How Do Mutual Funds Work?

If you’re into investing and want to know more about making money in the markets, you probably have asked yourself at one point this question: “What are mutual funds?” You’re not alone, either; mutual funds easily constitute one of the most popular asset classes for investment in the world.

Here, I will tell you what a mutual fund does, how it works, and talk about the advantages of mutual funds and how they compare to other asset classes.

What is a Mutual Fund?

A mutual fund is a collective investment scheme that takes investment funds from thousands of individual investors and pools mutual fundsit together into a pot of money. This pot is then used by a professional fund manager who uses it to buy and sell shares of stocks – or bonds, or commodities, or commercial notes, or other securities.

Put another way, let’s say you want to invest in real estate. You can pick a single home in a city and purchase it. Or, you could pool your money with your friends and give it to a professional real estate investor, who acts as your manager. The manager then takes that much larger pool of money and buys a residential home or two, plus a couple of apartment buildings, a townhouse, a luxury condo, and a couple of office buildings – all located across the city.

You have just created a mutual fund for real estate. In essence, what you’re doing is multiplying your purchasing power and diversifying your holdings at the same time – all while letting a paid professional do the dirty work of investment for you.

How Are Mutual Funds Valued?

The main way a mutual fund is valued is based off its net asset value(NAV), which is calculated by taking the number of shares of the fund that are out in the market and dividing them into the total value of the fund.

Before we go further, though, it’s important to understand the difference between the two different types of funds: open-end funds and closed-end funds.

An open-end fund is a mutual fund that issues shares based on demand. As long as people want shares of the fund, they will be issued – and as long as people want to sell their shares, the funds will buy them back. Most mutual funds are open-end funds.

A closed-end fund is one in which there is a limited number of shares. These are actually very much like stocks, in that they are traded on stock exchanges, except that these are actively managed by professional advisors.

Since open-end funds are what we think of when we think of “mutual fund”, and are the most common type of mutual funds, we’ll focus on that type. The value of an open-end mutual fund is calculated by dividing the value of the assets held by the mutual fund by the number of shares outstanding (i.e. NAV). NAV changes based on the underlying value of the assets in the fund’s portfolio.

NAV is the price at which you can buy shares of a fund. You profit from a mutual fund either by the difference between your purchase price and the sale price of the shares you buy and sell, respectively, or by dividends generated by the fund.

What Types of Funds Are There?

Within open-end funds, there are several types of mutual funds, including:

  • Stock funds: These are the most common types and feature bundles of stocks either in one industry or sector or spread across several.
  • Corporate bond funds: These are funds that invest in corporate bonds, which have lower returns on average than stocks but aren’t as risky.
  • Government bond funds: These funds invest in bonds and notes issued by governments, including the U.S. Treasury. These tend to be the safest funds in the world.
  • Junk bond funds: Also known as “high-yield bond funds”, junk bond funds invest in bonds that have very high yields, but are very risky – and are more vulnerable to downswings in the economy than other bonds.
  • Municipal bond funds: These funds invest in municipal bonds, which are bonds issued by cities and local/state governments. Income from these funds are tax-free, which means you can generate higher returns than other types of corporate or government bonds.

Within stock funds, there are several types:

  • Value funds: These funds invest in stocks that are determined to be undervalued, i.e. currently priced below what they normally should be as judged by the underlying financial strength of the companies represented. Commonly, these are either companies that have had their stock prices beaten down by the market but otherwise are sound, large, and here to stay, or stocks with low price-to-earnings ratios or price-to-book ratios.
  • Growth funds: These funds invest in stocks that generate higher-than-average earnings and are growing rapidly. You gain more return than with value funds at times, but you also are exposed to more risk.
  • Income funds: These funds invest in stocks that generate income through dividend. If you want steady, fairly-predictable income, these are your best bets. You can have income produced while also enjoying appreciation in your assets.

You can also find blend funds which combine two or more types into one tradable asset.

How Much Does It Cost to Trade Mutual Funds?

Investing in mutual funds does cost money. With stocks, you pay commissions or flat fees. With mutual funds, you also pay management fees and expenses. Trading stocks with discount online brokerages is generally viewed as less expensive than investing in mutual funds.

One way to avoid this is to find no load mutual funds, which are funds that have no transaction costs. Let’s say you have $1,000 to spend. You choose a load mutual fundthat charges a commission of 5%. You will pay $50 either on the front end or out of your profits for this fund, meaning only $950 is actually used (if it’s a front-end fee).

A no load fund would use the entire $1,000 amount. These are typically used because the investment company that owns the mutual fund issues shares directly, instead of going through intermediaries. If you want to avoid paying a broker or advisor who selects mutual funds for you to choose from, no load mutual funds are the way to go.

Generally speaking, it is better to find mutual funds with the lowest fees and expenses possible. Statistical analysis has shown that load mutual funds do not outperform no load mutual funds. In fact, one study has indicated that no load mutual funds actually outperformed load mutual funds from 2000 to 2002.

Why Invest in Mutual Funds?

The main reason most people turn to mutual funds is diversification. To get the same kind of diversification (i.e. risk mitigation) from a single mutual fund, you would typically pay more to get a basket of individual stocks that accomplishes the same thing. Plus, you’d have to keep up with dozens of individual stocks instead of one, convenient investment vehicle – the mutual fund.

Mutual funds are also great if you have no interest in picking stocks or are not good at it – and many traders aren’t. Plus, if you don’t have the time to play the stock market, a mutual fund will more than adequately suffice. Mutual funds, furthermore, are preferable for beginners who want to get into investing but probably shouldn’t jump right into picking stocks and letting the dice fly.

Finally, mutual funds are good for those who want professionals to pick and manage the assets.

Of course, there are three drawbacks to a mutual fund. The first is cost. Mutual funds are more expensive than individual stocks because they incorporate fees and expenses that are more than your typical stock trade commission.

The second drawback is that you lose control over what assets go into your mutual fund, whereas with a stock portfolio you and you alone have control.

Finally, the third drawback is how mutual funds are priced. The price of a stock changes in real time throughout the day. The price of a mutual fund isn’t assessed until the end of the trading day, with the fund’s closing price. This takes away the real-time trading aspect of stocks. One way to avoid this is to consider trading exchange-traded funds (ETFs), which are mutual funds that trade like stocks.

Mutual funds can be powerful assets to have in your portfolio. Ask your financial advisor for more information.

Twitter Digg Delicious Stumbleupon Technorati Facebook Email

About Karl

Connect with me on Google+

No comments yet... Be the first to leave a reply!

Leave a Reply