A mutual fund is a type of financial investment vehicle made up of a pool of money raised from many investors to invest in securities such as stocks, bonds, money market instruments and other assets.
Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors.
A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.
Mutual funds provide small or individual investors with access to professionally managed portfolios of stocks, bonds, and other securities.
Each shareholder, therefore, participates proportionately in the profits or losses of the fund. Mutual funds invest in a large number of securities, and performance is typically tracked as the change in the fund’s total market capitalization, derived from the aggregate performance of the underlying investments.
Understanding mutual funds
Mutual funds pool money from the investing public and use it to buy other securities, usually stocks and bonds.
The value of the mutual fund company depends on the performance of the securities it decides to purchase. So when you buy a unit or share of a mutual fund, you are buying the return of its portfolio or, more precisely, a portion of the value of the portfolio.
Investing in a share of a mutual fund is different from investing in stocks. Unlike stocks, mutual fund shares do not give their holders any voting rights. A portion of a mutual fund represents investments in many different stocks (or other securities) rather than just one share.
That’s why the price of a mutual fund share is known as the net asset value (NAV) per share, sometimes expressed as NAVPS.
The net asset value of a fund is obtained by dividing the total value of the securities in the portfolio by the total number of shares outstanding. Shares outstanding are those held by all shareholders, institutional investors and company officers or insiders.
Mutual fund shares can generally be purchased or redeemed as needed at the fund’s current net asset value, which, unlike the price of a share, does not fluctuate during market hours, but is settled at the end of each trading day. .
The average mutual fund holds hundreds of different securities, meaning mutual fund shareholders get significant diversification at a low price.
For example, we have an investor who buys only Google shares before the company has a bad quarter. He is likely to lose a lot of value because all of his dollars are tied to a single company. On the other hand, a different investor can buy shares of a mutual fund that owns some Google shares. When Google has a bad quarter, it loses significantly less because Google is only a small part of the fund’s portfolio.
How mutual funds work
A mutual fund is both an investment and a real company. This dual nature may seem strange, but it is no different from how a part of AAPL is a representation of Apple Inc.
When an investor buys Apple stock, they are purchasing partial ownership of the company and its assets. Similarly, a mutual fund investor is purchasing partial ownership of the mutual fund company and its assets. The difference is that Apple is in the business of making smartphones and tablets, while a mutual fund company is in the business of making investments.
Investors typically earn a return on a mutual fund in several ways:
If a mutual fund is interpreted as a virtual company, its CEO is the fund manager, sometimes called an investment advisor. The fund manager is hired by a board of directors and is legally obligated to work in the best interest of mutual fund shareholders.
Most fund managers also own the fund. There are very few employees in a mutual fund company. The investment advisor or fund manager may employ some analysts to help choose investments or conduct market research. A fund accountant is kept on staff to calculate the fund’s net value, the daily value of the portfolio that determines whether stock prices rise or fall.
Mutual funds should have a compliance officer or two, and probably an attorney, to keep up with government regulations.
Most mutual funds are part of a much larger investment company; the largest ones have hundreds of separate mutual funds. Some of these fund companies are names familiar to the general public, such as Fidelity Investments, The Vanguard Group, T. Rowe Price, and Oppenheimer Funds.
In Latin America, especially in Colombia, commission houses are in charge of managing mutual funds. Some of these recognized brokerage firms are Valores Bancolombia and Itáu Comisionista de Bolsa.
Types of mutual funds
Mutual funds are divided into several types of categories, which represent the types of securities they have targeted for their portfolios and the type of returns they seek. There is a fund for almost any type of investor or investment approach.
Types of mutual funds include:
- Capital funds
- Fixed income funds
- Index funds
- Balanced funds
- Money market funds
- income funds
- International/global funds
- Specialty Funds
- Exchange Traded Funds (ETFs)
Other common types of mutual funds include money market funds, sector funds, alternative funds, smart beta funds, target date funds, and even funds of funds or mutual funds that purchase shares of other mutual funds.
1. Capital funds
The largest category is stocks or stock funds.
As its name suggests, this type of fund invests primarily in stocks. Within this group there are several subcategories.
