What Are Mutual Funds? And Everything Else You Need To Know

Ever been at the water cooler at work and people start talking about which mutual funds they chose in their 401k?

Then you just nod along and pretend like you know exactly what they’re talking about, knowing that you have absolutely no clue.

It’s okay, I totally get it. I’ve been there too.

But if you would like to understand what in the world mutual funds are and how they actually work, keep on reading and you won’t ever have to experience that again.

How Mutual Funds Work

In simple terms, a mutual fund is just a group of people putting their money together in order to purchase a large amount of an investment. The most common mutual funds buy stocks, but there are also lots of bond mutual funds out there.

A stock mutual fund is an investment vehicle that brings a bunch of people’s money together to buy a variety of stocks. It would be like if you, me, and 8 other people each invested $3,000 together to buy 10 different stocks. Then we would have $30,000 to invest across the variety of stocks, instead of you trying to invest $3,000 on your own.

This allows you to buy a much larger variety of stocks or bonds than you could do if you were trying to invest by yourself.

Now, how do you make money with your mutual fund?

Without getting too deep into calculating mutual fund returns (which can be very complex), all you need to know is the acronym NAV.

The NAV or Net Asset Value, of a mutual fund, is a number that represents a mutual fund’s price-per-share value. The NAV is the share price that you would buy when you purchase shares of that mutual fund. Just like a stock price may be $16 per share, a mutual fund may have a price of $16 per share (or any number for that matter).

The NAV is calculated at the end of the day for mutual funds and only changes after the stock market closes, unlike stock prices which fluctuate constantly.

Well, how do they figure out the NAV? Glad you asked 🙂

At the risk of your eyes glazing over from math overload, let me explain.

The NAV is calculated by dividing the total value of the investments minus anything the mutual fund owes, by the total number of shares.

For example, let’s say your mutual fund owns 100,000 shares of stocks and the total value of those shares is $2.5 million. Also, the mutual fund owes $100,000 so the net assets is $2.5 million – $100,000 = $2.4 million.

Using the formula above: $2,400,000/100,000 shares = $24 per share. So the NAV for that mutual fund is $24 per share, and that’s what you would pay if you wanted to buy more shares.

So a mutual fund price increases or decreases based on the market value of each underlying asset. (I know, that’s confusing)

Let’s try it again in English.

Your investment makes you money or loses you money based on how well the stocks inside the mutual fund do as a whole.

If the overall value of the stocks inside the fund increase, then the overall value of the mutual fund increases by that same amount (minus fees).

The bottom line for how you make money though is ultimately the same ways you can make money buying regular stocks.

1. Buy the mutual fund when the share price is lower and then sell the mutual fund after the price increases (capital gains).
2. Buy the mutual fund and receive dividends and capital gains distribution from the mutual fund.

Like many stocks, most mutual funds distribute dividends and capital gains based on the stocks inside of that fund. So as far as you’re concerned, you make money in the exact same way as buying stocks. With mutual funds, you’re just buying a bunch at once, instead of one at a time.

Also like stocks, mutual funds have ticker symbols and can be searched for and bought in the same way. For instance, Apple’s stock ticker is AAPL and the total stock market index fund at Vanguard is VTSM.

Why Do People Use Mutual Funds? (Advantages)

For most people, unless you’re Warren Buffet, you’re not going to have enough money to buy all of the stocks that you would like to. So the huge advantage of mutual funds is that they allow you to invest in a large variety of stocks and diversify your investments with only a little bit of money. This diversity keeps you safe because if one company tanks, you’re whole investment doesn’t go down with it.

The second biggest advantage of a mutual fund is that it requires a lot less work and is much easier to deal with. No matter what type of mutual fund you own, it is managed by a third party company or manager. Therefore, you just choose the mutual fund and then just keep adding money to it and the third party takes care of everything else. This lets the average investor like you and me invest without having to waste too much time trying to pick all of the stocks ourselves.

So What’s the Catch? (Disadvantages)

The biggest disadvantage of the mutual fund is that you have to pay for the advantages.

