Mutual funds are a staple of many investors portfolios, but what exactly are they? In this post, we explore mutual funds and similar financial instruments that can offer you diversification at the click of a button.
What is a Mutual Fund?
Investopedia defines a mutual fund as “a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets”. A mutual fund invests in various securities to provide the investor with a positive return.
Like bonds, there are a plethora of different mutual funds, from passively managed funds to actively managed ones, and bond focused funds to stock focused funds.
How Do Mutual Funds Work?
Investing in a mutual fund is similar to purchasing a share in a company (see Stocks). You are purchasing a share in a mutual fund to profit from the assets it holds. Mutual funds are managed by a fund manager. The fund manager will choose to invest in whatever securities he believes will provide a return, providing the investments are in line with the objectives of the fund.
Every shareholder owns a small (or large depending on how many shares they own) portion of the portfolio’s profits. When the portfolio realises positive returns, the shareholders’ profit. Likewise, when the portfolio performs poorly, the shareholders’ lose money. Each share is worth a specific amount, called the net asset value per share (NAVPS). A fund’s NAVPS is calculated by dividing the value of the entire portfolio by the number of outstanding shares. NAVPS is calculated at the close of business each day.
As mentioned above, investors in a mutual fund aim to profit from the fund’s performance. This can be achieved in one of three ways.
- Dividends or Interest. Depending on the assets being held, mutual funds will receive dividends from stock holdings and interest payments from bond holdings. This income is passed onto the members of the mutual fund, usually in the form of a distribution. Some mutual funds will allow you to automatically reinvest distributions to purchase more shares in the fund.
- Security disposal. If a fund sells a security at a profit, this results in a capital gain for the fund. Much like dividends, these gains are passed onto shareholders in the form of a distribution.
- Fund Share Price Increase. If the holdings of the fund increase in value and are held, the fund share price will increase. You can sell your shares at an increased price profiting from the rise in value.
Types of Mutual Fund
There are various types of mutual funds, covering everything from stocks to bonds and from small companies to blue-chip ones. These can be explored in our Types of Mutual Fund post.
Mutual Fund Fees
One of the most important aspects of choosing a mutual fund is understanding the costs associated with owning it. Mutual funds must buy (and sell) securities to provide a return for the shareholders. As we know, buying and selling shares costs money. It also costs money to employ a fund manager and administration staff. All of these costs are bundled up into what is known as the expense ratio. A funds expense ratio covers the administration and management fees and is expressed as a percentage. Expense ratios are usually around 1% to 3% and are applied to the value of the funds under management. Needless to say, the lower the expense ratio the better.
There may also be charges associated with buying into the fund, these are known as shareholder fees. These fees are paid directly by the shareholders and usually consist of sales fees or commissions. A sales commission on a mutual fund is known as a “load”. Loads can be administered on the purchase of shares (front-end), or upon the sale of those shares (back-end). No-load mutual funds are becoming more prevalent and easier to find. The lower you can keep your costs the more upside potential you have, fees will eat into your overall return. Funds may also charge for the early redemption of shares so make sure you read the small print before investing.
Why Should You Invest in a Mutual Fund?
Mutual funds offer several advantages to the individual investor.
Diversification is one of the cornerstones of a successful long-term investing portfolio. Mutual funds often hold hundreds of individual stocks, giving you diversification in a single purchase. By holding a mutual fund, you are less likely to be exposed to risks associated with individual stocks. An individual investor would struggle to research and purchase enough stocks to be properly diversified.
There is a caveat to this diversification. As discussed above, mutual funds often specialise in a specific sector or company size. If a mutual fund invests only in oil companies, it is open to both systematic and unsystematic risk. You may think you are diversified as you own a mutual fund which holds 30 companies, but in reality, you are not.
When a mutual fund purchases shares of a company, it does not purchase a small amount as an individual investor would. Mutual funds by their nature have pooled resources to benefit from economies of scale. A mutual fund will pay less commission per share when it is purchasing a large number of shares. An individual investor can buy a single share in a mutual fund which can have a portfolio of hundreds of companies. If an individual investor wanted the same exposure they would be paying transaction costs on each share purchase resulting in much lower returns.
Access and Variety
Mutual funds can access shares and securities that individual investors cannot. Due to their large size, a mutual fund may be able to take part in an IPO or have access to securities reserved for institutional investors. Mutual funds can also invest in securities sold on markets in other countries, something that usually carries an additional cost for individual investors.
Mutual funds are usually easily accessible. A share in a mutual fund usually costs a fraction of the price of a share in a blue-chip stock. The barrier to entry is much lower with mutual funds, meaning you can invest small amounts regularly rather than saving to buy a single share of a large company.
As there are a huge number of mutual funds on the market, you should be able to find one that suits your needs. If you are interested in Japanese equities, there is a mutual fund for that. If you want one that focuses on small-cap growth stocks, there is a mutual fund for that. The variety of mutual funds on the market is a huge benefit to the individual investor, ensuring you can gain exposure to whatever interests you.
Mutual funds can be either passively managed (if it tracks an index) or actively managed. By purchasing shares in an actively managed fund you are getting access to a professional investor. This can be both a positive and a negative depending on the calibre of the manager in question. There is no doubt that there are good money managers out there, but finding one can be a skill in its own right. There is no cheaper way to get access to a professional money manager. If an individual was to hire a money manager they would probably need to have a six-figure sum to invest, a far cry from the price of a mutual fund share.
Having a professional manage your money can take some of the strain out of investing, but it isn’t for everyone. Some people enjoy the research aspect of picking stocks. If this sounds like you a mutual fund may not be appropriate.
Why Should You Avoid Mutual Funds?
Along with advantages, there are also disadvantages to owning mutual funds.
Investors are interested in returns, and cash does not provide a return. Mutual funds are constantly in a state of flux with investors putting money into the fund and withdrawing it. To be able to process withdrawals, mutual funds must have cash on hand. As they have a large portion of their assets in cash, they are not earning a return on it, which means the shareholders are not getting a return on that money either. Individual investors don’t have to deal with withdrawals. They can have a much smaller portion of their assets in cash, ensuring they have more money invested with the potential of returns.
We covered costs earlier, but it makes sense to emphasise the point here. Costs will impact directly on your returns. The magic of compounding works against you in this case. €100,000 invested over 25 years earning 5% a year with an expense ratio of 0.25% will return €319,044.15. The same investment with an expense ratio of 1% will result in a final amount of €266,583.63. A difference of 0.75% may not seem like much but it equates to a difference of €52,460.52. A huge difference!
As mutual funds often invest in different securities and with different approaches, it can be difficult to compare them to each other. The standard measures by which investors evaluate companies do not apply to mutual funds, you won’t find any P/E ratios here!
Index funds are the exception to this rule. As they track the same index, they should have the same holdings and perform similarly. If you come across an index fund that is underperforming both the index and comparable funds steer clear.
Is a Mutual Fund Right for You?
Ultimately, this will come down to personal circumstances and preferences. Mutual funds offer a fantastic way to diversify, usually at a cost accessible to most. They also have their drawbacks, with expense ratios being of particular importance to your returns. As with any investment decision, do your research before committing your hard-earned money.
The Stoic Trader