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What is a mutual fund?

Mutual funds can make for good investment opportunities.
Find out what they are, how they work, and what benefits they provide to investors.
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Mutual funds are a way to combine your investing power with that of other investors so that together - 'mutually' - you can buy into bonds, common stocks, and other securities on a scale that you could not achieve individually.

Institutions offer a variety of different mutual funds, usually with a portfolio manager who decides what to buy and where to invest members' money.

Mutual funds usually aim to beat a benchmark index, often a popular financial market index of top stocks.

While there is no guarantee of success, a well-managed mutual fund with a proven track record can be a tempting proposition if you want to beat the yields of the mainstream indexes.

How is a mutual fund price calculated?

The price of a mutual fund depends on its total value and the number of mutual fund shares available to buy in the fund.

Net asset value or NAV is the total value of all the securities held in the fund's portfolio added together.

Divide the NAV by the number of outstanding shares in the fund to get the price per share.

As individual securities in the portfolio go up and down in value, the total NAV fluctuates, which in turn affects the mutual fund price calculation at the end of each day.

The calculation is quite simple and means each share is worth an equal amount. If you buy a larger number of shares, you hold a larger stake in the total fund and receive higher returns.

However, it is also worth noting that buying into a mutual fund only puts your money into the fund itself. You never directly own any of the securities in the fund's portfolio.

How do mutual funds work?

Mutual funds are usually actively managed, which means one or more portfolio managers decide what to buy and sell, often with the help of sophisticated computer programs or human researchers.

Each fund typically has a benchmark it aims to outperform. So for example, your fund manager might try to generate higher yields than you would get by investing in the Standard & Poor's 500 index.

This also provides you with a useful way to check the past performance of mutual funds that have been running for several years, by comparing their real yields from previous years against the average returns from their benchmark index.

Short-term fluctuations are not uncommon, so when deciding whether or not to buy into a mutual fund, many investors instead look to the long-term yield for a clearer indication of how well the fund performs against its benchmark.

Should I buy mutual funds?

Mutual funds have several characteristics that are popular with investors, especially smaller investors.

They let you start to invest using a relatively small sum of money. Unlike some other low-value investments though, you pool this money with everyone else in the fund, which means you do not miss out on higher-value opportunities.

Different types of mutual funds have different minimum buy-ins, but you might be able to start a relatively strong investment portfolio with just a few thousand dollars.

Some of the most common types of mutual funds are as follows:

  • Money market funds
  • Equity funds (also known as stock funds)
  • Fixed-income funds (also known as bond funds)
  • Balanced funds
  • Index funds
  • Target-date funds
  • Income funds
  • Sector funds
  • Exchange-traded funds (ETFs)

Once you buy into a fund, you can usually 'top up' by investing more in smaller increments than the initial buy-in amount, for example, a few hundred dollars at a time.

The decision of whether mutual funds are right for you is a personal one. But many investors see them as a good way to start a managed portfolio with a small amount of money.

This can be as a risk-averse investment or as a stepping stone toward a larger portfolio in the future. It is always advised that a person speaks to a financial advisor before investing in mutual funds.

Benefits of mutual funds

It's not just the ability to buy into mutual funds cheaply that makes them an appealing proposition.

Because you invest alongside many other fund members, it's possible to spread the fund's total portfolio across a wider range of securities.

Fund managers can combine risk-averse securities that offer less volatility and good liquidity with less liquid but higher-yielding securities.

The fund will usually set out strict rules that govern how illiquid its holdings can be and what percentage of securities will fall under each category.

By doing this, funds offer diversified portfolios - often more than 100 different securities. They can provide good liquidity while still putting a percentage of members' money into less liquid, higher-yielding investments.

In contrast, if you were to attempt to do this alone, you would need a much larger amount of money to make meaningful investments in so many different securities, with direct exposure to any lack of liquidity in your chosen market.

Advantages of managed mutual funds

A managed mutual fund gives you the benefit of the expertise of professional management.

For a relatively small management fee, a mutual fund company will give you insight into stock market trends, often powered by sophisticated computer systems that analyze stock prices and look for opportunities to add significant value in the short term.

Fund managers have several different ways to decide what to buy. They may target individual stocks, wider sectors and industries, entire national economies, or they might make targeted investments based on technical data.

Combining multiple methods based on deep insight and years of experience can deliver substantial value to individual investors in the fund who might not be equipped to make such decisions for themselves.

How to sell a mutual fund

If you want to sell a share in the fund, you can usually do so at the close of trade, once per day.

At that point, you can redeem your stake for that day's calculated NAV, giving you a daily opportunity to sell some or all of your shares.

Mutual funds typically invest in enough liquid stocks to be able to pay any investors who choose to exit the fund on any given day.

If an unusually large number of mutual fund investors want to sell their shares at once, this can force the fund manager to sell a large portion of the fund's most liquid securities.

This, in turn, can drive down the net liquidity of the portfolio, creating a problem for the remaining investors.

Because of this, funds may restrict trading during times of crisis, so that one investor who wants to sell a large stake in the fund cannot excessively influence the liquidity available to the remaining members.

Compound gains from mutual funds

Mutual funds typically offer the ability to make compound gains. As your investment in the fund generates capital gains and dividends, you can leave those gains in the fund.

Over time, this increases the total value of the fund. Those gains generate more gains, which in turn add even more value, and so on.

Depending on the decisions made by the other investors in the fund, this may mean the total value increases by the sum of everybody's gains, or it might mean your share in the fund grows if other investors choose to withdraw their gains.

In reality, a combination of the two takes place, and while some investors may choose to take their capital gains as disposable income, others will reinvest.

Do I pay tax on mutual funds?

Investors pay tax on income paid by mutual funds in the form of periodic distributions. These include cash payments from the fund, for example when the fund manager sells securities and makes a capital gain. You usually pay tax on any such gains based on your personal circumstances, although there may be exemptions if the fund invests in municipal bonds. In some cases - such as if you invest in the mutual fund via an IRA or another tax-advantaged account - you may be able to avoid paying tax. But in general, the three types of tax you might have to pay are:

  • Capital gains when the fund manager sells securities, charged at the long-term capital gains rate or at your personal income tax rate.
  • Capital gains when you sell your shares in the fund for a profit, again charged at the long-term rate or your income tax rate, depending on how long you held the shares
  • Dividend income usually charged at your normal income tax rate

Tax is one way you lose value from your investment, so keep it in mind when buying into a mutual fund from the outset.

However, most investments are subject to capital gains tax and dividend income tax, so this is something to be aware of in general rather than an issue specific to mutual funds.

Mutual fund fees

Like many investments, mutual funds also charge a variety of mutual fund fees that can reduce your net yield over time.

It's normal to pay a transaction fee, whether buying into the fund or selling your shares, so be aware before you make a trade.

If the fund falls under what is known as a "back-end load", the fees are assessed when you decide to sell your shares. If a mutual fund has a "front-end load", however, the fees are assessed at the point of purchase.

Some funds charge an additional fee if you decide to sell some or all of your shares very soon after you bought them.

Finally, there may be management fees to pay for operating costs like hiring the fund manager and paying any research support staff.

Investors who choose mutual funds are usually well aware of these costs but decide that they are an acceptable price to pay for access to the expertise of the fund manager.

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