All mutual funds have some sort of fee associated with them. This is how the brokerage pays for maintaining and managing the fund. And of course, the “professional” manager also deserves a hefty cut for all of the sweet investment moves he’s making for you right?

Some of these fees come on the front end (front-end loaded mutual funds). This means that when you purchase shares of a fund you will also pay a fee. These are often somewhere between 3% – 5% of the amount of money you’re investing.

Sometimes fees come on the back end (back-end loaded mutual funds). These mutual funds charge you a percentage fee when you sell your shares.

Then you have your normal operating costs and fees which are typically captured inside the fund’s Expense Ratio (ER). These typically range anywhere from practically 0 to sometimes even as high as 2.5%. Of course, you can find some funds with ER’s much higher, which you really want to avoid.

These expense ratios are annual fees that keep the fund running. This means that if you have $10,000 worth of a mutual fund with an ER of 1%, you would pay $100 for the year for that mutual fund.

Now you won’t actually “see” the fee get taken out of your money. The mutual fund takes it out of the profits/losses of the fund, so you only see if reflected in the performance of your mutual fund.

These fees can totally eat away at your investments, and that’s why it’s extremely important to pay attention to them when choosing your mutual funds.

What Types of Mutual Funds Can You Invest In?

Anything you want.

Really.

According to statista there were 9,260 mutual funds in the U.S. alone and more than 79,000 worldwide in 2014!

Now of these thousands of funds, there are four main types:

1. Money Market funds that invest in short-term investments issued by U.S. Goverment or U.S. Corporations and have a very low return for low risk.
2. Fixed Income (bond funds) that invest in different types of government and coporate bonds.
3. Equity Funds (stock funds) that (you guessed it) invest in stocks.
4. Hybrid or Mixed funds that invest in a mixture of stocks, bonds, and even other mutual funds.

After that, the mutual funds can be broken up based on all sorts of different criteria including company size, geographic location, sector, industry, political values, amount of risk, and diversification.

There are funds that invest in the entire U.S. stock market and other funds that invest based on seemingly odd reasons like the Vice Fund. This fund invests in companies that profit from human fallability and provide what could be seen as human “vices” like tobacco companies, alcohol, gambling, and weapons manufacturers.

Truly there are as many mutual funds out there as there are specific needs, wants, and desires.

Ultimately, I wouldn’t recommend investing in a mutual fund just because you think it’s funny or neat though. You probably want to base your choice for your life savings on a little more than whether or not the mutual fund excites you.

To find out what the fund invests in every mutual fund typically has a short description on the brokerage website that explains the investment objectives and goals as well as the types of investments that the fund will purchase. If you are looking for more detailed information, every mutual fund is required to have a prospectus that provides detailed data of past performance and investment strategies that the fund uses.

You always want to be sure and check out the fund in detail to make sure that it aligns with your own investing goals.

Actively Managed Mutual Funds

The terms active or passive are used to denote how the fund is managed by the company or overseer. If a fund is actively managed it means that there is a professional investment manager who is paid to hand pick the stocks that the fund will invest in.

This means that a real live person will be involved in making trades, buying stocks, selling stocks, and transferring money as he or she sees fit as long as it aligns with the objectives outlined in the fund prospectus. An active manager may not make any trades on a given day, or they may trade all day long. It all depends on the style and personality of that manager and how they see fit to run the fund.

Actively managed funds on average will have a higher expense ratio because you have to pay for the “expertise” and time that the manager is providing to help you get a good return.

A typical actively managed mutual fund would be the American Funds “Investment Company Of America” fund, AIVSX which seeks to invest in large blend U.S. based companies that represent a wide cross-section of the U.S. economy. This fund compares itself to the S & P 500 Index and has an expense ratio of 0.59% and a front-end sales charge of 5.75%.

Index Funds (Passively Managed)

On the other end of the spectrum, you have index funds which are “passively” managed mutual funds. Instead of having a person make all of the trades, index funds use computers to automatical match a specific index.

