment decisions are based on allocations to match the chosen index and not on a team of researchers selecting investments.

How are Mutual Funds Priced?

The Net Asset value is what you would pay or receive for buying or selling a share of a mutual fund.  The Net Asset Value is the value of all the investments divided by the number of outstanding shares.  You can only trade shares once the NAV has been calculated for the day.  There is no intra-day trading available like you get with stocks, ETF’s or closed end funds.

At the end of a trading day mutual fund companies calculate their Net Asset Value (NAV) by running the following calculation.  NAV = Total value of all stocks (price of stock at close times shares of stock owned) divided by the number of mutual fund shares.

Example:

Stock 1: Closing Price ($2) times Shares (100) = $200

Stock 2: Closing Price ($4) times Shares (100) = $400

Mutual Fund Shares: 10

So it would look like this:  (100*2)+(100*4)/10 = $60 NAV

Mutual Fund Fees:

Mutual fund companies make money by charging you a fee.  There are a many types of fees that come into play.  Fees can include loads, management fees, marketing fees, and administrative fees.  Loads are taken out either when the money goes in or when it is taken out and is a percentage of the investment.  The other fees are charged on a yearly basis and come out of the proceeds of what the fund makes.

More on the impact of fees on your investments: Mutual Funds and Fees

Why use Mutual Funds:

Diversification – the best benefit of a mutual fund is that you get instant diversification of your money.  If you are just starting to invest by using a mutual fund you will get multiple stocks or bonds.  If you are investing in individual stocks you will not get diversification until you have enough money saved up to allocate over more than a few stocks.  Diversification is very important in minimizing risk in your portfolio.

Professional management – when you use a mutual fund you are paying someone do the investing and research for you.  You don’t have to dig through piles of research and fully understand a company that you are looking to invest in; someone is doing it for you.

Reduced Time – this goes along with the professional management in that you have to spend less time watching over your investments.  You don’t have to constantly stay on top of what individual companies are doing or what is going on in the commodity world.  You are paying someone to free up your investing time.

Reinvest income – to me this is another great benefit that is frequently forgotten about.  You can take the income that you make from the fund and put it right back into the fund to keep growing.  This is compounding at its best.  With a stock that does not have a DRIP program you get the dividends as cash that you then are responsible for getting reinvested.  Same with a bond, if you own it outright then you receive the payment and must manage its reinvestment.  With a mutual fund, you can just have them automatically put it right back in the fund and your money keeps working for you!  “I don’t have time” never becomes a factor in growing your money.

When Not to Use Mutual Funds

Mutual funds are not the right fit for you if you want complete control over what investments you are invested in or you enjoy managing individual investments.  You are not able to control these things with a mutual fund.

To learn more about how to invest in mutual funds check out our series that walks you step by step through the process.  How to Choose Mutual Funds