Lesson 11: Mutual Funds

Lesson 11: Mutual Funds

Mutual fundsThere are a lot of investments out there. There are corporate bonds, municipal bonds, small-cap stocks, mid-cap stocks, large-cap stocks, growth stocks, value stocks, the list goes on and on.  How can an investor diversify when bonds par at $1,000 and stock prices can easily be in excess of $100? If there were some way that many individual investors could pool their money together to own investments, they could all reap the benefits of investing without any one investor taking on a significant amount of risk.  This is why mutual funds exist.

Key Points

  • A mutual fund is a type of investment company.
  • Net asset value (NAV) is an important metric when looking at funds.
  • Advantages of investing in a mutual fund include professional management, diversification, and low investment for entry.
  • Disadvantages of investing in a mutual fund include additional costs, risk, and taxes.

What is an Investment Company?

A mutual fund is a type of investment company.  This begs the question “What is an investment company?”  Put simply an investment company is any company that issues securities and is in the business of investing in securities. How it basically works is that an individual investor buys shares of the investment company or more accurately shares of a fund the investment company controls. With the money procured from individual investors the investment company purchases securities as dictated by the goal of the fund and pays out the returns to the investors.

An investment company is usually one of four primary types. There are open-end funds (mutual funds). close-end funds (CEFs), and Unit Investment Trusts (UITs). The fourth and fastest growing type of investment company called an Exchange Traded Fund (ETF) will be discussed next lesson once we have a clearer picture of how these different types of funds function.  It should also be noted that “investment company” and “fund” tend to be interchangeable terms.

 

L11.1 Graph of Investment Companies
Types of Investment Companies

 

Net Asset Value

Before we dive into the differences there is a key metric that is very relevant to both closed and open end funds is known as net asset value (or NAV). The most comparable but not perfect comparison is to think of the NAV of a fund as the stock price of a stock. The net asset value is calculated by the following

Net asset value (NAV) = (Total Assets in Fund – Total Liabilities)/ Total Fund Shares Outstanding

Let’s assume that in the CD Super Awesome Fund had $100 billion in assets, $20 billion in liabilities and 10 billion in shares outstanding. The NAV would be calculated as follows:

NAV = ($100 – $20)/ 10 = $80/10 = $8/share

Why does this number matter? It plays a significant role in the share value of open-end funds (mutual funds) which we discuss later.

 

What is a Mutual Fund (Open-End Fund)?

An open-end fund is an investment company which issues new shares to anyone willing to buy and will redeem (buy back) any shares from those wishing to sell back. The money received from investors is then used by the managers of the mutual fund to buy securities for the mutual fund.  It helps to think of a mutual fund as just another public company that sells and can buy back stock from investors.

What price is charged to investors or does the mutual fund have to pay to redeem shares? Remember the Net Asset Value (NAV)? The Net Asset Value represents the share price of the mutual fund.  So let’s return to the CD Super Awesome fund.  If I were an investor wanting to buy 100 shares of the fund I would pay $800 at the share price established above.  Likewise if I wanted to sell 100 shares back to the fund I would receive $800 for my shares.

100 shares of CD * $8/share = $800

A very notable difference between the common stock we discussed earlier and a mutual fund share is that while a share of common stock is priced constantly throughout the day a mutual fund’s NAV is calculated once at the end of the trading day. So you want to sell or buy a share at 10:00 A.M.? Too bad. You have to wait till after trade closes and the new NAV (share price) has been established.  Thus based on whether the mutual fund’s assets have increased or decreased in value will determine whether the NAV has increased or decreased.

 

What is a Close-End Fund (CEF)?

A closed-end fund is an investment company that issues a fixed number of fund shares in an initial public offering and uses these funds to invest in securities according to the purpose of the fund.  These fund shares are then traded on exchanges similar to common stock.

What is the main difference between close-end and open-end funds (mutual funds)? The biggest difference is the process in which the shares of the close-end fund are traded.  If you remember in a mutual fund the fund stood ready to buy or sell as many shares as needed. In a close-end fund the number of shares is fixed.

What effect does this fixed number of shares have on the price of the shares of the fund? These shares are now sold and bought by investors during the day on major security exchanges at values independent of the fund’s NAV. The NAV is now driven by market forces of supply and demand. This means at any time a share of a close-end fund can trade at a discount (less than) or a premium (greater than) the fund’s NAV.  Close-end fund have become less popular with the emergence of Exchange-Traded Funds but still exist.

 

Advantages of Investing in a Mutual Fund

  • Management by Professionals: The decisions of what investments in a mutual fund is not made by you. Instead a professional money manager is charged with investing in certain securities according to the goal and type of the mutual fund. This way while you can focus on doing your job the money manager is meanwhile researching opportunities to make your money work for you.
  • Diversification: If you remember our risk vs. return lessons, one of the main strategies to reduce risk is to diversify (hold securities whose performances are independent of each other). By having over a billion dollars worth of assets a mutual fund can hold hundreds to thousands of
  • Low Investment for Entry: Many mutual funds have a minimum deposit of $3,000 to participate but some can be low as $1,000. Without a mutual fund it would be nearly impossible to achieve the same level of diversification with the same level of funds.

 

Disadvantages of Investing in a Mutual Fund

  • Costs: By purchasing securities directly you avoid some of the fees present in using a mutual fund. These fees include sales-charges, 12b-1 fees, and management fees.
  • Risk: Unlike a savings account, there is the risk that the mutual fund’s assets could decrease in value and thus your return on the investment could be negative.
  • Taxes: Federal income taxes are due on both dividends and gains made by the fund and any profits made when the shares are sold. One exception is when the distributions are channeled into tax-deferred retirement accounts (IRAs)

Conclusion

One final note about mutual funds: there are a ton of these things. The broad three categories are stock, bond, or balanced funds which accordingly hold stock, bonds, or a mixture of the two.  Further classification includes capital appreciation stock funds, growth stock funds, international stock funds, sector funds, municipal bond funds, the list goes on and on.  Your goal and risk tolerance as an investor will dictate which type of fund best suits your needs.

L11.2 Mutual fund types
Mutual Fund Types and Relative Market Share. Image courtesy of teensguidetomoney.com

 

Definitions

  1. Investment company: A company that issues securities and is in the business of buying and selling securities as its primary activity.
  2. Open-end fund: An investment company who will issue new shares as required and whose share price is equal to the fund’s NAV.
  3. Close-end fund: An investment company that has a fixed number of outstanding shares whose value is commonly at a discount or premium to the fund’s NAV.
  4. Unit Investment Trust: An investment company that holds a very small number of securities that it does not actively sell and also has a limited life.
  5. Exchange Traded Fund: An investment company that does not issue securities directly to investors, but instead issue large shares known as “creation blocks”.
  6. Net Asset Value: A metric of an investment company that is equal to the sum of the fund’s assets minus its liabilities divided by shares outstanding.

 

Further Reading

 

 

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