Mutual Fund Basics

As you probably know, mutual funds have become extremely popular over the last
20 years. What was once just another obscure financial instrument is now a part of
our daily lives. More than 0 million people, or one half of the households in
America, invest in mutual funds. !hat means that, in the "nited #tates alone,
trillions $yes, with a %!%& of dollars are invested in mutual funds.
'n fact, to many people, investin( means buyin( mutual funds. After all, it)s common
knowled(e that investin( in mutual funds is $or at least should be& better than simply
lettin( your cash waste away in a savin(s account, but, for most people, that)s where
the understandin( of funds ends. 't doesn)t help that mutual fund salespeople speak
a stran(e lan(ua(e that, soundin( sort of like *n(lish, is interspersed with jar(on like
M*+, ,A-.#, load/no0load, etc.
1ri(inally mutual funds were heralded as a way for the little (uy to (et a piece of the
market. 'nstead of spendin( all your free time buried in the financial pa(es of the
Wall #treet 2ournal, all you have to do is buy a mutual fund and you)d be set on your
way to financial freedom. As you mi(ht have (uessed, it)s not that easy. Mutual
funds are an excellent idea in theory, but, in reality, they haven)t always delivered.
,ot all mutual funds are created e3ual, and investin( in mutuals isn)t as easy as
throwin( your money at the first salesperson who solicits your business.
!his is why we)ve written this tutorial. We)ll explain the basics of mutual funds and
hopefully clear up some of the myths around them. 4ou can then decide whether or
What are Mutual Funds?
The Definition
A mutual fund is nothin( more than a collection of stocks and/or bonds. 4ou can
think of a mutual fund as a company that brin(s to(ether a (roup of people and
invests their money in stocks, bonds, and other securities. *ach investor owns
shares, which represent a portion of the holdin(s of the fund.
4ou can make money from a mutual fund in three ways5
6& 'ncome is earned from dividends on stocks and interest on bonds. A fund pays out
nearly all income it receives over the year to fund owners in the form of a
distribution.
2& 'f the fund sells securities that have increased in price, the fund has a capital
(ain. Most funds also pass on these (ains to investors in a distribution.
7& 'f fund holdin(s increase in price but are not sold by the fund mana(er, the fund)s
shares increase in price. 4ou can then sell your mutual fund shares for a profit.
8unds will also usually (ive you a choice either to receive a check for distributions or
to reinvest the earnin(s and (et more shares.
Advantages of Mutual Funds:
9 .rofessional Mana(ement 0 !he primary advanta(e of funds $at least theoretically&
is the professional mana(ement of your money. 'nvestors purchase funds because
they do not have the time or the expertise to ma na(e their own portfolio. A mutual
fund is a relatively inexpensive way for a small investor to (et a full0time mana(er to
make and monitor investments.
9 :iversification 0 ;y ownin( shares in a mutual fund instead of ownin( individual
stocks or bonds, your risk is spread out. !he idea behind diversification is to invest in
a lar(e number of assets so that a loss in any particular investment is minimi<ed by
(ains in others. 'n other words, the more stocks and bonds you own, the less any
one of them can hurt you $think about *nron&. =ar(e mutual funds typically own
hundreds of different stocks in many different industries. 't wouldn)t be possible for
an investor to build this kind of a portfolio with a small amount of money.
9 *conomies of #cale 0 ;ecause a mutual fund buys and sells lar(e amounts of
securities at a time, its transaction costs are lower than you as an individual would
pay.
9 =i3uidity 0 2ust like an individual stock, a mutual fund allows you to re3uest that
your shares be converted into cash at any time.
9 #implicity 0 ;uyin( a mutual fund is easy> .retty well any bank has its own line of
mutual funds, and the minimum investment is small. Most companies also have
automatic purchase plans whereby as little as ?600 can be invested on a monthly
basis.
Disadvantages of Mutual Funds:
9 .rofessional Mana(ement0 :id you notice how we 3ualified the advanta(e of
professional mana(ement with the word %theoretically%@ Many investors debate over
whether or not the so0called professionals are any better than you or ' at pickin(
stocks. Mana(ement is by no means infallible, and, even if the fund loses money, the
mana(er still takes his/her cut. We)ll talk about this in detail in a later section.
9 Aosts 0 Mutual funds don)t exist solely to make your life easier00all funds are in it
for a profit. !he mutual fund industry is masterful at buryin( costs under layers of
jar(on. !hese costs are so complicated that in this tutorial we have devoted an entire
section to the subject.
