Get answers to basic questions about mutual funds in this first chapter of our Beginner’s Guide to Mutual Funds.
In this chapter:
- What is a mutual fund?
- How do mutual funds work?
- Why are mutual funds so popular?
- What are the fees and costs of mutual funds?
A mutual fund is a basket of investable assets. Mutual funds come in many different shapes and sizes, but essentially they allow investors to easily hold the market or sector of the market.
The two most common types of assets that mutual funds hold are stocks and bonds. Stock mutual funds hold stocks of publicly traded companies, while bond funds hold Treasurys, municipal bonds, and/or corporate bonds.
Stock funds may hold dozens, hundreds, or even thousands of stocks. For example, a large-cap stock mutual fund likely holds many (if not all) of the stocks listed in the S&P 500 index. A total U.S. stock market fund may hold thousands of individual stocks. For most individual investors, it is (for several reasons) disadvantageous to hold hundreds or thousands of individual stocks. Holding shares of a stock mutual fund provides the benefit of diversification across several stocks, without the disadvantages of holding them directly.
In addition to stocks and bonds, a mutual fund can also hold other types of assets, including commodities, currencies, and real estate.
A mutual fund is issued by an asset management company. The issuer employs a fund manager to oversee the investments that the mutual fund makes.
Most mutual funds are open-end funds, which are purchased and redeemed directly with the issuer, or via a brokerage platform. Some mutual funds are closed-end funds, which can only be bought and sold on an exchange, similar to how individual stocks are traded.
An open-end mutual fund cannot be traded intra-day like stocks. A fund is priced at the end of each trading day, based on the net asset value of all of its holdings. The mutual fund’s net asset value (or, NAV) is akin to a stock’s price. A purchase or redemption of shares of a mutual fund are transacted at the end of the day at the fund’s NAV.
Mutual funds have seen a huge increase in popularity over the last 30 to 40 years. Mutual funds offer the benefit of diversification in a simple package. Instead of directly holding dozens, hundreds, or even thousands of individual stocks and bonds, a mutual fund investor can simply buy just a few funds to achieve proper asset allocation and portfolio diversification.
Mutual funds are also very popular with employer-sponsored retirement accounts, such as 401(k) or 403(b) plans. The rise in popularity in these types of accounts has led to a commensurate increase in the popularity of mutual funds over the last few decades.
To highlight the popularity of mutual funds, the chart below shows how much new cash has flowed into long-term mutual funds since 1984. On an annual basis, money has flowed out of the industry (negative net inflows) only twice during this 31-year period (1988 and 2008). In sum, more than $4.3 trillion of new cash flowed into mutual funds between 1984 and 2014. Note: this does not even include growth from dividends or price return. This is simply an illustration of new cash flowing in.
Mutual fund investors should be cautious of fees that can be incurred when purchasing, holding, or redeeming mutual funds. There are many fees to consider:
- Expense ratio: A mutual fund’s expense ratio is the percentage of an investor’s money that is charged annually. For instance, an investor who holds $10,000 in a mutual fund with an expense ratio of 1.50 percent pays $150 annually in fees. Mutual funds charge as little as 0.05 percent to upwards of 2.00 percent or more in expense ratios. Expense ratios are unavoidable. All mutual funds charge them. You should focus on investing in mutual funds with low expense ratios. Especially in the case of broad U.S. equity funds (e.g., a large-cap mutual fund), there’s no good reason to pay more than 10 or 20 basis points.
- Load fee: A sales load fee is a commission payable to a financial advisor, planner, or broker who sells a mutual fund. Load fees are typically charged on the initial purchase of a mutual fund (but can also be charged upon redemption), and are typically around 5 percent, but can be as high as 9 percent. Front-end load fees decrease the size of an investor’s initial investment. For example, in the case of a $10,000 purchase of a mutual fund that carries a 5 percent front-end load fee, the initial investment is immediately reduced by $500 to $9,500. Unless you hate money, you should always avoid paying load fees. In this day and age, they are a rip-off.
- Redemption fee: A redemption fee is charged when a mutual fund is redeemed (sold) within a specified period of time. This fee is used to discourage frequent short-term trading into and out of mutual funds and (unlike the other fees) is typically beneficial for the fund and the long-term fund investors who are not subject to it. If you try to time the market by frequently buying and selling mutual funds, you will usually be subjected to this fee. This isn’t a recommended strategy, as it drives up your transaction costs, not to mention that over the long run, no one is good at market timing anyway! As long as you are a long-term buy-and-hold mutual fund investor, this is one fee you won’t have to worry about.
- 12b-1 fee: A mutual fund’s 12b-1 fee is the percentage of assets that are used for marketing purposes. This fee is already included as part of the expense ratio. For the most part, you can ignore this fee, and really just focus on the total expense ratio.
Typically, actively managed mutual funds have much higher expense ratios than passively managed index mutual funds. International stock funds typically carry higher expense ratios than U.S. stock funds. Investors can avoid load fees by purchasing no-load funds themselves, without employing an intermediary advisor or planner.
The chart below shows the impact that fees can have on the value of an investment over time. Frankly, high fees can absolutely devastate your returns over the long term. Due to the effect of compounding returns over time, the value of an investor’s S&P 500 fund with a low expense ratio of 0.10 percent is worth considerably more than similar funds with higher expense ratios.
We’ve covered the basics of exactly what a mutual fund is. Now, in chapter two let’s turn to a very popular type of mutual fund — the index fund.