What is a Mutual Fund?
Mutual funds are one of many different types of investment funds. They’re a basket of assets operated and managed by an investment company, priced and sold to the public on a daily basis. Investors choose to invest in these funds for many reasons—namely, because they’re stable, managed and use pooled funds to create leverage. Mutual funds are popular among the risk averse, those in or approaching retirement and those who want a true “set it and forget it” investing option.
If you’re new to investing and want a primer on mutual funds, keep reading. You’ll learn everything you need to know to get started with confidence.
The Basics of Mutual Funds
Mutual funds have a few very important hallmarks that define them. The most important consideration is that the fund’s price changes daily, once per day. This is significant for several reasons. First, it deters intraday traders that might create volatility through rapid buying and selling. Second, it creates long-term price stability. Finally, it provides a single point of entry or exit each day for investors.
Just because the price changes once per day doesn’t mean the fund is static, though. In fact, mutual funds see active trading by managers throughout the day. The moves made by fund managers are what cause the price of the fund to appreciate over time—and result in the special dividends paid to fund members when it sells securities.
Speaking of active management, you’ll pay an expense ratio fee to invest in a fund. That said, money in a mutual fund is usually tax-exempt, creating a tax-advantaged situation that can offset the fund’s fees. However, when fund managers exit positions to profit, those returns get distributed among shareholders, triggering a taxable event.
What is Net Asset Value (NAV)?
The share price of a fund is its Net Asset Value (NAV). It’s the price at which investors can buy into the fund or sell out for. It’s calculated by subtracting the total of the fund’s assets minus the total value of its liabilities, divided by outstanding shares. Part of the reason the share price only changes once daily for mutual funds is because the NAV gets recalculated to account for manager activity.
Like stocks, mutual funds can trade at rates that are higher or lower than their NAV (book value for stocks). Funds that trade at prices higher than the NAV trade at a premium; those trading lower than NAV are available at a discount.
Types of Mutual Funds
Not all funds are the same. In fact, there are several key distinctions between mutual funds that make them more or less appealing to different types of investors. The three primary types of funds are closed-end funds, open-end funds and unit investment trusts (UITs):
- Closed-end funds. These funds offer a fixed number of shares to the public. Investors can buy into the fund only when shares are available on the market.
- Open-end funds. These funds create and retire shares based on demand. They’re more accessible and are typically geared to a wider audience.
- Unit investment trusts (UITs). In the age of robo investing, UITs have risen in popularity. They’re static portfolios of securities with no management.
There are also several broader types of funds that cater to different investing styles and products. Specifically, the SEC recognizes four types of mutual funds: money market funds, bond funds, stock funds and target date funds.
Mutual funds can also be actively managed or passively managed. Actively managed funds see managers buying and selling securities within the fund on a discretionary basis. Passively managed funds rebalance according to market conditions or are manually rebalanced at predefined intervals.
The Benefits of Investing in Mutual Funds
Mutual funds are widely considered one of the safest equity investments. This is because they’re highly diversified and actively managed. Investors get broad exposure from the fund and the protection that homes provide from a diversification hedge. Fund managers can also capitalize on market opportunities and avert potential problems in real-time. All this, with the stability of a price that changes only once daily.
Mutual funds appeal to investors who want stability and the peace of mind that comes with it. As such, there are many funds designed for specific purposes. For example, target date mutual funds rebalance according to risk tolerance as the maturation date gets closer. Likewise, a high dividend mutual fund could provide retirees with a steady stream of income with minimal risk attached.
Finally, liquidity is a great benefit of investing in a fund. Like most other equity investments, investors can sell out of a fund if they require cash. Cashing out entitles them to shares worth the current net asset value (NAV), less any redemption fees.
The Drawbacks of Mutual Funds
The biggest drawback of mutual funds is their fees—especially those of actively managed funds. The expense ratio of a fund can eat into the profits of shareholders over time. For example, if you deposit $50,000 into a fund with a 1% expense ratio and earn 10% annually over 10 years, you’d end up paying over $11,300 in fees.
Mutual funds aren’t as aggressive as other investment products, either. Their diversification is a great hedge against volatility, but it comes at the expense of more prolific growth. Investors looking for stronger growth prospects may turn to ETFs, which are similar in many ways, but offer a narrower fund focus.
Should You Invest in Mutual Funds?
Mutual funds are a great investment vehicle for those who want the peace of mind that comes with a diversified, actively managed fund. Moreover, pooling your investment dollars with others creates leverage to increase return on investment. This can be even more important when you begin preparing for retirement. To learn more, sign up for the Wealthy Retirement e-letter below. If you don’t mind paying the fees and accumulating over a longer time horizon, it’s hard to beat mutual funds.