9 :ilution 0 't)s possible to have too much diversification $this is explained in our
article entitled %Are 4ou 1ver0:iversified@%&. ;ecause funds have small holdin(s in so
many different companies, hi(h returns from a few investments often don)t make
much difference on the overall return. :ilution is also the result of a successful fund
(ettin( too bi(. When money pours into funds that have had stron( success, the
mana(er often has trouble findin( a (ood investment for all the new money.
9 !axes 0 When makin( decisions about your money, fund mana(ers don)t consider
your personal tax situation. 8or example, when a fund mana(er sells a security, a
capital0(ain tax is tri((ered, which affects how profitable the individual is from the
sale. 't mi(ht have been more advanta(eous for the individual to defer the capital
(ains liability.
Different Types of Funds
,o matter what type of investor you are there is bound to be a mutual fund that fits
your style. Accordin( to the last count there are over 60,000 mutual funds in ,orth
America> !hat means there are more mutual funds than stocks.
't)s important to understand that each mutual fund has different risks and rewards.
'n (eneral, the hi(her the potential return, the hi(her the risk of loss. Althou(h some
funds are less risky than others, all funds have some level of risk00it)s never possible
to diversify away all risk. !his is a fact for all investments. $4ou can learn more
about this in our financial concepts tutorial.&
*ach fund has a predetermined investment objective that tailors the fund)s assets,
re(ions of investments, and investment strate(ies. At the fundamental level, there
are three varieties of mutual funds5
6& *3uity funds $stocks&
2& 8ixed0income funds $bonds&
7& Money market funds
All mutual funds are variations of these three asset classes. 8or example, while
e3uity funds that invest in fast0(rowin( companies are known as (rowth funds,
e3uity funds that invest only in companies of the same sector or re(ion are known as
specialty funds.
=et)s (o over the many different flavors of funds. We)ll start with the safest and then
work throu(h to the more risky.
Money Market Funds
!he money market consists of short0term debt instruments, mostly !0bills. !his is a
safe place to park your money. 4ou won)t (et (reat returns, but you won)t have to
worry about losin( your principle. A typical return is twice the amount you would
earn in a re(ular checkin(/savin(s account and a little less than the avera(e
certificate of deposit $A:&. We)ve (ot a whole tutorial on the money market if you)d
like to learn more about it.
Bond/Incoe Funds
'ncome funds are named appropriately5 their purpose is to provide current income
on a steady basis. When referrin( to mutual funds, the terms %fixed0income,%
%bond,% and %income% are synonymous. !hese terms denote funds that invest
primarily in (overnment and corporate debt. While fund holdin(s may appreciate in
value, the primary objective of these funds is to provide a steady cashflow to
investors. As such, the audience for these funds consists of conservative investors
and retirees.
;ond funds are likely to pay hi(her returns than certificates of deposit and money
market investments, but bond funds aren)t without risk. ;ecause there are many
different types of bonds, bond funds can vary dramatically dependin( on where they
invest. 8or example, a fund speciali<in( in hi(h0yield junk bonds is much more risky
than a fund that invests in (overnment securitiesB also, nearly all bond funds are
subject to interest rate risk, which means that if rates (o up the value of the fund
(oes down.
Balanced Funds
!he objective of these funds is to provide a %balanced% mixture of safety, income,
and capital appreciation. !he strate(y of balanced funds is to invest in a combination
of fixed0income and e3uities. A typical balanced fund mi(ht have a wei(htin( of C0D
e3uity and E0D fixed0income. !he wei(htin( mi(ht also be restricted to a specified
maximum or minimum for each asset class.
A similar type of fund is known as an asset allocation fund. 1bjectives are similar to
those of a balanced fund, but these kinds of funds typically do not have to hold a
specified percenta(e of any asset class. !he portfolio mana(er is therefore (iven
freedom to switch the ratio of asset classes as the economy moves throu(h the
business cycle.
