Mutual Funds for Dummies and How do They Work?


1. Introduction to mutual funds

Mutual funds have become very popular over the last 20 years. What was once just another financial instrument that was overlooked, today it is a part of our daily lives, well, at least for some of us anyway. Today, more than 80 million people invest in mutual funds which mean trillions of dollars are invested in mutual funds.

In fact, many households in the U.S. invest in mutual funds. After all, it’s common knowledge that investing in the mutual fund is much better than wasting your money on a savings account. But unfortunately, many people don’t understand what mutual funds are.

Originally, mutual funds were for the “little guy” as he wanted a piece of the market. That mean instead of spending your free reading and analyzing tons of financial data all you had to do was to buy a mutual fund and you’d be set on your way to a financial freedom. Seems easy, right? Well, as you might have guessed, it’s not that easy. In theory, they are an excellent idea, but in reality, they haven’t always delivered.


2. What are mutual funds?

A mutual fund can be defined as a fund or a collection of bonds and/or shares. Best to think of mutual fund as a company that brings a group of people who invest their money in stocks, bonds and other securities in the open market. Each investor in the fund owns a percentage of shares, bonds and other securities in the fund.

You can make money from a mutual fund in three ways:
1. Income that is earned from dividends on stocks and interest on bonds.
2. If a fund sells securities (shares, bonds, etc.) that have increased in price, the fund has a capital gain.
3. If fund holdings increase in price but are not sold by the fund manager, the fund’s shares increase in price. If that is the case, you can sell your mutual fund share for a profit.

Mutual funds pros and cons:

2. 1. Advantages:

• Professional management – first and foremost, the primary advantage and primary disadvantage is professional management. Investors purchase funds because they do not have the time or the expertise to manage their own portfolios. A mutual fund, as I’ve said before is a perfect way to the “little guy” to start his own portfolio.

• Diversification – by owning shares in the mutual fund, your risk is spread out. Diversification is a simple and it says that loss in a particular investment is minimized by gains in others. In other words, to put it simply, the more stocks, bonds and other securities you own, the less any of them can hurt you. Large mutual funds typically own hundreds of different stocks, bonds and other securities in many industries to minimize the risk. An average investor can’t possibly build this kind of a portfolio with a small amount of money.

• Economies of Scale – usually mutual funds buy and sell large amounts of securities at a time and therefore, its transaction costs are lower than what an individual would pay for securities transactions.

• Liquidity – this is a very important advantage of a mutual fund since a mutual fund allows you to request that your shares are converted into cash at any time.

• Simplicity – buying is mutual fund is super easy. Almost any bank had its own line of mutual funds, and the minimal investment is really small. Almost anybody can afford to own a part of a mutual fund. Most companies, including banks, have automatic purchase plans whereby as little as $100 can be invested on a monthly basis.

2. 2. Disadvantages:

• Professional management – as said before, this is also a disadvantage as many investors debate how professional the management is. Management is by no means perfect and even if the funds loses money, the manager still gets paid.

• Costs – a mutual fund has to make a profit and it has lots of costs associated with it. Usual costs are creating, distributing and running a mutual fund. A manager has to be paid, other employees have to be paid too. Since fees vary widely from one mutual fund to other, failing to pay attention to fees is suicidal in the long-term.

• Dilution – diversification is good, but as we know, too much of anything is not good, thus, it’s possible to have too many diversifications. Usually, what happens is that funds have small holdings in so many different companies and high returns don’t make much of a difference on the overall return. When money pours into funds that have had strong success, the managers often have trouble deciding what a good next investment will be.

• Taxes – ah, taxes. When a manager sells a security, a capital-gains tax is triggered. Investors who might be concerned about the impact of taxes on their potential gains need to keep in mind those concerns when investing in mutual funds. You can try to mitigate taxes by investing in tax-sensitive funds or by holding the non-tax sensitive mutual fund in a tax-deferred account, such as a 401(k) or IRA.

3. Types of mutual funds

It doesn’t matter if you are a bull, bear or a pig, for every investor there is a mutual fund that fits you investing style. Actually, according to the latest count there are more than 10,000 mutual funds in North America, which is a lot!

Investors have to keep one thing in mind. Each mutual fund has different risks and rewards. In general, the higher the potential return, the higher the risk of loss. Although it is possible to minimize the risk through investing smart and patient, it’s never possible to diversify away all risk. This is the fact for every investment.

