Introduction to Mutual Funds

Wealthy individuals and institutions have always had access to professional money managers. They also have the wherewithal to properly diversify their holdings. These are the two major disadvantages for the small time individual investor – the relatively small size of their portfolio does not allow them to properly diversify and most top money managers require a minimum of $250,000 (or more) to open an account.

Mutual funds provide the answer for the individual investor. Most have very low initial investment requirements and some have no minimum requirement at all – you can start investing with as little as $100.00 or even less!

What is a mutual fund?

A mutual fund is a professionally managed investment company that combines the money of many individuals and invests this “pooled” money in a wide variety of different securities.

It is by pooling the money of many individuals that mutual funds are able to provide the diversification and money management (along with many other advantages) that were once reserved only for the wealthy.

Professional money managers take this pool of money and invest it in a wide variety of stocks, bonds, or other securities depending on the investment objective, or goal, of the particular fund. It is the investment objective of the fund that guides the manager in selecting the various securities for the fund.

It is the investment objective of the mutual fund that also guides the investor on which funds to invest in. Since different investors have different objectives, there are a number of different kinds of mutual funds, i.e., some mutual funds may provide monthly income while others seek long-term capital appreciation.

Mutual funds can be classified according to their investment objective. Some of the classifications include money market funds, growth funds, balanced funds, income funds, and many others. We will discuss the many different types of funds and their characteristics elsewhere on this website. (See Categories of Mutual Funds.)

How to Profit with Mutual Funds

When you invest in a mutual fund you hope that the value will rise and you can eventually sell your shares for a profit. This is one of the ways you can profit with mutual funds. Another way is through capital gains. When a mutual fund sells a security for a higher price than it originally paid for it, it is known as a capital gain. Most mutual funds distribute their capital gains to shareholders at least annually, some more often. The last way to profit with mutual funds is with dividends or interest. If the fund has invested in bonds or dividend-paying stocks, it must pass the dividends or interest earned on to its shareholders. Like capital gains, this is done at least annually.

Net Asset Value (NAV)

When you invest your money in a mutual fund, you buy shares in that fund. To determine the price of those shares, each day the fund adds up the total value of the securities held in its portfolio. This total is divided by the number of shares outstanding. The resulting figure is known as the Net Asset Value or NAV.

To find out the value of your holdings, you simply multiply the number of shares you own by the net asset value. The NAV of most funds is listed in most daily newspapers. The NAV will change daily depending on how well the underlying securities of the fund perform. If the securities held by the fund go up in value so will the value of your shares.

Open End & Closed End Mutual Funds

As stated above, mutual funds are generally classified according to the investment objective of the fund. They are also classified according to how they are bought and sold. There are open- or closed-end funds and there are load or no-load funds.

An open-end mutual fund is a mutual fund that continuously issues new shares as needed and buys them back when investors wish to sell. There is no limit to how many shares an open-end fund can sell. The buy and sell price is based on the net asset value of the fund. The majority of mutual funds on the market today are open-end funds and are the type we are concerned with in this tutorial.

The characteristics of a closed-end mutual fund more closely resemble that of an individual stock. A closed-end fund is a mutual fund that issues a fixed number of shares which are then traded (bought and sold) on a stock exchange or over the counter. Although the underlying value of the securities in a closed-end fund may be, for example, $10.00 per share, they may sell for more or less depending on investors outlook for the future value of the securities.

Load Funds vs No-Load Funds

Load funds are simply mutual funds with a sales charge, or load. Load funds are generally sold by stockbrokers, financial planners, or other financial salespeople who charge you a commission every time you buy new shares. Under rules set by the National Association of Securities Dealers (NASD), the maximum charge or load allowed is 8.5% which is deducted from the amount of your investment. On a $1,000 investment, for example, you are really beginning with just $915.00. The difference goes to the salesperson who sold you the shares. This is known as a front-end load. There may also be a fee charged when you redeem, or sell, your shares. This fee, known as a back-end load, may be the only charge or it may be in addition to the front-end load.

No-load funds are mutual funds with no sales charge. They are generally bought directly from the fund. 100% of your money is invested in shares of the particular fund. Similar to no-load funds are funds known as low-load funds. These are funds with a load of between 1% and 3% and are bought either directly from the fund or through financial salespeople.

One other fee to be aware of is the so-called 12b-1 fee (named after the SEC regulation that authorized it). This regulation allows mutual funds to charge up to 1.25% of their net asset value to pay for such things as advertising and marketing expenses. If a fund charges 12b-1 fees (about 40% do) it must be stated in the prospectus.

In this tutorial we are only concerned with open-end mutual funds. This author further suggests learning all you can about mutual funds and sticking with no-load or low-load mutual funds. There is no evidence that load funds perform better than no-load funds. Unless you need help in selecting a fund, go with a no-load fund and save the sales charge. Over time that “small” fee can mean many thousands of dollars to you. Let’s look at an example:

Let’s assume you invest $10,000 in each of two funds, one a no-load fund and the other a load fund with an 8.5% load. Let’s further assume both funds earn an identical 15% average annual return. After 5 years, the no-load fund would outperform the load fund by $1,710; after 10 years, $3,439; and after 20 years the no-load fund would outperform the load fund by $13,911 – more than your original total investment!

$10,000 invested:
15% average annual total return:

No-Load Load Difference
5 Years 20,114 18,404 1,710
10 Years 40,456 37,017 3,439
20 Years 163,665 149,754 13,911

As the above example shows, it does pay to stay with no-load or low-load funds.

In Introduction to Mutual Funds, we have described what a mutual fund is and how they are classified according to their investment objective. We have shown the three ways you can profit with mutual funds. We have also described the charges a mutual fund can levy and why it may be best to stick with no-load or low-load funds.

In History of Mutual Funds we will give a brief history of mutual funds and who invests in them.