Mutual funds have a long and storied history. In this post, I am going to give you a breakdown of mutual fund basics. Everything you really need to know about mutual funds is below. For the most part, I will touch on many areas and at times, will link to more in-depth posts that I have written about specific topics about mutual funds. So let’s get started on learning mutual fund basics.
Mutual Fund Basics
What Is A Mutual Fund
A mutual fund is a basket of investments that you can buy. Instead of buying 10 shares of General Electric and 5 shares of Apple, you can instead buy 20 shares of a mutual fund. Doing so will get you shares in both General Electric and Apple.
Of course, this is a simplified example. A typical mutual fund owns shares of thousands of companies. When you buy a share of the mutual fund, you aren’t buying 1 share in each company; you are buying fractions of shares in these companies. So, if you own 10 shares of a certain mutual fund, you might own:
1 share of General Electric
0.75 shares of Apple
0.55 shares of AT&T
0.30 shares of Best Buy
There is no relationship between the number of mutual fund shares you buy and the number of company shares you own. In other words, the 10 shares you bought above will not necessarily equal out to owning 10 shares of various companies.
Types Of Mutual Funds
When talking about mutual fund basics, we can’t overlook the various types of mutual funds. There are 3 main types of mutual funds:
Open Ended Mutual Funds
Open ended mutual funds are the most common type of mutual fund. In fact, when you hear people talking about mutual funds in general, odds are they are talking about open ended mutual funds.
An open ended mutual fund is a mutual fund that has no set number of shares. You can buy or sell at any time, without needing another person on the other end. The mutual fund is the entity that will issue you new shares and buy your shares back.
Close Ended Mutual Funds
Close ended mutual funds are more like stocks. They issue a set number of shares to the public. Because of this, you need to find a buyer when you sell and a seller when you want to buy. Doing this is fairly easy, as with stocks.
The main difference is with this type of mutual fund is that they trade at a premium or a discount. This means the price you pay or sell for can be different than what the net asset value (NAV) of the fund is. (More on this later.)
Unit Investment Trusts
Unit investment trusts are their own breed. This type of mutual fund issues a set number of shares like a close ended mutual fund does. But, this type of fund has a date when the trust will end.
If you want to sell your shares, you can do so by either selling them back to the trust, wait to redeem your shares when the trust ends, or you can sell your shares in the open market. Note that selling your shares in the open market is not common.
Mutual Fund Classifications
Taking the topic of mutual fund basics one step further are the underlying assets of the mutual funds themselves. As I mentioned earlier, a mutual fund is a basket of investments. These investments can include stocks or bonds, or even both! Here is an easy breakdown of the common mutual fund classifications:
- Equity Fund: Invests in stocks
- Bond Fund: Invests in bonds
- Money Market Fund: Invests in short term debt instruments
- Hybrid Fund: Invests a percentage in both stocks and bonds
Mutual funds are broken down further in each of these classifications. For example, with a bond fund, you could invest in a short-term bond fund (the underlying investments mature in about 5 years), an intermediate bond fund (investments mature in roughly 15 years) or a long-term bond fund (investments mature in roughly 30 years).
Don’t get confused about the underlying investments maturing. These funds are not like the unit investment trusts I talked about before. A mutual fund continuously buys new bonds all of the time, so a short-term bond fund will have the underlying bonds maturing all the time. It’s just that that average maturity of the bonds it holds is roughly 5 years.
Mutual Fund History
We couldn’t talk about mutual fund basics without talking about the history of the mutual fund. The first mutual fund was established in Europe way back in the 1700’s. In the US, mutual funds showed up in the late 1800’s. While investors did invest in mutual funds throughout the 1900’s, mutual funds didn’t explode in popularity until the 1980’s. This is when 401k plans were first introduced. From that point on, the interest in mutual funds has only grown. With the raging stock market of the 1980’s and 1990’s, ordinary Americans found investing in mutual funds an easy way to get exposure to the stock market with little money.
Today, mutual funds remain a popular choice, but have some serious competition with exchange traded funds. These funds, or ETFs take a lot of the negatives of mutual funds and turn them into advantages. So what are these positives and negatives?
Advantages And Disadvantages of Mutual Funds
I am only going to briefly highlight the advantages and disadvantages in this post. I recently wrote much more about this topic – you can read about mutual fund advantages here and mutual fund disadvantages here (and trust me, you should read it). But with that said, here is what you need to know when considering mutual funds.
Invest With Little Money: with a mutual fund, you can invest with a small amount of money. For most mutual funds, just $500 to $1,000 will allow you to make an initial investment. From there, any additional investing in the fund is as little as $50 to $100. This low barrier for entry makes mutual funds popular with smaller investors.
Quick Diversification: when you buy a mutual fund, you are buying shares of thousands of companies at once. As a result you are instantly diversified as an investor. This lowers some of the risk you face investing.
Too Diversified: Some investors see a mutual fund as a single investment and not a basket of investments. As a result, they buy many mutual funds thinking this will make them more diversified. The problem is that many of these mutual funds own the same underlying securities, just in different allocations. So while you think you are doing yourself a favor by investing in many mutual funds, you could be simply shooting yourself in the foot.
