How Mutual Funds Work

We might think “everyone” knows something we don’t understand. Mutual funds have been around for decades, but they didn’t become common for average investors much before the late 1970s. Even many sophisticated professionals don’t really understand what’s in their retirement accounts or the kids’ 529 college savings plans. But there are several different types of mutual funds, from actively managed funds to passively managed index funds, with differing sales charges. Let’s review basics and make sure all the gaps are filled in.

What Are Mutual Funds?

At the most basic, mutual funds are a collection of investments that some investment company or fund manager has put together. You probably can’t buy one share in 400 or 2,000 different companies, or own hundreds of bonds. Instead you can buy a mutual fund share that owns all these investments. A fund manager can buy all those investments for you, because they pool all their investors’ money.

When you buy a mutual fund, the share price of reflects the value of all those investments divided among all the shareholders of the mutual fund. This is known as the net asset value, or NAV. At the end of the day, after trading is finished and all the investments contained in the mutual fund have a closing price, the fund’s liabilities (e.g. fees owed to investment managers or banks, or for services) are deducted from the total value of the fund’s holdings. The remaining value is divided by number of shares outstanding to give you the value of your shares.

Did the NAV go up? That means the market for the fund’s investments was good that day.

What Are the Benefits of Professionally Managed Mutual Funds?

Mutual funds average your risk by diversifying among a large collection of investments. It would be very rare to see a mutual fund lose every penny, which is certainly a possibility with individual stocks. On the other hand, that safety comes at a price: you probably won’t see a 300% gain the way you might with a good stock pick.

Because mutual funds are regarded as safer, more prudent, and easier for the average investor to understand and choose, many types of accounts will allow only mutual fund investments. Your workplace retirement accounts and 529 plans will probably only allow you to choose mutual funds, not individual stocks or bonds. 

Mutual funds also have drawbacks. These are covered in 8 Dangers of Mutual Funds.

What Are Index Funds vs. Actively Managed Mutual Funds?

Some funds are very broad-based and attempt to meet or beat an index. An index is a collection of investments (stocks of specific companies or bonds with specific characteristics) that an independent company has established as representative of a part of the market. Some are easy to understand, such as the S&P 500, which collects the 500 largest U.S. companies. Some indexes are more nuanced; for example, MSCI has five versions of its main developed market index.  

A mutual fund may be passively managed, meaning the fund manager just buys everything in a particular index the fund is tracking. Or a fund may be actively managed: Managers make their own choices, attempting to beat an index. Nevertheless, most funds will measure (or “benchmark”) themselves against an index. Be aware, however, that an index is whatever the index company says it is, and it can be selected to make a fund’s performance look a bit better.

A mutual fund can have just about any focus. There are funds that emphasize dividends, specific investing strategies, types of industries, specific countries or regions — really, just about anything that an investor might choose. Your challenge will be learning how to select a diversified portfolio.

Other types of mutual funds include:

• balanced funds, which have stocks and bonds in a relatively steady proportion
• target-date funds, which include stocks and bonds and become more conservative as you reach the target date
• funds of funds, which include several types of funds in a premixed selection
• money market funds, which invest in very short-term debt, usually providing just a little more than a savings account (which is investing in about the same thing); these are considered very safe and therefore have very low returns

What Fees Do Mutual Fund Companies Charge?

"Load funds" charge you a commission or sales charge to purchase. These have become less popular, as people have realized the commissions (especially on bond funds) often exceed returns. Some high-powered actively managed funds are still sold by companies that charge these loads. Some load funds may be available in 401(k)s and similar accounts, but often the load will be waived if an overall management fee is charged.

No-load funds are free to buy or sell. You give the fund your money and you get its worth in shares on the day you buy.

But no fund is completely free: There’s a cost of doing business! Someone processes the trades, writes the annual report, mails you your withdrawals, prints up the nice brochures and “consumer education," and so on. So nearly all funds charge an internal management fee. You’ll never see that money deducted from your account; it will be taken out of returns before they’re ever credited. The lower the management fee, the more money will be returned to you.

Some investments are harder to manage than others, so you’ll typically see very low fees on bond funds and much higher fees on, say, emerging market funds that require a lot of research. Under 1% is generally considered acceptable.

Recently, some companies have rolled out zero-fee funds. These are essentially loss-leaders designed to attract you to the fund company, which absorbs the cost. The fund company hopes that, once there, you’ll purchase other funds in its stable.

Can a Financial Adviser Help?

When you're dealing with small sums, the decisions seem simpler. But if your account has grown to a size where you feel uncomfortable managing and maintaining it yourself, or simply feel you don’t have the time or knowledge, you might want to seek the services of a financial planner or investment adviser.

But because mutual funds often comprise baskets of stocks, you should take the time to learn about the characteristics of quality stocks and how to build wealth over the long term. You can get started on learning the basics by sampling BetterInvesting's free resources.

Check to see whether you're comfortable with the adviser's independence: For example, a financial adviser for an investment company may only make recommendations sold by their company. Be careful that this person follows a fiduciary standard, meaning that the adviser is obligated to put your interests first, instead of being mainly concerned about commissions or the adviser's employer.

---