A mutual fund is an investment vehicle in which a pool of investors collectively put forward funds to an investment manager to make investments on their behalf. The fund is regulated by the Securities Exchange Commission, or SEC.
When involved with a mutual fund, each investor benefits proportionally to the amount of money they invested. Mutual funds may invest in stocks, bonds, money market instruments, or other assets. Depending on the vehicle of investment and redemption patterns, mutual fund investment can offer tax benefits.
The advantages of mutual funds are the ability to diversify a portfolio across industries, low fees, and availability of professional expertise in the guise of fund managers. The disadvantages of mutual funds are that they do not provide ownership of underlying holdings to investors; hence, investors do not have much say on the composition and constituents of mutual funds. Mutual funds are also more expensive and riskier as compared to index funds.
Basics of Mutual Funds
Mutual funds can be a good opportunity for small or individual investors to benefit from a professionally managed investment portfolio. They usually invest in a large number of securities, and their performance is tracked as the change in the market cap of the fund, which itself is determined by the performance of the underlying investments.
Mutual funds charge a sales commission, known as load, as well as management fees related to the fund’s administration. While all funds charge management or administration fees, there are funds in the market that are no-load, meaning they do not charge a sales commission. The returns of a mutual fund are based on the performance of its constituents.
Therefore, skill and expertise is required to pick equities that provide desired returns. Highly-trained professionals function as fund managers for mutual funds. You can use fund rankings issued by research firms like Morningstar and Standard & Poor to select funds. Buying shares of a mutual fund does not give investors voting rights in a company; instead the fund manager votes on their behalf.
However, since mutual funds generally incorporate hundreds of different securities, it does give investors the benefit of diversification of their portfolios. The value of a share of mutual fund is called the net asset value per share, or the NAV. The price is determined by taking the net value of all the securities in the fund and dividing by the outstanding shares.
Mutual funds can be open-ended or closed-ended. An open-ended mutual fund issues an unlimited number of shares in the open market and redeems them at market value from investors. The share price of an open-end fund is based on the net asset value of its constituents. Closed-end mutual funds function in the opposite manner i.e., they issue a fixed number of shares and redemption is not allowed. Instead, the only way for an investor to “redeem” a share is by selling it to someone else.
Therefore, their price is based on the dynamics of supply and demand and they always trade at a discount to the net asset value of their constituents.
Types of Mutual Funds
Broadly there are four types of mutual funds. They are as follows:
- Equity Mutual funds: Equity mutual funds consist of collections of stocks of companies. Investors can allocate funds to funds based on their goals. For example, growth funds are focused on stocks of companies with significant growth potential in the future. Income funds include stocks of companies that pay regular dividends.
- Money Market mutual funds: Money market mutual funds invest in short-term debt issued by corporates, government, state, and municipalities. For example, they might invest in US treasuries and debt issued by established companies like Apple Inc. or Exxon. The aim of this type of mutual fund is to generate income while minimizing risk.
- Bond funds: Bond funds are considered conservative investments and provide fixed income to investors in such funds. Like money market mutual funds, their investment portfolio is restricted to government and corporate debt. They are generally favored for retirement planning.
- Balanced Funds: Balanced funds aim to strike a balance between equity and bond investing. They are long term funds that incorporate a mix of stocks and bonds in a given ratio. For example, they might have 60% stocks and 40% bonds. Rebalancing these funds on a periodic basis adjusts their composition to prevailing economic conditions. Some are rebalanced based on the investor’s goals. For example, they might incorporate a more conservative approach close to retirement.
Tax Implications of Mutual Funds
The tax implications of mutual funds depend on the investment vehicle used to conduct the transactions. If mutual funds are traded from inside a retirement account, then capital gains accruing from the sale are deferred. If, however, the trades occur outside a retirement account, then the investor is responsible for paying the prevailing capital gains tax.
Dividends from the mutual fund or redemption of units contained within the fund are also taxed at regular rates for income and capital gains.
Pros and Cons of Mutual Funds
The benefits of mutual funds are as follows:
- Mutual funds are available in various flavors and help diversify a portfolio across sectors and industries.
- Mutual funds enable regular investors, who do not have much knowledge about the markets, to access sophisticated and professional expertise of fund managers at low costs.
- Active mutual funds that take large positions in stocks can make a significant difference to the performance of that equity and generate profits for investors who hold shares in that fund.
- Mutual funds are a liquid market, meaning it is relatively easy to trade and find a buyer for them. The same cannot be said for several assets.
The drawbacks of mutual funds are as follows:
- Mutual funds do not offer ownership of shares. Therefore, it is not possible for investors to select or pick the composition of a fund to align with their values.
- Mutual fund fees can add up over time. According to 2016 research by the Investment Company Institute (ICI), the after-fee return for $1,000 annual investment averaging 7% return over 30 years for mutual funds is $86,000. Index funds offer $99,000 over the same timeframe due to lower management fees.
- While they are a type of mutual fund, index funds have become more popular in recent times as compared to regular index funds. This is because they are cheaper and less risky. Unlike mutual funds, whose constituents are selected with rigorous analysis, index funds stick to a tried-and-tested formula and track indices.
- For those who hold very few units of mutual funds, returns can be negligible or very low, especially when they are compared to similar equity investments.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.