Mutual funds are investment vehicles that pool money from multiple investors to purchase a diversified portfolio of assets, such as stocks, bonds, or other securities. They are designed to provide individuals with an opportunity to invest in a diversified portfolio of assets, even if they have limited capital to invest. Mutual funds are managed by professional fund managers who make investment decisions on behalf of the fund’s investors. These funds offer a way to invest in a wide range of asset classes, including stocks, bonds, and more.
Mutual funds operate by allowing investors to buy shares in the fund, which effectively makes them part owners of the fund. As part owners, they share in the fund’s profits and bear a portion of its expenses. When the underlying stocks or bonds within the fund generate income through dividends or interest, the fund collects these profits and distributes them to its shareholders in the form of income distributions, minus any expenses incurred in managing the fund.
Moreover, when the fund’s managers make profitable sales of investments within the portfolio, they pass on the after-expense profits to the shareholders as capital gains distributions. Investors typically have the flexibility to choose whether to receive these distributions in cash or reinvest them automatically in the fund, thereby increasing the number of shares they hold.
It’s important to note that mutual funds come with associated fees. These fees can be charged at specific times, based on actions taken by the investor, or on an ongoing basis. The details of these fees can be found in each fund’s prospectus, which provides comprehensive information on the fund’s operations and costs.
Furthermore, it’s worth mentioning that mutual funds are regulated financial instruments and are registered with the Securities and Exchange Commission (SEC). This regulatory oversight helps ensure transparency and investor protection in the mutual fund industry.
Professional Management. One of the primary reasons to invest in mutual funds is the benefit of professional management. Fund managers are experienced experts who conduct thorough research, analyze market trends, and make informed investment decisions on your behalf. They carefully select the securities that go into the fund’s portfolio and continuously monitor their performance. This level of expertise can be particularly valuable for investors who lack the time or knowledge to manage their investments effectively.
Diversification. The famous saying, "Don’t put all your eggs in one basket," is a fundamental principle of investing. Mutual funds inherently provide diversification because they invest in a range of companies, industries, and asset classes. This diversification helps spread the risk, reducing the impact of any single company’s poor performance. In essence, it’s a risk management strategy that can be especially attractive to investors seeking stability in their portfolio.
Affordability. Mutual funds are known for their accessibility. Most mutual funds set relatively low dollar amounts for the initial investment and subsequent purchases. This means that investors with various budget sizes can participate in these funds, allowing them to start building a diversified investment portfolio without needing significant capital.
Liquidity. Mutual funds offer high liquidity, providing investors with the flexibility to redeem their shares at any time. The redemption is typically done at the current net asset value (NAV) of the fund, plus any applicable redemption fees. This feature ensures that your money is not locked in for extended periods, and you have the freedom to access your investments when needed, enhancing your financial flexibility.
Net Asset Value (NAV). The price of a mutual fund share is known as the net asset value (NAV) per share, sometimes expressed as NAVPS. The NAV represents the value of the mutual fund’s portfolio, which is essentially the combined performance of the various securities it holds. It’s important to note that mutual fund shares do not grant their holders any voting rights, unlike individual stocks.
Calculation of NAV. The NAV of a mutual fund is calculated by dividing the total value of the securities in the fund’s portfolio by the total number of shares outstanding. The outstanding shares encompass those held by all shareholders, including institutional investors, and company officers or insiders.
Purchasing and Redemption. Mutual fund shares can typically be bought or redeemed at the fund’s current NAV. Unlike individual stocks, the NAV of a mutual fund does not fluctuate during market hours. Instead, it is settled at the end of each trading day, ensuring that all investors receive the same price for their transactions. When you buy or sell mutual fund shares, the price you receive is based on the NAV calculated at the end of that trading day.
Diversification Benefits. One of the key advantages of investing in mutual funds is diversification. A mutual fund typically holds a diverse selection of stocks and other securities. This diversification helps mitigate the risk associated with investing in a single company’s stock. For example, if you invest solely in one company’s stock, your returns are closely tied to that company’s performance. In contrast, a mutual fund’s gains and losses are spread across its various holdings, which can offset the impact of individual security performance.