At the fundamental level, there are three types of mutual funds:
1) Equity funds – stocks
2) Fixed-income funds – bonds
3) Money market funds

Let us start with the safest and work our way down.

3. 1. Money market funds

The money market usually consists of short-term debt instruments such as Treasury bills. This is one of the safest places to invest. Since the risk is very low, you won’t get great returns, but you won’t have to worry about losing your principal.

3. 2. Bond/Income funds

Income funds are named “income” because their main purpose is to provide current income on a regular basis. When investors are referring to mutual funds, the terms “fixed-income, “bond” and “income” are synonymous. The primary objective, as I already said it, is to provide a steady cash flow to investors. Usually, bond/income funds consist of conservative investors and retirees.

On the other hand, we have bond funds. They are likely to pay a higher return that certificates on deposit and money market funds, but they come with a certain amount of risk. After all, there are numerous bond funds on the open market and they can vary depending on where they invest. Here is a quick example, there are funds that are specializing in high-yield junk bonds and they are much riskier than your average bond fund. Moreover, almost all of the bonds funds are subject to interest rate risk, which means that if the rates go up, the value of fund goes down.

3. 3. Balanced funds

Balanced funds, as their name says, provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a combination of fixed income and equities.

A similar, but a bit different type of fund is known as asset allocation funds. Their objectives are similar to those of balanced funds, but these funds do not have to hold a specified percentage of any asset class, be it fixed income or equity. In other words, the portfolio manager is given freedom to switch the ratio of different asset classes as the economy moves through the business cycle.

3. 4. Equity funds

Equity funds invest in stocks. They represent the largest category of mutual funds. The primary objective of an equity fund is to gain long-term capital growth and some income. However, there are many different types of equity funds because there are different types of equities.

For example, there are mutual funds that invest in large-cap companies that are in strong financial shape, but their share prices have fell. On the other side, we have mutual funds that invest in startup technology companies with a superb growth strategy.

3. 5. Global/International funds

A global fund will invest anywhere around the world, including your home country. An international fund will invest only in foreign markets.

It’s a bit tough to classify these funds as they are pretty volatile and every global/international fund has unique political risks. Then again, they have well-balanced portfolios and they reduce the risk by increasing their diversification.

3. 6. Specialty funds

Specialty funds are special kinds of funds as they specialize on a certain segment of the economy. In other words, they “forget” diversification. Some of specialty funds are sectors funds, regional funds, and socially-responsible funds.

3. 7. Sector funds

Sector funds are targeting specific sectors of the economy such as financial, technology, health, etc. Sector funds are highly volatile. As such, there is a greater possibility for higher gains, but you have to understand that your sector may tank.

3. 8. Regional funds

Regional funds – regional funds focus on a specific area of a world or a country. An advantage of these funds is that they make it easier to buy stocks in foreign countries, which is otherwise very difficult and very expensive. Moreover, just like sector funds, your region may fall into the jaws of recession.

3. 9. Socially responsible funds

Socially responsible funds – these funds invest only in companies that meet strict, certain guidelines or beliefs. Most socially-responsible funds don’t invest in industries such as weapons, tobacco, nuclear power, etc. for obvious reasons. The main idea behind these funds is to be competitive while maintaining a healthy conscience.

3. 10. Index funds

Lastly, we have index funds. This type of mutual funds usually tries to replicate the performance of a broad market index such as S&P 500 or Dow Jones Industrial Average (DJIA). The type of people who invest in index funds figure it out that you don’t have to “fight” with the market, you can simply replicate it.

4. What costs come with mutual funds?

As mentioned before, costs are the biggest problem with mutual funds as they can eat into your potential return. Also, they are the main reason why the majority of funds end up with sub-par performance.

Some people even go as far as saying that mutual funds get away with fees because an average beginner investor does not understand what he or she is paying for.

Fees can be broken down into two categories:
1. Ongoing yearly fees to keep you in the fund
2. Transaction fees when you buy or sell shares in the funds, they are also called loads (more on them later)

4. 1. The expense ratio

Expenses ratio are ongoing expenses in a mutual fund. Sometimes, they are referred to as the management expense ratio or MER. They are composed of following:

The cost of hiring the fund manager or managers – this is also called a management fee and it averages between 0.5% and 1% of assets. At first, it may sound small, but they still remain in the top echelon of earners. Just think about it. 0.5% of 250 million is $1.25 million – well I certainly know that fund managers are not hungry.