High Fees: mutual funds cost money to invest in. You never get a bill in the mail however. All mutual funds take their fee from the performance of the fund. Because of this, many investors pay a higher fee than they are aware. Mutual fund fees add up over time. As a result, it is important to pay attention to how much you are paying in fees.
Mutual Fund Fees
Any talk about mutual fund basics has to cover fees. There are all sorts of fees mutual funds charge. To start off, all mutual funds charge a management fee. This fee pays the portfolio manager and the costs associated with running the fund. As I talked about above, this fee is taken directly from the fund itself.
For example, let’s say your mutual fund charges you a fee of 1% per year. At the end of the year, you see your mutual fund returned 7%. What the fund really returned is around 8%. After the fee is taken out, you earn what is left over.
The average mutual fund fee for an equity fund is 1.40%. There is no reason you should be paying this high of a fee. Unlike with everything else in life, where “you get what you pay for”, mutual funds work the opposite way – you get what you don’t pay for. In other words, the lower the fees, the better off you are.
Why is this? Because no fund manager can consistently beat the market. They get lucky and beat the market from time to time, but no one does it every single year. From 1991 through 2005, Bill Miller of Legg Mason did beat the market every single year. The ironic thing is that even he chalked it up to luck. (For those of you curious, the odds of actually doing this are 1 in 2.3 million).
Unfortunately the fees don’t end with management fees for mutual funds. Here are a handful of other fees you can expect to encounter. (Note that not all mutual funds charge the following fees):
Load: This is a fee you pay to invest in a mutual fund in the first place. Why would you pay to invest in a mutual fund? Beats me, but many people do it.
When you pay to invest in a mutual fund, it is referred to as a front load. Some mutual funds charge a back load instead. In this case, they take a fee when you sell. Typically, this fee is only on certain classes of mutual funds.
12b-1Fee: This is a fee charged by the distributor of the mutual fund for providing services to shareholders. Typically this fee is 0.25% but can be much higher.
Short Term Redemption Fee: Some mutual funds charge this fee to those that sell out of a fund within 90 days or less of buying the fund. The idea here is that the fund wants to stop short-term trading. While on the surface short-term trading doesn’t seem like trouble, it actually is. The more trading a fund does, the more costs are added to the fund that get passed through to you.
Net Asset Value
The net asset value, or NAV of a mutual fund is calculated after the market closes. The NAV is simply the value of the underlying assets the fund holds minus the funds liabilities. It is then divided by the number of shares outstanding. To find how much your holdings are worth, you simply multiply the number of shares you own by the NAV of the fund.
An open ended mutual fund always trades at the NAV because you are buying shares directly from the fund or selling your shares back to the fund. In other words, if you buy or sell shares of an open ended mutual fund, you know you are paying or receiving the same value of what the fund is worth.
With a close ended mutual fund, this is not the case. Since you buy and sell shares with other investors and not the fund itself, you can pay more or less than the NAV. It all depends on the demand of the fund.
Mutual Funds: What To Look For
So now that you have an understanding of mutual fund basics, what should you look for when it comes to picking and investing in mutual funds? Luckily, I have another in-depth post about this as well, which you can read here. But here is a quick breakdown for what you need to know:
Look For Low Fees: As I said, low fees are the key. One percent might not sound like much, but it adds up over time. If you have $50,000 invested, this means you are paying $500 per year to invest. That is just crazy. You shouldn’t have any mutual funds with a fee over 1%. Heck, you shouldn’t have anything over 0.75% for that matter. If you want to see how much you are paying in fees, check out Personal Capital.
Watch Out For Other Fees: If a fund is charging you a load, run the other way. There are so many mutual fund options out there, you can easily invest in a good mutual fund without a load. In fact, you could get away with just 3 funds! The same idea holds true for 12b-1 fees as well.
Turnover: I didn’t talk about turnover above, but it is something to look for. Simply put, turnover is how often the portfolio manager buys and sells the underlying investments. If the number is over 100% (and with many fund it is) this tells you that the underlying investments you owned when you first bought the fund are not the same as one year later. Remember what I told you about the more trading a mutual fund does, the higher the costs are to you? Here is a prime example of this in action. Look for low turnover.
I realize that this was a lot of information about mutual fund basics, but there is a lot to know. I suggest you take the time to re-read the post a few times so you can digest all of the information. When you are finished, you should have confidence enough to start looking over mutual funds to invest in. If you have any questions along the way, feel free to reach out to me.
While I can’t tell you exactly what to invest in, I can help you understand things you might be overlooking. Also, be sure to check out my online broker comparison chart to find a broker that offers mutual funds with no trading fees.
With that said, if you want a simple way to invest, look into Betterment. You can set up an account and have an automatic investment ready to go with them in under 10 minutes. I personally use them for part of my investing strategy and love what they do.
Another option is Motif Investing. Here you can build a motif of common stock or even chose a pre-built model. Low costs and no fees make it a worthwhile option to consider.
Lastly, just remember, it’s your money. No one cares about it as much as you do. Because of this, it is important to understand as much as you can about investing. Again, I am here to help you in any way that I can.