!"uity Funds
8unds that invest in stock represent the lar(est cate(ory of mutual funds. Fenerally,
the investment objective of this class of funds is lon(0term capital (rowth with some
income. !here are, however, many different types of e3uity funds because there are
many different types of e3uities. A (reat way to understand the universe of e3uity
funds is to use a style box, an example of which is below. $"sin( a style box to
classify mutual funds was populari<ed by Morningstar.&
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!he idea is to classify funds based on both the si<e of the comp anies invested in and
the investment style of the mana(er. !he term %value% refers to a style of investin(
that looks for hi(h 3uality companies that are out of favor with the market. !hese
companies are characteri<ed by low ./* ratios, price0to0book ratios, and hi(h
dividend yields, etc. ! he opposite of value is (rowth, which refers to companies that
have had $and are expected to continue to have& stron( (rowth in earnin(s, sales,
and cash flow, etc. A compromise between value and (rowth is %blend,% which simply
refers to companies that are neither value nor (rowth stocks and so are classified as
bein( somewhere in the middle.
8or example, a mutual fund that invests in lar(e0cap companies who are in stron(
financial shape but have recently seen their share price fall would be placed in the
upper left 3uadrant of the style box $lar(e and value&. !he opposite of this would be
a fund that invests in startup technolo(y companies with excellent (rowth prospects.
#uch a mutual would reside in the bottom ri(ht 3uadrant $small and (rowth&.
#lo$al/International Funds
An international fund $or forei(n fund& invests only outside your home country.
Flobal funds invest anywhere around the world, includin( your home country.
't)s tou(h to classify these funds as either more risky or safer. 1n the one hand they
tend to be more volatile and have uni3ue country and/or political risks. ;ut, on the
flip side, they can, as part of a well0balanced portfolio, actually reduce risk by
increasin( diversification. Althou(h the world)s economies are becomin( more
interrelated,
it is likely that another economy somewhere is outperformin( the economy
of your home country.
%pecialty Funds
!his classification of mutual funds is more of an all0encompassin( %etc. cate(ory%
that consists of funds that have proven to be popular but don)t necessarily belon( to
the cate(ories we)ve described so far. !his type of mutual fund for(oes broad
diversification to concentrate on a certain se(ment of the economy.
#ector funds are tar(eted at specific sectors of the economy such as financial,
technolo(y, health, etc. #ector funds are extremely volatile. !here is a (reater
possibility of bi( (ains, but you have to accept that your sector may tank.
+e(ional funds make it easier to focus on a specific area of the world. !his may
mean focusin( on a re(ion $say =atin America& or an individual country $for example,
only ;ra<il&. An advanta(e of these funds is that they make it easier to buy stock in
forei(n countries, which is otherwise difficult and expensive. 2ust like for sector
funds, you have to accept the hi(h risk of loss, which occurs if the re(ion (oes into a
bad recession.
#ocially0responsible funds $or ethical funds& invest only in companies that meet the
criteria of certain (uidelines or beliefs. Most socially responsible funds don)t invest in
industries such as tobacco, alcoholic bevera(es, weapons, or nuclear power. !he idea
is to (et a competitive performance while still maintainin( a healthy conscience.
Inde& Funds
!he last but certainly not the least important are index funds. !his type of mutual
fund replicates the performance of a broad market index such as the #J. H00 or
:2'A. An investor in an index fund fi(ures that most mana(ers can)t beat the market.
An index fund merely replicates the market return and benefits investors in the form
of low fees.
'osts
Aosts are the bi((est problem with mutual funds. !hese costs eat into your return,
and they are the main reason why the majority of funds end up with sub0par
performance.
What)s even more disturbin( is the way the fund industry hides costs throu(h a layer
of financial complexity and jar(on. #ome critics of the industry say that mutual fund
companies (et away with the fees they char(e only because the avera(e investor
does not understand what he/she is payin( for.
8ees can be broken down into two cate(ories5
6. 1n(oin( yearly fees to keep you invested in the fund.
2. !ransaction fees paid when you buy or sell shares in a fund $loads&.
The !&pense (atio
!he on(oin( expenses of a mutual fund is represented by the expense ratio. !his is
sometimes also referred to as the mana(ement expense ratio $M*+&. !he expense
ratio is composed of the followin(5
9 !he cost of hirin( the fund mana(er$s& 0 Also known as the mana(ement fee, this
cost is between 0.HD and 6.0D of assets on avera(e. While it sounds small, this fee
ensures that mutual fund mana(ers remain in the country)s top echelon of earners.
!hink about it for a second5 6D of 2H0 million $a small mutual fund& is ?2.H million00
fund mana(ers are definitely not (oin( hun(ry> 't)s true that payin( mana(ers is a
necessary fee, but don)t think that a hi(h fee assures superior performance.
