A mutual fund is a financial/investment vehicle that pools assets from shareholders to invest in stocks, bonds, money market instruments, and other such assets. Professional money managers handle these funds, allocate the assets, and try to bring monetary gains for the investors. The mutual fund portfolios are formulated and run to match the desired investment objectives. Investors can access professionally managed portfolios.
While mutual funds invest in securities, its performance is tracked as the change in the fund’s market cap (decided after aggregating performances of underlying investments).
How Do Mutual Funds Get Priced?
A mutual fund’s value depends on the securities’ performances, in which, it is investing. Buying a mutual fund means that the investor is also buying the portfolio’s performance/value.
Unlike market stocks, mutual fund shareholders don’t get voting rights. Having a share in a mutual fund means investments in multiple stocks/securities.
Generally, mutual funds’ share prices are also referred to as the Net Asset Value (NAV).
Net Asset Value gets decided by dividing the securities’ total value under the portfolio by the total amount of outstanding shares. Outstanding shares refer to the ones held by all shareholders, institutional investors, and corporates.
These shares can be purchased or redeemed at the fund’s current Net Asset Value. This NAV doesn’t generally fluctuate during market hours and gets settled at the end of each trading day. After the NAVPS gets settled, mutual fund prices get updated too.
As mutual funds hold different market securities, the shareholders also gain on the diversification front. So, if you have multiple company stocks under your portfolio, a loss in one of them can be offset easily by the profits made by other shares.
How Are Returns Calculated For Mutual Funds?
Just like buying a stock, buying a mutual fund too gives the individual partial ownership of the mutual fund and its assets.
While you, as a mutual fund investor, can earn on a quarterly and annual basis, it happens in three ways.
The first category of mutual fund income is earned from stock dividends and bond interests held under the funds’ portfolio. Here, funds give investors a choice to either receive a distribution check or reinvest the earnings to purchase the mutual fund’s additional shares.
If the mutual fund is selling securities that have higher price tags, the fund in return gets a capital gain, which gets passed on to the investors.
Also, if the mutual fund shares’ prices increase, you can sell them for a profit.
While researching for mutual fund returns, before buying the policy, the potential investor must see the “total return” or the investment’s value change over a particular period. This “total return” consists of interests, dividends, or capital gains the fund generated and its market value changes. These returns are calculated for one, five, or 10-year periods as well as the mutual fund’s starting date.
Example of Mutual Funds
In 1963, Fidelity Investments’ started its mutual fund services called Magellan Fund (FMAGX) in the United States. The objective was to ensure capital appreciation via investment in common stocks and saw its peak time from 1977 to 1990, as its assets under management increased from USD 18 million to USD 14 billion. By 2000, the same figure grew to nearly USD 110 billion. It has still remained in prominence. As per 2022 data, Fidelity Magellan has nearly UD 28 billion in assets.
Some of the other best-performing mutual funds within the US are Johnson Equity Income, T. Rowe Price Dividend Growth, State Street US Core Equity Fund, Fidelity Large Cap Core Enhanced Index, and BlackRock Exchange BlackRock.
Fees & Shares
Mutual funds have annual operating/shareholder fees. Under the annual fund operating one, the customers will have to pay an expense ratio (summation of the advisory or management fee and its administrative costs) ranging between 1-3%.
Under the shareholder category, the fees are mostly sales charges, commissions, and redemption fees, and they get directly paid by investors while buying or selling the funds.
Investment companies also offer no-load mutual fund, where you don’t need to pay commission or sales charges since no other party is involved apart from the companies and the customers.
Another category of fees consists of charges/penalties for early money withdrawals or for selling the holding before a specific time frame.
While most of the mutual fund investors purchase the schemes through brokers, the process requires a front-end load of up to 5% or more, along with management and distribution fees. Financial advisors selling mutual funds tend to encourage customers to buy higher-load offerings to generate commissions. To deal with this problem, the investment companies now designate share classes, like ‘level load’ C shares, which don’t carry these front-end loads.
In between A and C, comes category B, under which mutual funds charge management and other fees whenever the investors sell their holdings.
Types Of Mutual Funds
The most prominent one is the category called ‘Stock Funds’, under which the fund invests in market equities. The money can be invested in small, medium and large companies, and approaches like aggressive growth, income-oriented, and value, can be taken. You can invest both in domestic and foreign stocks and in either of them.
Also, there is a something called growth fund, where the mutual funds invest the customers’ money in companies having strong earnings and sales growth, along with a steady cash flow.
Then comes the category of ‘blend’ companies, which segregates businesses with neither value nor growth stocks from the rest.
Large-cap companies have market capitalizations of more than USD 10 billion. Small-cap ones are valued at somewhere between USD 250 million to USD 2 billion. These companies are also dubbed as newer, riskier investments. In between these two, you have mid-capped ones.
Mutual funds generally blend between investment and company sizes.