Returns on mutual funds are calculated by considering the multiple ways investors can earn from their investments:
Income Distributions. Mutual fund investors typically earn returns in the form of income distributions. These distributions are generated from the dividends on stocks and the interest on bonds held in the fund’s portfolio. Funds often pay out the majority of the income they receive over the year to the fund owners in the form of these distributions. Investors usually have the choice of either receiving a check for the distributions or reinvesting the earnings to purchase additional shares of the mutual fund.
Capital Gains Distributions. When a mutual fund sells securities that have increased in price, it realizes capital gains. These capital gains are usually passed on to the investors in the form of capital gains distributions. This provides investors with the opportunity to benefit from the fund’s profitable transactions.
Market Price Appreciation. Another way for mutual fund investors to earn returns is when the fund’s shares increase in price. In this scenario, investors can sell their mutual fund shares on the market for a profit. The change in market value represents the capital appreciation aspect of the return.
Total Return Calculation. When assessing the returns of a mutual fund, investors often come across the concept of "total return." This measure reflects the change in the investment’s value over a specific period, considering any interest, dividends, or capital gains generated by the fund, as well as the change in its market value over that time. Total returns are typically calculated for various periods, such as one, five, and ten years, as well as since the fund’s inception.
Stock Funds. These funds primarily invest in equity or stocks. They can be further categorized based on the size of the companies they invest in, such as small-cap, mid-cap, or large-cap. There are also subcategories based on investment approaches, like aggressive growth, income-oriented, and value. Stock funds can focus on domestic (U.S.) stocks or foreign equities.
Bond Funds. Bond funds, or fixed income funds, concentrate on investments that offer a fixed rate of return. This category includes government bonds, corporate bonds, and other debt instruments. These funds generate interest income, which is distributed to shareholders. Bond funds can vary in risk based on the types of bonds they invest in.
Index Funds. Index funds track major market indices like the S&P 500 or the Dow Jones Industrial Average. These funds require less active management and often have lower expenses, making them a cost-effective choice for investors.
Balanced Funds. These funds invest in a mix of asset classes, including stocks, bonds, money market instruments, and alternative investments. Balanced funds aim to reduce risk by diversifying across different asset classes. Some funds have fixed asset allocation strategies, while others adjust their allocation based on market conditions or investor objectives.
Money Market Funds. Money market funds invest in safe, short-term debt instruments like government Treasury bills. While they offer minimal returns, they provide principal stability and are ideal for conservative investors.
Income Funds. Income funds focus on providing a steady stream of current income. They invest in government and high-quality corporate debt and hold these bonds until maturity to generate interest payments. These funds are suitable for investors seeking a reliable cash flow.
International/Global Funds. International funds invest in assets located outside the investor’s home country, while global funds can invest worldwide. The performance of these funds can be influenced by foreign economies and political factors, making them useful for diversification.
Specialty Funds. Specialty funds have specific investment objectives. Sector funds target particular sectors of the economy, such as technology, healthcare, or financial services. Regional funds concentrate on a specific geographic area or country. Socially responsible funds invest according to specific ethical guidelines, avoiding certain industries or favoring environmentally responsible companies.
Diversification. Mutual funds offer diversification by mixing various investments and assets within a single portfolio to reduce risk. This diversification includes different capitalizations, industries, and bond maturities, providing investors with a more balanced and less risky investment.
Easy Access. Mutual funds are highly liquid and can be bought and sold on major stock exchanges with relative ease, offering convenient access to various assets, including foreign equities and commodities.
Economies of Scale. Mutual funds provide economies of scale by pooling investors’ money and lowering transaction costs, allowing investors to benefit from dollar-cost averaging and lower transaction fees. The fund’s ability to buy and sell in bulk also reduces transaction costs.
Professional Management. Mutual funds are managed by investment professionals who conduct research and make investment decisions. This professional management is cost-effective for individual investors and provides access to skilled portfolio management.