For instance, VFINX is an index fund that seeks to match the S&P 500 index. This fund is very similar to the American Fund AIVSX mentioned above. Except, instead of investing in similar companies as the S&P 500 and trying to beat it, VFINX simply copies the S&P 500 to perform exactly how the market does.

Index funds have a major advantage over actively managed funds because they take a lot of emotions out of investing (which is where most people screw up). In fact, in 2014, 86% of actively managed large-cap mutual funds failed to beat the indices. One NY Times article points out that the amount of actively managed funds that routinely beat the average market is effectively zero.

A big fat zilch.

So why pay all of the high fees if no one seems to even beat the index? Which is after all, the reason you’re paying them.

Great question.

That’s why I invest in index funds and you should too. Index funds are set to match the market. No guessing. No emotional investing. Just straight up match the index.

And because of this, these funds have INSANELY low fees. If you have your investment account with Vanguard and invest in Vanguard funds they won’t charge you any transaction fees. You will only have to pay the expense ratio on the fund.

Compare the 0.17% expense ratio of VFINX to the 0.59% expense ratio and 5.75% sales charge of AIVSX.

If you invested $10,000 in VFINX and had a 7% annual return before expense, your money would be worth $39,045 after 20 years. But if you invested that same $10,000 into AIVSX at 7%, your money would only be worth $33,850 after 20 years. That’s a difference of $5,000 on an initial investment of $10,000!

In order to just break even with VFINX the mutual fund manager would need to make 7.72% per year before fees. And as we saw above, the likelihood of a fund manager consistently beating the market over a 20 year period is slim to none. Then once you throw in your odds of actually picking the right mutual fund out of the thousands out there, it’s practically impossible that you’ll beat the market over the long term.

And that doesn’t even start looking at what happens if you invest regularly like on a monthly or yearly basis. Every time you invest money into AIVSX, you’re starting out 5.75% behind VFINX. And that’s a large gap to cross.

The bottom line is that you should invest in index funds because you will get to keep more of your own money by not having to pay incredibly high costs for some “professional” to guess and not beat the market anyways.

Exchange Traded Funds (ETFs)

One special type of mutual fund that I want to briefly mention is called an exchange traded fund or ETF. These funds are unique in that they actually trade throughout the day like stocks instead of at the end of the day like I explained above.

There are other advantages that ETFs provide such as typically lower operating expenses and low minimum investments. However, when you’re first starting out I wouldn’t worry about the differences between ETFs and mutual funds just yet.

Many people can get caught up in trying to time ETFs and then end up losing more money due to emotions and guesswork.

Just start with mutual funds and get a grip on how they work. Then one day if you would like to transfer to ETFs after considering the differences, you can. Companies like Vanguard will actually allow you to convert your index funds to their ETF equivalent if you like.

Hybrid Stock and Bond Funds

Hybrid mutual funds are fantastic for the investor that wants to be hands-off. These funds provide a mixture of both stocks and bonds that allow you to get a specific asset allocation based on your own tolerance for risk.

Balanced funds and target date retirement funds are two types of hybrid mutual funds that are very popular.

Balanced funds are used for a specific strategy or balance of stocks and bonds. If you’ve got a long investment horizon and would like to take on a bit more risk, you might consider the Vanguard 80/20 Balanced Fund VASGX. This fund invests 80% of its assets into stocks and 20% into bonds.

If you’re investing for a retirement, a great option would be a target date retirement fund. These funds provide an all-in-one solution for retirement and allow you to send all of your retirement money to one single fund. This makes life incredibly easy and keeps your expenses extremely low.

Hybrid funds are fantastic investment solutions for the majority of people because they provide a low-maintenance, low-cost option, to get your money working for you.

So What?

If you’ve got a retirement plan through work or plan to do any investing at all, it’s extremely important that you understand the basics of mutual funds.

They simply provide the best option for the average investor to get started in the stock market.

Question: What do you think about mutual funds? Do you prefer actively managed or passively managed? Leave a comment or shoot me a message and let me know what you think! I’d love to hear your thoughts.