Some equity funds are named by the size of the companies they invest in: small, medium or large cap.
Others are named for their investment approach: aggressive growth, income-oriented, value and others. Equity funds are also classified by whether they invest in domestic (US) stocks or foreign stocks.
There are so many different types of equity funds because there are so many different types of stocks. A great way to understand the equity fund universe is to use a style chart, an example of which is show below.
The idea here is to classify funds based on both the size of the companies invested (their market caps) and the growth prospects of the stocks invested.
The term value fund refers to an investment style that seeks out high-quality, low-growth companies that are not in favor of the market. These companies are characterized by their low price-to-earnings (P/E) ratios, low price-to-book (P/L) ratios, and high dividend yields. In contrast, Specters are growth funds, which look for companies that have had (and are expected to have) strong growth in earnings, sales and cash flows. These companies typically have high P/E (Price to Earnings) ratios and do not pay dividends.
The trade-off between strict value and growth investing is a “blend,” which simply refers to companies that are neither values nor growth stocks and are classified as intermediate.
The other dimension of the style box has to do with the size of the companies in which a mutual fund invests. Large-cap companies have high market capitalizations, with values of more than $5 billion. Market capitalization is obtained by multiplying the share price by the number of shares outstanding. Large-cap stocks are typically blue-chip companies that are often recognizable by name. Small-cap stocks refer to stocks with a market capitalization between $200 million and $2 billion. T hese smaller companies tend to be newer, higher-risk investments. Mid-cap stocks fill the gap between small-cap and large-cap stocks.
A mutual fund can combine its strategy between the investment style and the size of the company. For example, a large-cap value fund would look for large-cap companies that are in good financial shape but have recently seen their stock prices decline and would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects: small cap growth. Such a mutual fund would reside in the lower right quadrant (small and growing).
2. Fixed income funds
Another large group is the fixed income category. A fixed income mutual fund focuses on investments that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments. The idea is that the fund’s portfolio generates interest income, which is then passed on to shareholders.
Sometimes called bond funds, these funds are often actively managed and seek to purchase relatively undervalued bonds to sell at a profit.
These mutual funds are likely to pay higher returns than certificates of deposit and money market investments, but bond funds are not without risk.
Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund that specializes in high-yield junk bonds is much riskier than a fund that invests in government securities. Additionally, almost all bond funds are subject to interest rate risk, meaning that if rates rise, the value of the fund decreases.
3. Index funds
Another group, which has become extremely popular in recent years, falls under the moniker “index funds.” His investment strategy is based on the belief that it is very difficult, and often expensive, to try to beat the market consistently. Therefore, the index fund manager buys stocks that correspond to a major market index such as the S&P 500 or the Dow Jones Industrial Average (DJIA). This strategy requires less research by analysts and advisors, so there is less expense to reduce returns before passing them on to shareholders. These funds are often designed with cost-sensitive investors in mind.
4. Balanced funds
Balanced funds invest in both stocks and bonds to reduce the risk of exposure to one asset class or the other. Another name for this type of mutual fund is “asset allocation fund.” An investor can expect the allocation of these funds between asset classes to be relatively immutable, although it will differ between funds. The objective of this fund is the appreciation of assets with lower risk. However, these funds carry the same risk and may be subject to fluctuations as other fund classifications.
A similar type of fund is known as an asset allocation fund. The objectives are similar to those of a balanced fund, but these types of funds generally do not have to hold a specific percentage of any asset class. Therefore, the portfolio manager is free to change the ratio of asset classes as the economy progresses through the business cycle.
5. Money market funds
The money market consists of safe (risk-free) short-term debt instruments, primarily government Treasury bills. This is a safe place to park your money. You won’t make substantial profits, but you won’t have to worry about losing your capital. A typical return is a little more than the amount you would earn in a regular checking or savings account and a little less than the average certificate of deposit (CD). While money market funds invest in ultra-safe assets, during the 2008 financial crisis, some money market funds experienced losses after the share price of these funds, typically pegged to $1, fell below that. level and broke the money bag.