Variety and Freedom of Choice. Mutual funds offer a wide range of investment styles and management goals, allowing investors to choose from managers with different investment approaches, such as value, growth, income, and various asset classes. This variety allows for exposure to diverse investments, both domestic and foreign.
Transparency. Mutual funds are subject to industry regulation, ensuring accountability and fairness to investors. Regulations mandate transparency and disclosure to protect investors’ interests.
No Guarantees. Mutual funds, like other investments, carry the risk of depreciating in value. Equity mutual funds experience price fluctuations, and there is no guaranteed return. Mutual fund investments are not insured by the FDIC.
Cash Drag. Mutual funds often hold a significant portion of their portfolios in cash to meet daily share redemptions. This cash, which earns no return, is known as "cash drag" and can reduce the fund’s overall performance.
High Costs. Mutual funds charge fees that impact overall returns, regardless of the fund’s performance. Active management and transaction costs can accumulate over time, eroding long-term returns.
"Diworsification" and Dilution. Overcomplicating portfolios by holding too many funds with similar investments can lead to "diworsification." Additionally, a successful fund that attracts substantial new capital may struggle to find suitable investments for all the new money, resulting in dilution of returns.
End of Day Trading Only. Mutual fund redemptions typically take place only at the end of each trading day, unlike stocks that trade throughout the day. This can limit an investor’s ability to respond quickly to market changes.
Taxes. When a fund manager sells a security, a capital gains tax is triggered, potentially leading to tax implications for investors. Strategies to mitigate taxes include investing in tax-sensitive funds or using tax-deferred accounts.
Evaluating Funds. Comparing and evaluating mutual funds can be challenging due to the lack of readily available data for direct comparison, unlike stocks. Net asset value (NAV) provides a basis for comparison, but differences in portfolio diversity make it challenging to compare funds, even with similar names or objectives.
Decide whether to go active or passive. Determine your investment approach by choosing between active and passive mutual funds. Active funds are managed by professionals who aim to outperform the market, while passive funds (index funds or exchange-traded funds known as ETFs) aim to match the market’s performance. Consider your risk tolerance and investment goals when making this decision.
Calculate your budget. Assess your financial situation and establish a budget for your mutual fund investments. Determine how much you can comfortably invest without affecting your daily expenses or financial security.
Decide where to buy mutual funds. Choose a platform or financial institution to purchase mutual funds. Options include brokerage firms, online investment platforms, banks, or direct through mutual fund companies. Consider factors like fees and expenses, account accessibility, and available fund options when selecting a provider.
Understand mutual fund fees. Be aware of the fees associated with mutual funds. These fees may include the expense ratio, sales loads, transaction fees, and redemption fees. It’s essential to understand how these fees can impact your investment returns over time.
Manage your portfolio. Create a diversified portfolio by selecting mutual funds that align with your investment strategy. Diversification helps spread risk. Regularly review and rebalance your portfolio to ensure it remains aligned with your financial goals.
An example of a notable mutual fund is the Fidelity Investments’ Magellan Fund (FMAGX). Established in 1963, this fund has a primary investment objective of capital appreciation through investments in common stocks. The Magellan Fund is renowned for its historical success, particularly during the tenure of Peter Lynch as its portfolio manager from 1977 to 1990. Under Lynch’s management, the fund’s assets under management (AUM) grew significantly, increasing from $18 million to an impressive $14 billion.
Fidelity’s performance with the Magellan Fund remained robust, and its AUM continued to grow, reaching nearly $110 billion by the year 2000. However, due to its substantial size, Fidelity temporarily closed the fund to new investors in 1997. It remained closed for over a decade until reopening in 2008.
As of March 2022, the Fidelity Magellan Fund boasts nearly $28 billion in assets and has been under the management of Sammy Simnegar since February 2019. Over the years, the fund’s performance has closely tracked or slightly outperformed that of the S&P 500, making it a well-known and historically successful mutual fund choice for investors.