9 Administrative costs 0 !hese include necessities such as posta(e, record keepin(,
customer service, cappuccino machines, etc. #ome funds are excellent at minimi<in(
these costs while others $the ones with the cappuccino machines in the office& are
not.
9 !he last part of the on(oin( fee $in the "nited #tates anyway& is known as the
62;06 8ee. !his expense (oes toward payin( brokera(e commissions and toward
advertisin( and promotin( the fund. !hat)s ri(ht, if you invest in a fund with a 62;06
fee, you are payin( for the fund to run commercials and sell itself>
1n the whole, expense ratios ran(e from as low as 0.2D $usually for index funds& to
as hi(h as 2.0D. !he avera(e e3uity mutual fund char(es around 6.7D06.HD. 4ou)ll
(enerally pay more for specialty or international funds, which re3uire more expertise
from mana(ers.
Are hi(h fees worth it@ 4ou (et what you pay for, ri(ht@
Wron(.
2ust about every study ever done has shown no correlation between hi(h expense
ratios and hi(h returns. !his is a fact. 'f you want more evidence, consider this 3uote
from the #*A)s website5
"Higher expense funds do not, on average, perform better than lower expense
funds."
)oads* A+,+A+ -Fee for %alesperson-
=oads are just fees that a fund uses to compensate brokers or other salespeople for
sellin( you the mutual fund. All you really need to know about loads is this5 don)t
buy funds with loads.
'n case you are still curious, here is how certain loads work5
9 8ront0end loads 0 !hese are the most simple type of load5 you pay the fee when
you purchase the fund. 'f you invest ?6,000 in a mutual fund with a HD front0end
load, ?H0 will pay for the sales char(e, and ?KH0 will be invested in the fund.
9 ;ack0end loads $also known as deferred sales char(es& 0 !hese are a bit more
complicated. 'n such a fund you pay the a back0end load if you sell a fund within a
certain time frame. A typical example is a CD back0end load that decreases to 0D in
the seventh year. !he load is CD if you sell in the first year, HD in the second year,
etc. 'f you don)t sell the mutual fund until the seventh year, you don)t have to pay
the back0end load at all.
A %no0load% fund sells its shares without a commission or sales char(e. #ome in the
mutual fund industry will tell you that the load is the fee that pays for the %service%
of a broker choosin( the correct fund for you. Accordin( to this ar(ument, your
returns will be hi(her because the professional advice put you into a better fund.
!here is little to no evidence that shows a correlation between load funds and
superior performance. 'n fact, when you take the fees into account, the avera(e load
fund performs worse than a no0load fund.
Buying and %elling Funds
Buying and %elling
4ou can buy some mutual funds $no0load& by contactin( the fund companies directly.
1ther funds are sold throu(h brokers, banks, financial planners, or insurance a(ents.
'f you buy throu(h a third party there is a (ood chance they)ll hit you with a sales
char(e $load&.
!hat bein( said, more and more funds can be purchased throu(h no0transaction fee
pro(rams that offer funds of many companies. #ometimes referred to as a %fund
supermarket,% this service lets you consolidate your holdin(s and record keepin(,
and it still allows you to buy funds without sales char(es from many different
companies. .opular examples are #chwab)s 1ne#ource, -an(uard)s 8undAccess, and
8idelity)s 8unds,etwork. Many lar(e brokera(es have similar offerin(s.
#ellin( a fund is as easy as purchasin( one. All mutual funds will redeem $buy back&
your shares on any business day. 'n the "nited #tates companies must send you the
payment within seven days.
The .alue of /our Fund
,et asset value $,A-&, which is a fund)s assets minus liabilities, is the value of a
mutual fund. ,A- per share is the value of one share in the mutual fund, and it is
the number that is 3uoted in newspapers. 4ou can basically just think of ,A- per
share as the price of a mutual fund. 't fluctuates everyday as fund holdin(s and
shares outstandin( chan(e.
When you buy shares, you pay the current ,A- per share plus any sales front0end
load. When you sell your shares, the fund will pay you ,A- less any back0end load.
Finding Funds
!he Mutual 8und *ducation AllianceL is the not0for0profit trade association of the noload
mutual fund industry. !hey have a tool for searchin( for no0load funds at
http5//www.mfea.com/8und#elector
Mornin(star is an investment research firm that is particularly well known for its fund
information5
http5//www.mornin(star.com
0o1 To (ead a Mutual Fund Ta$le
'oluns 2 3 4: 546Week 0i and )o1 6 !hese show the hi(hest and lowest prices
the mutual fund has experienced over the previous H20weeks $one year&. !his
typically does not include the previous day)s price.
