What is a mutual fund?
From FinancialPlanning
The mutual fund, or "Investment Company" in legal terms, is the principal vehicle for owning securities for investors in the United States. A mutual fund is a pool of money gathered from shareholders, and invested in securities by professional managers. By combining the money of many investors, the managers are able to purchase a well-diversified mix of investments that would be impractical to own individually for the shareholders of the fund. While $5,000 can't buy very many stocks without too much being eaten up by commission costs, $5,000 investments from thousands of individuals make it possible to assemble, efficiently, a well-diversified portfolio including dozens or even hundreds of stocks.
There are thousands of mutual funds in existence, in every conceivable category of investment. Hundreds of new ones spring up, and hundreds are dissolved/merged, every year. This article summarizes the broad categories of mutual funds as well as terms you may come across when researching them.
Contents |
Types of Mutual Funds
Investing Strategies
Investment Type
There are nearly as many investing strategies as there are mutual funds, but you can break them down into some broad categories. The first way of sorting them is simply by the type of investments that the mutual fund buys. While managers may have some discretion as to what they can purchase, funds typically stick within fairly narrow categories, such as:
- US Stocks
- International Stocks
- Corporate Bonds
- Government Bonds
- Real Estate Investment Trusts
- Commodities
Some funds, such as Balanced funds or Global funds, purchase combinations of these. And within each of these broad categories, many sub-categories are available. For example, within "US stocks" you can purchase mutual funds that focus on a specific company size (small-cap, mid-cap, large-cap), valuation (growth, value, core/neutral), or industry sector.
Each fund's prospectus describes the allowable investments, and most fund names at least hint at their focus.
Active Management vs. Passive Management
While you won't always see it described in these terms, one significant way of dividing all mutual funds is into those that are actively managed, and those that are passively managed.
Active management is the process of researching individual securities and determining which are the best to purchase or sell. Imagine there are 500 large, prominent corporations in the United States, whose products account for the majority of commerce -- among the companies whose stock you can purchase on a stock exchange. An active manager who focused on US stocks, and who managed too much money to bother with tiny companies, might review these companies and purchase stocks of those that he believes are likely to perform well in the future. Perhaps Drug Company A has a new prescription drug coming to market next year, and earnings are expected to be very high. The manager would purchase Drug Company A's stock to benefit from those profits.
Passive management, in contrast, assumes that is impossible to identify "winning" prospects consistently. While this seems at first glance to be nonsense, consider that if a manager knows about Drug Company A's new drug, presumably so do all of the other portfolio managers -- and they've already bought the stock, and bid up the stock price accordingly. In fact the price probably started rising years earlier, as the drug made its way through clinical trials and FDA approval, and the likelihood of it coming to market became greater. A passive manager believes that the current prices of stocks already reflect this kind of information -- in fact, they reflect all available information about the company. So how can you win? Rather than trying to pick and choose the best and worst, it's better to simply own a large set of companies that represent a certain segment of the world of investments. An investor in large US companies might buy the 500 most prominent companies in the United States...the ones included in the Standard & Poor's 500 Index.
While the S&P 500 is one of the most common bases for passively-managed mutual funds, passive management is applied to virtually every type of investment available. There are passively managed bond mutual funds, international stock mutual funds, REIT mutual funds, and so on. In each of these the general principal applies: the passive manager believes that it is impossible to consistently identify the "winning" securities in advance, because market prices reflect all known information about each of these securities.
Most passively-managed mutual funds are "index funds," meaning their manager attempts to match the performance of a well-know index such as the S&P 500 (a benchmark for large US stocks), Russell 2000 (small US stocks), Dow Jones REIT Index (US REITs), Wilshire 5000 (US stocks of all sizes), MSCI-EAFE (foreign stocks), Lehman Aggregate (US bonds), etc. Not all passively-managed funds, however, are index funds; the distinguishing factor is using a rote criteria, rather than securities analysis, to choose which investments to buy and sell.
Because passively-managed funds choose securities using rote criteria, they typically have much lower operating expenses than actively-managed funds. Averages vary from year to year, but active-fund costs in the range of 1.4% per year are common, as are passive-fund costs below 0.30%, for US stock funds. The actively-managed fund must pay the costs of a research staff, its travel, offices, equipment, bonuses, etc. None of this is required for the passive fund management company, which might pay simply a licensing fee for the use of a benchmark index name (such as the S&P 500) in their marketing materials, and a trained monkey (or computer) to make sure the fund owns the 500 stocks in the correct proportions. In fact, the core belief of many passive managers isn't so much that it's impossible to "beat the market," but rather that it's much too difficult to do so after paying the costs of doing the research necessary to identify the winners.
Method of Purchasing
Mutual funds can also be sorted by the manner of purchase. These categorizations are above and beyond investment strategy...once you've picked a category of investment, and decided whether you want an actively-managed fund or a passively-managed fund, you may still have some choices to make...
