What is a Mutual Fund in Simple Terms?

What is a Mutual Fund

Mutual funds are financial investments that consist of a specific group of assets that are collectively gathered into one large pot. These investments such as bonds, stocks, savings or types of debts, are overseen by fund managers who provide advice to investors looking to acquire capital gains on the proceeds. These funds also contain a disclosure document that details the asset allocation and structure upon which gains are realized.

The funds, which include a wide variation of securities are monitored and reported based on the performance of it’s investments. Mutual fund gains or subsequent losses are distributed amongst their investors or shareholders in accordance with each of their asset allocations. When shares of the fund are sold, so is the value of the portfolio of securities held at the time. This is known as a NAV or net asset value per share which increases or decreases in value each day.

How Do Mutual Funds Work?

Mutual funds work by operating as a dual investment comprised of a company as well. When a piece of the fund is purchased, rights are given as a shareholder as well as an owner of the company’s investments. An example would be having ownership in a flagship fund such as VTSAX or VTSMX, which in turn provides shares of each stock portfolio held by said fund. 

Additionally, some company founders function in multiple capacities such as fund managers and CEOs, as they are elected by the company’s board of directors and must put the shareholder’s interests above their own profits. 

There are several ways to earn a profit based on the returns produced including the following:

  1. Capital gains – The difference in the amount of the current share price compared to the share price of lesser value. Capital gains are given to shareholders on a quarterly, semi-annually or annual basis depending on the prospectus guidelines. 
  2. Marketing shares – Earnings received based on higher value shares that have remained under the umbrella of the fund’s unsold holdings. Once the shares are put on the market, the profits can be realized similar to a stock gain.
  3. Dividends – As assets are held in a fund, interest accumulates over time which produces stock dividends. These are typically cashed out; however, they can also be re-allocated as part of a DRIP(dividend reinvestment program).

The increase or decrease in net asset value of a funds portfolio isn’t directly subjected to market swings as with other investments, since the number represents the daily value of the portfolio at a given time and is often settled at day’s end. 

Types of Mutual Funds

There are many different types of mutual fund classifications, with each one highlighting their expected returns as well as the various securities involved. The most important aspects involved in differentiating a mutual fund are its portfolio offerings, daily value, dividend frequency, market capitalization, and long-term objectives.

Some of the most well-known fund categories are:

Equity Mutual Funds

Equity funds are mostly comprised of stocks and are by and large known as stock funds. They are categorically separated based on several factors such as whether they contain foreign or national holdings, their approach to investment growth, or the median size of the companies held inside the fund. 

Index Funds

Index funds are those with the sole purpose of tracking the most successful market indices such as the Dow Jones Industrial Average, S&P 500, or other variations of it. These funds were designed based on a premise that timing the markets is far more costly than simply tracking them as a whole. Another aspect of index funds is that they are categorized with some of the most profitable sectors like technology, finance, space, and agriculture. 

Growth Mutual Funds

Growth funds are known for having investments in asset classes that are credited with having large potential for growth such as small, mid cap, or large companies. They commonly set goals of beating the stock market which is measured by the S&P 500. Growth funds are popular with long term investors who are risk averse. 

Municipal Bond Mutual Funds

Muni-bond funds are heavily invested in state and government backed municipal bonds. These are often sold or funded to spur projects that improve the city’s infrastructure, revitalization efforts, or other public improvements. These are typically tax exempt which have benefits in states where taxes are higher than usual.

Income Funds

Income funds were created as a vehicle to provide a regular income. Investments feature those in areas of corporate debts as well as those owned by governmental entities. The value of income funds increase steadily over time and have the ability to be redeemed on a consistent basis. Increased taxes are often due as a result and are driven towards investors on the conservative side. 

Balanced Mutual Funds 

Balanced funds are a mixture of a variety of asset classes including stocks, medium-risk bonds, bonds opens, and other assets. Their hybrid nature allows them to contain equity as well as debt components as a way to balance out the holdings of the portfolio. The ratio of investments is often aligned with the ongoing changes of the market and provide a diverse asset allocation.

Mutual Fund Fee Structures 

Mutual fund fees are structured into two basic categories. These consist of operational fees that take place on an annual basis or shareholder fees that have several itemizations. Also known as expenses, they are calculated based on administratively added costs and managing fees. 

Most of the funds can be front loaded, assuming fees upon the purchase of shares or loaded on the back end allowing for fee assessment once the shares are subsequently sold. These fees, allocated to the shareholder are passed on as commissions, charges, or redemptions. On the other hand, admin fees are deducted on an annual basis and fall under 3 percent. 

Mutual Fund Shares

Mutual fund shares are attached to various types of classes dependent upon their numeric classifications and fee amounts. The shares are arranged in an alphabetical nature with each corresponding letter having its own fee percentage. 

  • A shares – Contain front-end sales charges in exchange for a portion in broker fees. For example: A  $500 investment with a 5% fee is equal to $25 up front costs and $475 total invested. 
  • B shares – Contain fees based on the time frame in which sales are sold known as a contingent deferred sales charge. These fees are also higher due to being based on expense ratios and the ability to convert to A shares. 
  • C shares – Allocate a small percentage of shares sold within a year. The fees are comparable to B shares however, they are lower in cases of short- term investing.
  • Transaction shares – Shares that are “clean” or don’t consist of deferred sales charges or typical front-end fees. At times they do require a brokerage commission as well as an investment fee.

Pros and Cons of Mutual Funds

Mutual funds have been popular among a wide class of investors for several different aspects. Investing in mutual funds allows benefits such as long-term investing, dividends, diversification, a variety of fund choices, as well as professional investment advisors.

Pros

  • Professional investment advice
  • Portfolio diversification
  • Fund variety
  • Sales liquidity
  • Long or short term options

Cons 

  • Not insured as with other accounts
  • Holding portfolio can be complicated
  • Higher fees and commission structures
  • Unstable returns

How to Buy a Mutual Fund

Mutual funds are purchased from a brokerage that handles a variety of investment vehicles. Upon reviewing a prospectus which lays out the offerings and fees, a broker then sells individual funds based on asset classes among other factors. 

Conclusion

Mutual funds are an asset that are available to varying classes of investors. Knowing your risk tolerance, investment strategy, and which brokerages have the best offerings can provide you with a profitable avenue to passively earn in all stages of life.

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