How Do Mutual Funds Work

Guide Note: Mutual funds are not for thrill-seekers, but in general, they are a way to slowly and steadily increase your wealth. This page explains why they can be such a secure investment and covers some basic lingo you'll need to know before choosing among the thousands of funds on the market. Read it and you may never again wonder, How do Mutual Funds Work?

Disclaimer: The content of this page is intended for general informational purposes only and is not a substitute for professional financial advice. Table of Contents:

Introduction

  • If you view the stock market as one big, international casino, where you play the right slot and get rich quick, you're better off investing in the wild and unpredictable futures market than in mutual funds. Mutual funds are some of the most cautious, conservative investments you can make. If you're looking to grow your assets slowly, surely and unexcitingly, mutual funds may be your best bet. Read on to find out how they work and how to choose and invest in them.

What is a Mutual Fund?

A good mutual fund will deposit your eggs in the right baskets. (Creative Commons photo by Hannah McIntyre)
A good mutual fund will deposit your eggs in the right baskets. (Creative Commons photo by Hannah McIntyre)
  • No doubt you've heard the adage, Don't put all your eggs in one basket. In investment, this rule is called diversification: putting your eggs (dollars) in a number of different baskets (stocks, bonds, money market accounts) in order to minimize risk, while maximizing profit. A mutual fund is a bundle of investments that—in theory—represents the best baskets: the ones that will keep your eggs safe, while giving them the room they need to hatch and grow. But that's more or less where the chicken metaphor ends. Here's how it works:
  1. You buy shares in a mutual fund, either directly from the company that administers the fund, or through a broker who in turn passes on your money to the company.
  2. Your money is combined with those of hundreds, or thousands, of other investors.
  3. The pool of money is invested in an array of different securities, depending on the specific mutual fund.
    • The fund may invest in stocks, bonds, money market accounts, futures, currencies, or even other mutual funds, targeting one area of the economy, or spread throughout.
    • Most mutual funds are administered by a fund manager who decides what and when to buy and sell.
  4. You have no say in matters of the fund's day-to-day management. However, you may choose to remove all your money from a fund and end your participation.
    • Many companies administer funds in fund families. A fund family is a range of funds from which to choose, with different holdings and varying levels of risk. If you remove your money from a fund, you'd have the convenience of simply transferring to another within the same family.
  5. It's the fund manager's job to maximize the earnings of the fund's investors, but they often don't succeed.
  6. As the fund earns money, you are paid in periodic dividends, which you may choose either to keep or to reinvest into the fund.
  7. Unlike with stocks, the official value of a share in a mutual fund does not change moment-to-moment, throughout the day. Instead, the net asset value (NAV) per share is calculated and posted once a day, usually at 4 p.m. EST.

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Types of Funds

  • Mutual funds are categorized under several headings, some of which overlap. Before you choose a mutual fund, you should know the meaning of each.
When the stock market starts looking like a casino, consider mutual funds. (Creative Commons photo by lasky_michael)
When the stock market starts looking like a casino, consider mutual funds. (Creative Commons photo by lasky_michael)

Stock Funds

  • Stock funds, which are sometimes also called equity funds, are mutual funds that invest in stocks.
  1. Because they invest in the stock market, stock funds are subject to the same market risks. (For example, if the stock market crashes, so will your investment) Because they are diversified, however, they are theoretically safer than an investment in a single stock.
  2. Though riskier than most other kinds of mutual funds, stock funds may also yield a higher return on your investment.
  3. Two categories of stock funds are growth funds and value funds.
    • Growth funds invest in fast-growing companies and are considered above-average risk compared to funds with other kinds of holdings.
    • Value funds invest in companies that analysts consider to be undervalued: in other words, companies believed to be worth more than they are currently trading on the stock market. Undervalued stocks often represent successful companies caught up in a bad economy: when the market corrects itelf, so will the stock.
  4. Another subcategory of stock funds is the cap. Individual mutual funds are referred to as small-cap, medium-cap, large-cap or mixed cap. These terms refer to the size of the companies in which the fund invests. Conventional wisdom is that large-cap funds are more secure long-term investments. For example:
    • Royce Value Plus Service (RYVPX) is a small cap fund. Its top holding is in a company called Agnico-Eagle Mines—not exactly a major corporation.
    • T. Rowe Price Blue Chip Growth (TRBCX), by contrast, is a large-cap fund whose chief holdings holdings include General Electric and Microsoft.