Load vs. No-load
Load funds are mutual funds that incur commission charges at purchase and/or sale. The commission is meant to compensate a stockbroker or similar individual for assisting you with the selection and purchase of the fund, but you may pay a load even if you don't receive this type of assistance. The commission rate varies by fund, as well as by share class. The share classes you will see for the typical load fund are:
- A-shares: typically incur a 5%-5.75% commission at purchase, with lower rates for higher invested amounts. If the rate is 5%, $1000 invested means you receive $950 in mutual fund shares, with the other $50 paid as a commission. No commissions are paid at time of sale. Investors may be able to commit to a series of purchases over a time period to receive the lower commission rates.
- B-shares: no commission is charged at purchase, but higher annual operating expenses and a "contingent deferred sales charge" (CDSC) that is paid at the time of sale. The CDSC percentage drops gradually and if you hold the shares long enough -- typically over 7 years -- the shares convert to A-shares. Though you pay no "visible" commission up front, the fund compensates the stockbroker at the time of purchase.
- C-shares: 1% annual commission, which may be called a "fee"
Mutual funds may create other share classes and only by reading the prospectus for the fund will you know all the details about fees and expenses for each. Note that we're talking about just one mutual fund -- all of these own the same underlying investments -- but your net return will be different depending on what class of shares you own.
Most load funds are actively-managed, but there are some passively-managed funds out there with the above types of share classes.
No-load funds are mutual funds that do not incur the types of commission charges described above. They may be called "direct sold," No Transaction Fee (NTF) or, cynically, "no-help" funds. No-load funds that are sold on NTF "fund supermarkets" such as those at Charles Schwab or Fidelity are not quite "free"...in addition to the costs of managing the fund, the mutual fund pays the brokerage firm to be included in the supermarket. As of the time of this update, the typical fee was reported to be 0.40% per year, a cost that is passed on in some way to fund shareholders.
Some no-load funds, such as those from The Vanguard Group, do not pay those fees for access to NTF platforms. This means that you may have to pay a "ticket charge" to purchase such funds through an account at another brokerage firm. This technically does not make the fund a "load" fund, however.
Open-end vs. Closed-end
By a wide margin, the majority of mutual funds are open-ended, meaning the fund administrator creates new shares whenever investors send in additional cash, and dissolves shares when investors request that shares be redeemed for cash. The per-share value of an open-end mutual fund ("NAV" - net asset value) is determined each day, based on the actual value of the investments held by the mutual fund. An open-end mutual fund is theoretically limitless in size, and the manager of this type of fund must deal with inflows and outflows of cash at unpredictable times. Because certain investment types (such as small-company stocks) are difficult to purchase in large volumes, fund managers sometimes shut off open-end funds to new investors. This may be referred to as a "closed" fund...not to be confused with a closed-end fund.
In contrast, a closed-end mutual fund ("CEF") creates a fixed number of shares and sells them in a public offering. After that point, no outside cash is added to the fund. The shares trade on a stock exchange, much like an individual stock. The fund's share price is set not by the actual value of the investments held by the mutual fund (its NAV), but rather by the supply and demand for the fund's shares at any given time. While it seems the price should be close to the NAV, most closed-end funds trade at a discount or premium. Financial publications such as Barron's typically quote the current discount/premium alongside each closed-end fund quote.
Closed-end funds are a bit of an oddity, and most mutual fund investors never bother with them. To the extent they're mentioned on MIFP, it's often municipal bond or other fixed-income CEFs, which use leverage (borrowing) to attempt to boost returns above that of traditional (open-ended) mutual funds in the same categories.
Closed-end funds have some similarities to exchange-traded funds (ETFs), which are addressed in their own section.
Advantages of Mutual Funds
- Well-diversified investments - with one purchase, you can own thousands of securities, which would be impossible in an individual account without very large amounts of money
- Great deal of flexibility with investment size - deposit or withdraw $500, $5,000, $50,000
- Professional management for any size investment - try finding someone willing to manage a $5,000 account of individual stocks
- Low cost - annual cost of ownership can be well under 0.75% for most types of investments
- Access to larger variety of investments - more of a factor in certain investment categories. Bond mutual fund managers have a much bigger inventory of bonds to choose from than an individual investor, even one with a lot of cash to invest.
Disadvantages of Mutual Funds
- Costs - you pay a manager, and perhaps sales loads. These costs reduce your returns. Cost vary widely among different mutual fund types and companies - annual costs may be as low as 0.18% or less, or as high as 2.3% or more.
- Selection is difficult - there may be more US-stock mutual funds than there are US stocks to purchase. Every investor needs to go through the exercise of figuring out how to pick mutual funds and, depending on the method chosen, keep up with the funds they've picked.
- Actions of other shareholders can affect you
- Bad timing - fund managers often receive cash when the market is going up, and are hit with redemptions when the market is going down. "Buy high, sell low" isn't exactly a winning strategy.
- Tax liabilities - if a fund has a lot of redemptions, and you stick around, you may be hit with a tax bill at the end of the year, if you hold the fund in a taxable account. The fund is forced to sell investments to raise cash for the redemptions, and eventually is selling investments that have taxable gains. Mutual fund tax law requires that the fund make taxable distributions to the remaining shareholders, so you may be hit with a tax bill (even if the fund has dropped in value).
