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Mutual Funds

Guide to Understanding Mutual Funds

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Mutual Funds

In This Article
  • What is the definition of a mutual fund?
  • What are the advantages to investing in a mutual fund?
  • What are the different types of mutual funds?
  • What is the difference between mutual funds and ETFs?

Mutual Funds Definition

For retail and institutional investors, mutual funds are a cost-efficient option to build a diversified portfolio of stocks, bonds, and other financial instruments

A mutual fund is an investment vehicle of pooled capital contributed by investors that hold ownership stakes in the fund’s returns/profits.

A portion of ownership in a mutual fund is referred to as a unit (or unit share), in which the amount of unit shares held in the fund is proportional to the investment size.

Most mutual funds are open-ended, meaning that more unit shares can continue to be issued if there is sufficient investor demand (and investors can increase or decrease their holding as needed).

Vanguard – Top Mutual Funds Example

One of the largest asset management firms is Vanguard, which offers an extensive list of low-cost mutual funds and other options such as ETFs.

In the mutual fund industry and related products, Vanguard is considered the “gold standard” due to its:

  • Historical Returns
  • Cost-Effectiveness (i.e. Low Fee Structure)
  • Flexibility in Options (e.g. 401(k)s, Pension Plans, IRAs)
  • Market Commentary and Research Reports

Vanguard“The Value of Ownership” (Source: Vanguard)

Mutual Fund Net Asset Value (NAV) Per Unit

Mutual funds are bought and sold at the fund’s net asset value (NAV).

The NAV is the net value of all the assets held by the fund, inclusive of any undeployed cash, divided by the total number of shares.

NAV Per Unit Formula
  • Net Asset Value (NAV) = (Fund Assets – Fund Liabilities) / Total Shares Outstanding

Since the calculation is done at market close, the value of each share in a mutual fund is determined by the closing market prices of the portfolio holdings.

For example, if a mutual fund has issued 1 million units and the total NAV is $20 million, each unit would be valued at $20.

  • Unit Value = $20 million NAV / 1 million Units
  • Unit Value = $20 NAV Per Unit

Advantages of Investing in a Mutual Fund

Professional Oversight + Affordability

The professionals employed at mutual funds actively manage and monitor the portfolio of investments – i.e. purchases, selling holdings, and rebalancing the portfolio as needed.

Mutual funds offer investors access to professional money managers without having to incur the hefty fines charged by more specialized investment firms like hedge funds.

Not only do mutual funds charge lower fees for managing portfolios, but the required initial investment – among other regulatory hurdles that frequently impede investors (e.g. income requirements) – are not as stringent for mutual funds.

Diversification Benefits

Mutual funds also enable investors to hold a diverse portfolio of securities that can contain:

Portfolios are constructed intentionally to de-risk the exposure to a single asset class. For instance, if the value of one investment declines, the losses can be offset by the growth in value of another investment.

Reaping the benefits from diversification is typically associated with large institutional investors that can afford to purchase multiple types of securities at any given time, which is a strategy most individual investors cannot do.

But mutual funds provide a pathway for everyday investors to affordably spread out their portfolio risk, without needing a significant sum of capital – as well as for institutional investors like pensions and endowments.

Types of Mutual Funds

Mutual funds tend to be more risk-averse than most active management investment vehicles.

For instance, bond mutual funds invest primarily in low-risk debt instruments – i.e. fixed income – such as:

The most common types of mutual funds are the following:

  • Equity Funds: Primarily concentrated in the common shares of publicly traded companies – most have a specific investment style (e.g. value or growth stocks) or focus on certain sectors of the market (e.g. technology, financial services, utilities).
  • Fixed Income Funds: Defined earlier, these funds invest in bonds and other debt securities, offering a steady source of income generation while prioritizing capital preservation.
  • Multi-Asset Funds: Portfolio has exposure to a broad number of asset classes – for example, traditional equity, fixed income, indices-tracking funds, and financial derivatives, which provides diversification benefits ordinarily associated with larger institutional investors

Thus, another benefit to mutual funds is the broad variety of offerings available in the market for investors with different risk appetites.

Risks of Mutual Funds

The fund managers at mutual funds have a fiduciary duty to act in the best interests of their investors, which means the objectives stated in the fund’s prospectus must be maintained through the life of the fund.

However, mutual funds can change their strategy and reshuffle their portfolio, often in response to unexpected market conditions such as:

  • Economic Slowdown (i.e. GDP)
  • Higher-than-Expected Inflation Rate
  • Crisis and Pandemics (e.g. COVID-19)

Given the continuously changing market conditions, no strategy that worked in the past will continue to work for decades into the future without adjustments.

Fund managers can thereby take short-term measures to protect the downside of their fund’s NAV, but a complete overhaul of the core strategy would be required to be shared with shareholders in advance.

In such a case, the investors that are not comfortable with the new direction of a fund are given the option to exit and sell their stake.

Nonetheless, the degree of risk associated with mutual funds is far less than most other riskier investment vehicles.

Mutual Fund Expense Ratio

For most investors, the expense ratio of the mutual fund is a key consideration.

The expense ratio states the annual percentage charged by the fund to cover its expenses, which reduces the fund’s adjusted returns.

As a generalization, the expense ratio for an actively managed mutual fund tends to range around ~0.5%.

By investing in a mutual fund, the investors are obligated to pay certain expenses, which are charged to cover:

  • Administrative Fees (e.g. Accountants, Legal)
  • Management and Employee Salaries
  • Overhead Costs (e.g. Office, Equipment, Utilities)

Other expense considerations include the following:

  • Transaction costs for purchasing and selling securities, which flow down to the shareholders
  • Investors can incur a sales charge from buying in (i.e. purchasing the mutual fund’s unit shares)
  • Redemption fees can be charged to investors that sell pre-maturely before a specified date

Taxes on Mutual Funds

If applicable, mutual funds periodically distribute dividends or interest income to their investors – which can be issued on a monthly, quarterly, or annual basis.

Similar to equities and bonds, such distributions are subject to taxation.

  • Dividends and Interest Income: Taxed at the unit holder’s ordinary income tax rate generally.
  • Distributions of Capital Gains Post-Sale: Depending on the holding period of the securities by the mutual fund, can either be taxed at 1) the ordinary income tax rate or 2) at the reduced long-term capital gain tax rate

Shareholders can receive the profit proceeds as income distributions or in the form of capital gains – and can opt to take profits (i.e. exit) or reinvest them back into the mutual fund.

Tax-Exempt Mutual Funds

Certain mutual funds invest in municipal bonds, making their dividend distributions exempt from the federal income tax and in some cases the state income tax too.

In addition, there are long-term mutual funds (i.e. individual retirement accounts) that carry more tax advantages, such as the deferral of taxes until the holder begins to take profits and withdraw money.

Mutual Funds vs ETFs

Compared to ETFs, mutual funds tend to carry less flexibility in terms of liquidity, as ETFs trade more like public stocks because they can be bought or sold throughout the day when the markets are open.

By contrast, mutual fund shares are priced only once per day upon market close and tend to be less tax-efficient than ETFs, where there is more flexibility in terms of the timing of taxation.

Since mutual funds are actively managed whereas ETFs are passive investments that track market indices, commodity prices, sectors, etc., the standard expense ratio is higher to cover the increased expenses.

However, mutual funds can derive more benefits related to economies of scale – i.e. the greater the assets under management (AUM), the greater the profitability.

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