Index Funds

  • The index fund is technically a kind of stock fund, but distinct enough to warrant its own category. As opposed to the typical "managed" fund (guided by a fund manager), an index fund is a kind of passive mutual fund that's barely managed at all. In the name of diversification, the company that administers it simply buys an equal holding of every stock on a certain market index.
  1. A market index, such as the Dow Jones Industrial Average, or the S&P 500, is a kind of Nielsen Ratings for stock markets that samples a particular array of stocks to reflect the performance of a certain sector of the economy or an individual stock exchange.
  2. Index funds that invest in the S&P 500 index actually outperform 75% of managed funds.
  3. Index funds may be one of the least exciting way to invest, but also one of the least risky. You'll only lose a lot of money if there's an overall market crash or a whole sector of the economy goes kaput.
  4. When choosing an Index Fund, it's most important to research the past and projected performance of the index itself.

Money Market Funds

  1. Because they are legally required to make low-risk investments, money market funds themselves are considered low-risk.
  2. Money market funds are not to be confused with government-insured money market savings accounts available from banks.
  3. Though money market funds typically yield higher returns than bank accounts, they feature some of the same conveniences:
    • It's possible to withdraw or transfer your money from a money market fund at virtually any time.
    • You can also write checks from money market fund.

Bond Funds

  • Bond funds are mutual funds that invest primarily in government and corporate bonds.
  1. Bond funds are a popular way to take advantage of the relative stability of bonds, but without the associated complications and limitations.
  2. The drawbacks of investing in individual bonds include: the uncertainty of corporate bonds, the hassle of understanding concepts like yield to maturity and only being able to collect dividends (or properly speaking, coupon payments) twice a year.
  3. Bond funds usually pay out dividends every month, and include the advantage of getting to leave the complexities to the and bond manager.

Mixed Asset Funds

  1. As a category, mixed asset funds are arguably the most diversified, but their composition varies too much from one to another to make many blanket statements about their safety or performance.
  2. Some mixed asset funds, such as the Fidelity Freedom 2015 Fund invest almost exclusively in other mutual funds administered by the same fund company.

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Fees, Expenses & Taxes

Extraneous expenses can take an unpleasantly large bite out of your returns. (Creative Commons photo by Shane McGraw)
Extraneous expenses can take an unpleasantly large bite out of your returns. (Creative Commons photo by Shane McGraw)
  • There are several factors that can whittle down your earnings when investing in mutual funds. Add them up and they can significantly detract from your returns, so it's important to keep them low.

Load

  • Any given mutual fund is either classified as a load fund, or no-load. If you invest in a mutual fund through a broker, it will likely come with a load attached—a load is essentially a commission fee paid by the fund to the broker.
  1. The load is taken as a percentage of your investment and earnings, so it's very important to make sure it isn't excessively high.
  2. In theory, load funds are better managed and more successful than no-load funds, but according to The Motley Fool, this is not the case.
  3. Load and non-load funds are available from both brokers and fund companies themselves.
    • Many brokerages, even discount brokerages like ETrade administer their own mutual funds and also broker funds from other companies. Vanguard is a broker that specializes in mutual funds, particularly its own family of index funds.
    • Many banks also sell index funds, mainly load funds.

Expenses

  • Even no-load funds will take out a chunk of change for internal expenses. These expenses are distinct from the outright membership fee of the load, and include a commission to the fund manager and/or the day to day administrative costs of running th fund.
  1. These costs are tallied as a percentage, referred to as the expense ratio of a given fund.
  2. The expense ratio of a fund can be found in an [online quote] of the fund's specs.
  3. The average expense ratio of a managed fund is about 1.5%, while that of an index fun can be as little as 0.18%.

Taxes

  • Tax is another drag on the personal returns to investors in mutual funds. Each time a fund manager sells a particular asset—be it shares in a company, government bonds, whatever—the fund owes a percentage of that sale to the government in capital gains tax. As you might guess, the cost is passed along to the investor.
  1. A fund's turnover rate, which measures the rate at which the fund buys and sells assets, can provide a good indication of its tax burden.
  2. The turnover rate can be found in the fund's prospectus (a sort of overview of the fund that's provided to investors.
  3. Funds with higher turnover rates pass along a heavier burden of capital gains taxes than those with lower rates.

Choose a Mutual Fund

  • Now that you know a little something about how mutual funds work, its time to put that knowledge into action. See How to Choose a Mutual Fund.

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