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'olun 7: Fund 8ae 6 !his column lists the name of the mutual fund. !he
company that mana(es the fund is written above in bold type.
'olun 9: Fund %pecifics 6 :ifferent letters and symbols have various meanin(s.
8or example, %,% means no load, %8% is front end load, and %;% means the fund has
both front and back0end fees. 8or other symbols see the le(end in the newspaper in
which you found the table.
'olun 5: Dollar 'hange 6 !his states the dollar chan(e in the price of the mutual
fund from the previous day)s tradin(.
'olun :: ; 'hange 6 !his states the percenta(e chan(e in the price of the
mutual fund from the previous day)s tradin(.
'olun <: Week 0igh 6 !his is the hi(hest price the fund traded at durin( the past
week.
'olun =: Week )o1 6 !his is the lowest price the fund traded at durin( the past
week.
'olun >: 'lose 6 !he last price at which the fund was traded is shown in this
column.
'olun 2?: Week@s Dollar 'hange 6 !his represents the dollar chan(e in the price
of the mutual fund from the previous week.
'olun 22: Week@s ; 'hange 6 !his shows the percenta(e chan(e in the price of
the mutual fund from the previous week.
The Truth (evealed A$out Mutual Fund Ads
')m sure you)ve noticed all those mutual fund ads that 3uote their ama<in(ly hi(h
one0year rates of return. 4our first thou(ht is %wow, that mutual fund did (reat>%
Well, yes it did (reat last year, but then you look at the three0year performance,
which is lower, and the five year, which is yet even lower. What)s the underlyin(
story here@ =ets look at a real example00' (ot the fi(ures from the local paper
$names withheld of course&5
2 year 7 year 5 year
H7D 20D 66D
1k, last year the fund had excellent performance at H7D. ;ut in the past three years
the avera(e annual return was 20D. What did it do in years 6 and 2 to brin( the
avera(e return down to 20D@ #ome simple math shows us that the fund made an
avera(e return of 7.HD over those first two years5 20D M $H7D N 7.HD N 7.HD&/7.
;ecause that is only an avera(e, it is very possible that the fund lost money in one of
those years.
't (ets worse when we look at the five0year performance. We know that in the last
year the fund returned H7D and in years 2 and 7 we are (uessin( it returned around
'nvestopedia.com G the resource for investin( and personal finance education.
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7.HD. #o what happened in years E and H to brin( the avera(e return down to 66D@
A(ain, by doin( some simple calculations we find that the fund must have lost
money, an avera(e of 02.HD each year of those two years5 66D M $H7D N 7.HD N
7.HD 0 2.HD 0 2.HD&/H. ,ow the fund)s performance doesn)t look so (ood>
't should be mentioned that, for the sake of simplicity, this example, besides makin(
some bi( assumptions, doesn)t include calculatin( compound interest. #till, the point
wasn)t to be technically accurate but to demonstrate how misleadin( mutual fund
ads can be. A fund that loses money for a few years can bump the avera(e up
si(nificantly with one or two stron( years.
'onclusion 3 (esources
=et)s recap what we)ve learned in this tutorial5
A mutual fund brin(s to(ether a (roup of people and invests their money in
stocks, bonds, and other securities.
!he advanta(es of mutuals are professional mana(ement, diversification,
economies of scale, simplicity, and li3uidity.
!he disadvanta(es of mutuals are hi(h costs, over0diversification, possible tax
conse3uences, and the inability of mana(ement to (uarantee a superior
return.
!here are many, many types of mutual funds. 4ou can classify funds based on
asset class, investin( strate(y, re(ion, etc.
Mutual funds have lots of costs.
Aosts can be broken down into on(oin( fees $represented by the expense
ratio& and transaction fees $loads&.
!he bi((est problems with mutual funds are their costs and fees.
Mutual funds are easy to buy and sell. 4ou can either buy them directly from
the fund company or throu(h a third party.
Mutual fund ads can be very deceivin(.
(elated )inks
As we mentioned, index funds can be an excellent way to invest in mutual funds
without the hi(h fees. We talk more about this in our tutorial called %Inde& Basics.%
'f you would like to learn more about how the mutual fund industry can hide
instances of its poor performance, see our article called %The Truth Behind Mutual
Fund (eturns.%