6. Income funds
Income funds are named for their purpose: to provide ongoing income on a consistent basis. These funds invest primarily in high-quality government and corporate debt, holding these bonds to maturity to provide interest streams.
While fund holdings may appreciate in value, the primary goal of these funds is to provide steady cash flow to investors. As such, the audience for these funds consists of conservative and retired investors. Because they produce regular income, tax-conscious investors may want to avoid these funds.
7. International/global funds
An international fund (or foreign fund) invests only in assets located outside its home country. Meanwhile, global funds can invest anywhere in the world, even within their home country.
It is difficult to classify these funds as riskier or safer than domestic investments, but they have tended to be more volatile and have unique political and country risks.
On the other hand, they can, as part of a well-balanced portfolio, reduce risk by increasing diversification, since returns in foreign countries may not be correlated with returns at home. Although the world’s economies are increasingly interrelated, it is likely that another economy somewhere is outperforming the economy of your home country.
8. Specialty Funds
This classification of mutual funds is more of an umbrella category consisting of funds that have proven popular but do not necessarily fall into the more rigid categories we have described so far.
These types of mutual funds forgo broad diversification to focus on a certain segment of the economy or a specific strategy. Sector funds are strategic funds aimed at specific sectors of the economy, such as finance, technology, health, etc.
Sector funds can, therefore, be extremely volatile as stocks in a given sector tend to be highly correlated with each other. There is a greater possibility of large profits, but a sector can also collapse (for example, the financial sector in 2008 and 2009).
Regional funds make it easier to focus on a specific geographic area of the world. This may mean focusing on a broader region (e.g. Latin America) or an individual country (e.g. just Brazil). An advantage of these funds is that they make it easier to buy stocks in foreign countries, which can otherwise be difficult and expensive. As with sector funds, you must accept the high risk of loss, which occurs if the region enters a serious recession.
Socially responsible funds (or ethical funds) invest only in companies that meet the criteria of certain guidelines or beliefs. For example, some socially responsible funds do not invest in “sinful” industries such as tobacco, alcoholic beverages, weapons or nuclear energy. The idea is to obtain competitive performance while maintaining a healthy conscience. Other similar funds invest mainly in green technology, such as solar and wind energy or recycling.
9. Exchange Traded Funds (ETFs)
A twist on the mutual fund is the exchange-traded fund (ETF). These increasingly popular investment vehicles pool investments and employ strategies consistent with mutual funds, but are structured as investment trusts that trade on stock exchanges and have the added benefits of stock characteristics.
For example, ETFs can be bought and sold at any time during the trading day. ETFs can also be sold short or bought on margin.
ETFs also typically have lower fees than the equivalent mutual fund.
Many ETFs also benefit from active options markets, where investors can hedge or take advantage of their positions. ETFs also enjoy tax advantages of mutual funds. The popularity of ETFs speaks to their versatility and convenience.
Mutual Fund Fees
A mutual fund will classify expenses into annual operating fees or shareholder fees. Annual fund operating fees are an annual percentage of the funds under management, typically ranging from 1 to 3%. Annual operating fees are collectively known as the expense ratio. A fund’s expense ratio is the sum of its advisory or management fees and its administrative costs.
Shareholder fees, which come in the form of sales charges, commissions and redemption fees, are paid directly by investors when buying or selling the funds. Sales charges or commissions are known as “the load” of a mutual fund. When a mutual fund is front-loaded, fees are assessed when shares are purchased. For a fund load, mutual fund fees are assessed when an investor sells his or her shares.
Sometimes, however, an investment company offers a no-load mutual fund, which carries no commissions or sales charges. These funds are distributed directly by an investment company, rather than through a secondary party.
Some funds also charge fees and penalties for early withdrawals or for selling the holding before a specific time has passed. Additionally, the rise of exchange-traded funds, which have much lower fees thanks to their passive management structure, has given mutual funds considerable competition for investors’ money. Financial media articles about how fund expense ratios and loads can affect rates of return have also sparked negative sentiments about mutual funds.
Advantages of mutual funds
There are a variety of reasons why mutual funds have been the vehicle of choice for retail investors for decades. The overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds. Multiple mergers have been equated to mutual funds over time.