Administrative costs – they include stuff that every mutual fund needs such as postage, record keeping, cappuccino machines, tabels, PCs, servers, etc. Some funds minimize these costs, while others (the ones with gaming PCs and cappuccino machines) do not.
12B-1 fee (in the U.S. anyway) – these expenses goes toward paying brokerage commissions and toward advertising the fund.

4. 2. Loads

Loads are just a fancy word that mutual fund uses to compensate a broker or other salespeople for selling you the mutual fund. Usually, you should avoid a mutual fund with loads.

In case you still want to know how loads work, here is how:

Front end loads – These are the simplest loads available. You pay the fee when you purchase the fund. For example, if you invest $500 in a mutual fund, a 5% front-end load will pay the sales charge, and $25 will be invested in the mutual fund

Back-end loads – in a back-end load mutual fund, you pay load if you sell your fund within a certain time frame. If you don’t sell the mutual fund until sometimes later, you don’t have to pay the back-end load at all.

There there are no-load funds and they sell their shares without commission (or sales charge). Some people who are connected with the financial industry might tell you that when you pay a load, you are choosing the “correct” fund if you will. By that logic, the gains should be higher because a professional advice told you to buy a certain mutual fund. You should not listen to this kind of people as there is little to no correlation between mutual funds with loads and mutual funds without loads.


5. How to buy a mutual fund?

5. 1. Buying mutual fund

You can buy a mutual fund, be sure to buy the ones without loads by contacting fund companies directly. Other funds are sold through a broker, banks, various financial planners or insurance agents. If you buy through a party (bank, broker, etc.) you may pay a load or a commission if you will.

5. 2. What should I know before buying a mutual fund?

First and foremost, you should know the net asset value (NAV). NAV is defined as a fund’s assets minus liabilities and it represents the value of a fund. NAV per share is the value of one share in the mutual fund. You can think of NAV per share as the price of a mutual fund. It is important to say that NAV per share fluctuates every day as fund holdings and shares outstanding change.

If an investor buys shares, he or she pays the current NAV per share plus any sales front-end load. When he or she sells their shares, the fund will pay you NAV less any back-end load.

5. 3. How to find a mutual fund?

To be honest, it is pretty straightforward. Since we are living in 2015 and almost every mutual fund has its own website all you have to do is pick a search engine of your choice, type the name of the fund or a fund company and hit search.

If you are serious about buying a share in a mutual fund, there are a variety of ways, some of the resources are even available online. Two notable ones are:

The Mutual Fund Education Alliance – a non-profit association of the no-load mutual fund industry. They have various tools for searching for no-load funds.

The other one is Morningstar. They are an investment research company that is excellent for its mutual fund information.

5. 4. Your goals and risk tolerance

Before you even think of buying a share in a fund, you need to think about why are you investing? What are your goals? Do you prefer long-term capital gains or a current income? What is your risk tolerance? Identifying is important because it will steer you in the right direction.

For really short-term objectives, your best bet would be money market funds. If your goals are few years in the future, you should bond funds. For long-term goals, stock funds may be the way to go.

Then again, the one factor that is usually overlooked, the risk tolerance. If something happened, can you accept dramatic swings in portfolio value? If you can accept this, you may prefer stock funds over bond market. On the other hand, if you are a conservative investor, you may want to invest the in bond funds.

Some additional questions you should ask yourself is how much money you have to invest, whether you should invest in a lump sum or a little bit over time? These are just some of the questions you should answer before investing in a fund.

6. What have we learned about mutual funds?

So far we have learned the following:

• A mutual fund brings together a group of people, usually investors and invests their money in stocks, bonds, and other securities.
• Some of the advantages are professional management, diversification, economies of scale, simplicity and liquidity.
• On the other hand, disadvantages are high costs of running, dilution, possible negative tax consequences.
• There are lots of types mutual funds. You can base your investing strategy based on types of mutual funds.
• Costs can be broken down into ongoing fees and transaction fees
• Mutual funds are very easy to buy and sell. You can buy them through a third party or directly through a company.
• Their ads can be rather a deceiving.



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