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What are Mutual Funds?

Brandan A. by Brandan A.
June 28, 2024
in Investing
Reading Time: 7 mins read
What are Mutual Funds?

Mutual funds have become one of the most popular investment vehicles worldwide, providing investors with an affordable and convenient way to build wealth over the long run. By pooling money from many individual shareholders, mutual funds allow average investors access to a diversified portfolio of stocks, bonds, and other securities that would otherwise require substantial capital to construct independently.

In this article, we will examine what mutual funds are, their key features and benefits, different types of funds investors can choose from based on their objectives, and important factors to consider when selecting mutual funds. We’ll also explore performance measurement metrics, related costs, and how to buy and sell fund shares. The goal is to provide a comprehensive overview of this ubiquitous yet often misunderstood investment class.

What are Mutual Funds?

At their core, mutual funds are professional investment companies that raise money from individuals and institutions to invest in a portfolio of securities selected by fund managers to meet specified objectives. The portfolio is continuously adjusted within the guidelines of the stated strategy.

Individuals purchase shares in a fund, becoming partial owners along with other shareholders. Daily, the net asset value (NAV) of the portfolio is divided by shares outstanding to determine the fund’s per-share price, which fluctuates with the value of underlying holdings.

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When investors redeem their shares, the proceeds received are equivalent to their proportionate stake in the current NAV. New shares are likewise issued based on the current price when purchasing into a fund. This creates buy-and-sell liquidity without disrupting the holdings.

Features of Mutual Funds

Mutual Funds

Professional Management  

The defining feature of mutual funds is the involvement of portfolio managers skilled in security selection and constantly monitoring positions. This delegation of decision-making to experts, rather than individual stock picking, appeals to most retail investors who lack the time or expertise required.

Diversification

Owning a stake in a fund provides instant diversification across many companies, regions, market sectors, and asset classes depending on the fund’s objective. This risk-mitigating aspect is nearly impossible for a typical small investor to replicate alone.

Low Minimums

Fund companies set low minimum investment thresholds, often just a few hundred dollars, to make investing accessible to all. This is substantially smaller than the cost of directly owning a similarly diversified portfolio.

Liquidity

Shares in open-ended funds, which can issue new shares at any time, can generally be redeemed daily at the current NAV price. This easy buy-and-sell convenience compares favorably to holding individual securities.  

Types of Mutual Funds

Funds come in various categories based on their strategies, asset mixes, and risk-return profiles. The core types are:

  • Stock (Equity) Funds – Focus entirely on publicly traded company shares across large, mid, and small market capitalization levels globally or domestically.  
  • Bond (Fixed Income) Funds – Primarily invest in various debt instruments issued by governments, municipalities, and corporations of differing credit qualities and maturities.
  • Balanced (Hybrid) Funds – Maintain a preset target mix, usually 60-80% stocks and the remainder in bonds, to generate balanced returns with reduced volatility.
  • Money Market Funds – Very low-risk funds focused on short-term debt instruments like commercial paper, Treasury bills, and certificates of deposit seeking to preserve capital and provide liquidity.
  • Index Funds – Aim to track major indexes like the S&P 500 very closely without attempting to outperform through active stock selection by managers—a lower-cost approach.
  • Sector Funds – Narrowly specialized funds targeting specific industries or market segments such as healthcare, technology, real estate, energy, commodities, or specific regions/countries.

Within each category, funds can differ significantly in style based on market capitalization focus, credit quality emphasis, or index tracked. Understanding the strategy is key to selection.

Performance Measurement

Fund performance is expressed as total returns incorporating share price changes plus any distributions like dividends and capital gains. Average annual returns over set periods form the basis for comparison to peers and relevant benchmarks.

Standardized ratios are also calculated to measure risk-adjusted returns, efficiency, and consistency including:

  • Sharpe Ratio – Used excess return over the risk-free rate relative to volatility to identify a higher reward for risk.
  • Sortino Ratio – Similar to Sharpe but isolates only downside deviation, not full volatility.
  • Alpha – Determines if active managers are truly adding value beyond market indexes in their category after fees.   
  • R-Squared – Measures how closely a fund tracks its stated benchmark on a scale of 0-100%.
  • Beta – Expresses volatility relative to the overall market through economic cycles via the S&P 500 benchmark.

These metrics assist in analyzing past successes and shortcomings to inform future fund selection decisions. Consistently superior risk-adjusted performance is the goal.

Fund Costs and Fees

Owning mutual funds does carry ongoing annual costs through various embedded fees:

  • Expense Ratio – Deducted from assets, this covers operational, management, and marketing expenses and is the largest recurring cost as a percentage usually ranging from 0.10-2.00%.
  • Front-End Sales Charges – Some funds levy an up-front percentage fee, typically around 5%, on purchases that are deducted directly from investment amounts.
  • Back-End Redemption Fees – Some funds impose charges like 1-5% if shares are sold within the first year to discourage frequent trading.
  • Transaction Fees – Direct purchases from fund companies often charge online or phone transaction fees of $25 or less per trade.

It’s important for investors to carefully consider costs when selecting funds as lower-fee choices can have profoundly positive long-term effects through compound growth due to more money working actively.

Choosing the Right Funds

Mutual Funds

There are several aspects to consider when determining which mutual funds are best for an investor. First, a fund’s investment objective should align with the investor’s time horizon, risk tolerance, and income or growth requirements.

Actively managed funds need good previous performance from fund managers, whilst index funds are better suited to long-term buy-and-hold clients. It is critical to evaluate the performance and risk parameters of any possible fund over several years to peers and relevant benchmarks.

Expenses are another important issue, as lower operating ratios allow an investor to keep more of their gains in the long term. The reputation and expertise of a fund’s portfolio manager are critical; seek individuals who have demonstrated success in changing market circumstances. Finally, larger fund companies typically have more research resources and back-office assistance for shareholders.

Weighing these factors helps investors limit the hundreds of accessible funds to a selection of top candidates that correspond with their specific objectives. Prospectuses then include specific information about a fund’s strategy and assets.

Buying and Selling Mutual Fund Shares

Once a fund is chosen, direct purchases can typically be made through the fund company website or by calling their representatives. Many brokers also let clients buy certain funds within their accounts for convenience.

Purchase amounts and automated investment plans can usually be set up through direct debit from a bank account. Prospectuses outline policies around subsequent investments and minimum purchase levels.

Redemptions can similarly be completed online, by phone, or through the broker. Fund companies will initiate the sale at the next available NAV price and deposit proceeds into the shareholder’s account within a few business days depending on the redemption method selected.

Systematic withdrawal plans permitting regularly scheduled distributions are often available as well. Most funds place no limits on the number of buy-sell transactions but may apply redemption fees for very short-term holdings.

Conclusion

In summary, mutual funds are a popular but powerful financial vehicle that provides diversification, competent management, and minimal entry hurdles for people. Investors can protect their savings for retirement, children’s education, or other long-term requirements by selecting funds based on their particular financial goals, risk tolerance, and time horizons, as well as outstanding prior performance. Cost, reputation, and investing goals must all be carefully considered when selecting and using mutual funds.

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