Diversification
Diversification, or combining investments and assets within a portfolio to reduce risk, is one of the advantages of investing in mutual funds.
Experts advocate diversification as a way to improve a portfolio’s returns while reducing its risk.
Buying shares of individual companies and offsetting them with industrial sector stocks, for example, offers some diversification. However, a truly diversified portfolio has securities with different capitalizations and industries and bonds with different maturities and issuers. Buying a mutual fund can achieve cheaper and faster diversification than buying individual securities. Large mutual funds typically own hundreds of different stocks in many different industries. It would be impractical for an investor to build this type of portfolio with a small amount of money.
Easy access
Trading on major stock exchanges, mutual funds can be bought and sold with relative ease, making them highly liquid investments.
Additionally, when it comes to certain types of assets, such as foreign stocks or exotic commodities, mutual funds are often the most feasible – in fact, sometimes the only – way for individual investors to participate.
Scale economics
Mutual funds also provide economies of scale. Purchasing one saves the investor from the numerous commission charges necessary to create a diversified portfolio.
Buying a single security at a time leads to large transaction fees, which will eat up a good portion of the investment. Additionally, the $100 to $200 that an individual investor might pay is usually not enough to buy a round lot of the stock, but they will buy many mutual fund shares. Smaller mutual fund denominations allow investors to take advantage of dollar-cost averaging.
Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions.
Additionally, a mutual fund, because it pools the money of many smaller investors, can invest in certain assets or take larger positions than a smaller investor. For example, the fund may have access to IPO placements or certain structured products only available to institutional investors.
Professional management
A primary advantage of mutual funds is not having to pick stocks and manage investments. Instead, a professional investment manager takes care of all of this through careful research and skillful trading. Investors buy funds because they often don’t have the time or experience to manage their own portfolios, or they don’t have access to the same type of information that a professional fund has.
A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments. Most private, non-institutional money managers deal only with high net worth individuals, people with at least six figures to invest.
However, mutual funds, as noted above, require much lower investment minimums. Therefore, these funds provide a low-cost way for individual investors to experience and hopefully benefit from professional money management.
Variety and freedom of choice
Investors have the freedom to research and select among managers with a variety of management styles and objectives. For example, a fund manager may focus on value investing, growth investing, developed markets, emerging markets, income, or macroeconomic investing, among many other styles.
A manager may also oversee funds that employ several different styles. This variety allows investors to gain exposure not only to stocks and bonds, but also to commodities, foreign assets and real estate through specialized mutual funds. Some mutual funds are even structured to benefit from market declines (known as bear funds). Mutual funds provide opportunities for foreign and domestic investment that would not otherwise be directly accessible to ordinary investors.
Transparency
Mutual funds are subject to industry regulation that ensures accountability and fairness for investors.
Fund evaluation
Researching and comparing funds can be difficult. Unlike stocks, mutual funds do not offer investors the opportunity to juxtapose price-to-earnings (P/E) ratio, sales growth, earnings per share (EPS), or other important data. The net asset value of a mutual fund may offer some basis for comparison, but given the diversity of portfolios, comparing the proverbial pears to apples can be difficult, even among funds with similar names or stated objectives. Only index funds that track the same markets tend to be truly comparable.
Example of a mutual fund
One of the most famous mutual funds in the investment universe is the Fidelity Investments Magellan Fund (FMAGX) . Founded in 1963, the fund had an investment objective of capital appreciation through investment in common stocks. The fund’s glory days were between 1977 and 1990, when Peter Lynch served as its portfolio manager. Under Lynch’s tenure, Magellan regularly posted 29% annual returns, nearly double that of the S&P 500.
Even after Lynch left, Fidelity’s performance remained strong and Assets Under Management grew to nearly $110 billion in 2000, making it the fund so large that Fidelity closed it to new investors. and would not reopen until 2008.
As of April 2019, Fidelity Magellan has more than $16 billion in assets and has been managed by Jeffrey Feingold since 2011, with Sammy Simnegar becoming co-manager in February 2019. The fund’s performance has tracked or surpassed slightly that of the S&P 500.