The next category of mutual funds deal with bonds. Here the scheme generates minimum return under the fixed income category. Under this, the customer’s money goes into investments offering a set return rate, like government bonds, and corporate bonds. The fund portfolio first generates interest income and then passes it to the shareholders. These funds also tend to buy undervalued bonds and sell them at a profitable rate. Funds specializing in high-yield junk bonds are riskier than the ones investing in government securities. Bond funds are also subject to interest rate risk.
Index funds mainly invest in stocks corresponding to major market indexes. Since the advisors/analysts don’t need to research before reaching out to the customers, the latter don’t need to pay many expenses. In short, this is a cost-effective option.
Balanced mutual funds invest in various types of assets, be it stocks, bonds, money market instruments, or alternative investments. It is also known as an asset allocation fund, which reduces the risk factor for investors.
While some funds have pre-defined allocation strategies for the investors (to help the investors to have a predictable exposure across asset classes), others follow a dynamic allocation strategy, suited to investors’ priorities (like responding to market conditions, and business cycle changes).
There are mutual funds that operate in the money market, consisting of safe and short-term debt instruments (government treasury bills). The investor does not gain significantly under this scheme, as the monetary return under this scheme is slightly over the one earned from regular savings accounts.
Income funds invest mostly in government and high-quality corporate debts and then hold these bonds until the latters’ maturity. The whole operation provides consistent cash flow to the customers. It’s very popular among old-school investors and senior citizens.
There is also a mutual fund called an international/foreign fund, where the money gets invested in assets outside the investor’s home country. While this scheme is highly volatile, given the changing nature of the global economy and politics, it offers well-balanced and diverse portfolios.
Sector funds are targeted strategy funds covering specific areas within a formal economy, like finance, technology, and healthcare.
There is a new player in the field of the mutual fund, known as exchange-traded fund. These entities use tactics similar to the MFs. These are fashioned like investment trusts. ETFs can be bought and sold during trading days and these carry lower fees than mutual funds. They also enjoy tax advantages from mutual funds. And last but not the least, these entities are more cost-effective and liquid than mutual funds.
Is Investing In Mutual Funds Profitable?
Yes, it is. First of all, it brings the element of diversification and mix-mashing your investments and assets within a portfolio will reduce the risk factor for the customer. A diversified portfolio comes with securities and bonds. And the mutual fund is a cost-effective diversification option here.
Also, trading can be done on major stock exchanges through mutual funds. These funds can easily be bought and sold during trading hours, making these entities highly liquid investments.
Using mutual funds, investors can also participate in buying or investing in assets such as foreign equities.
Mutual funds give the option of a diverse portfolio to investors and the latter don’t need to pay commission charges and other transaction fees, since they are not buying one security at a time. The monetary side of investing in a mutual fund is a cost-effective one, since it sells a large number of securities, Apart from investing in assets.
Investing in a mutual fund, with the guidance of an ‘Investment Manager’, bring the element of trust into the play, since the person uses his/her research and trading experiences, before reaching out to the customer. Since mutual funds require lower investment minimums, taking the help of ‘Investment Managers’ provides customers with a low-cost, professional solution.
Last but not the least, these funds are properly governed by industry rules and market watchdogs, providing accountability and fairness to the customers.
However, not everything is as rosy, when it comes to the mutual fund. Just like any other finance scheme, it has its drawbacks as well.
A mutual fund can also go through the phenomenon of value depreciation, like any other investment plan. Equity mutual funds go through price fluctuations, affecting the returns.
To maintain liquidity and to accommodate money withdrawals, mutual funds keep a significant portfolio’s portion as cash. Since cash earns no return, it results in a “cash drag.”
Since investors require professional help to operate mutual funds, they also need to pay service fees, thereby affecting the fund’s payout. Fees vary from fund to fund, and if the investors don’t pay attention to the fact, they can face negative consequences in the area of transaction costs.
Acquiring too many highly related funds counterbalances the benefits of diversification. Similarly, pouring fresh money into strong funds can result in the ‘Investment Manager’ having trouble finding other suitable investments.
While a mutual fund allows its customers to convert the latters’ shares into cash easily, many other such schemes offer redemptions only after the trading day ends. After the ‘Investment Manager’ sells the security, a capital-gains tax gets activated. These taxes can be mitigated by investing in tax-sensitive funds or by holding non-tax-sensitive mutual funds in a tax-deferred account.
Another problem area is researching and comparing mutual funds. Different from stock trading, these schemes do not offer investors the opportunity to juxtapose the price-to-earnings (P/E) ratio, sales growth, earnings per share, etc. Generally, a mutual fund’s net asset value can offer some basis for comparison, but having the element of portfolio diversification means studying funds and finding similarities in them, before investing, becomes a herculean task.
Talking about whether mutual funds are safe to be invested in, there is an element of risk here as well, especially, while purchasing securities like stocks, and bonds. The capital put in these securities is not insured. However, these funds are considered to be liquid assets and can be sold at any given point in time. However, the investors need to review the mutual fund policies and check clauses in areas such as exchange fees and redemption fees. Also, check the tax-related details for capital gains earned with mutual fund redemption.