What are Mutual Funds?
A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt.
The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates.
Common Types of Mutual Funds
There are six common types of mutual funds:
1. Money Market Funds
Money market funds invest in short-term fixed-income securities. Examples of short-term fixed-income securities would be government bonds, Treasury bills, commercial paper, and certificates of deposit. These types of funds are generally a safer investment but with a lower potential return than other mutual funds.
2. Fixed Income Funds
Fixed income funds buy investments that pay a fixed rate of return. This type of mutual fund focuses on getting returns coming into the fund primarily through interest.
3. Equity Funds
Equity funds invest in stocks. Furthermore, there are different types of equity funds such as funds that specialize in growth stocks, value stocks, large-cap stocks, mid-cap stocks, small-cap stocks, or a combination of these stocks.
4. Balanced Funds
Balanced funds invest in a mix of equities and fixed-income securities – typically in a 40% equity 60% fixed income ratio. The aim of these funds is to generate higher returns but also mitigate risk through fixed-income securities.
5. Index Funds
Index funds aim to track the performance of a specific index. For example, the S&P, or TSX. Index funds follow the index and go up when the index goes up and goes down when the index goes down.
Index funds are popular as they typically require a lower management fee compared to other funds (due to the manager not needing to do as much research).
6. Specialty Funds
Specialty funds focus on a very small part of a market such as energy, telecommunications, healthcare, industrials, etc.
How Are Mutual Funds Priced?
The value of the mutual fund depends on the performance of the securities in which it invests. When buying a unit or share of a mutual fund, an investor is buying the performance of its portfolio or, more precisely, a part of the portfolio’s value.
Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give their holders any voting rights. A share of a mutual fund represents investments in many different stocks or other securities.
The price of a mutual fund share is referred to as the net asset value (NAV) per share, sometimes expressed as NAVPS. A fund’s NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Outstanding shares are those held by all shareholders, institutional investors, and company officers or insiders.
Mutual fund shares can typically be purchased or redeemed at the fund’s current NAV, which doesn’t fluctuate during market hours, but is settled at the end of each trading day. The price of a mutual fund is also updated when the NAVPS is settled.
How to buy and sell mutual funds
Investors buy mutual fund shares from the fund itself or through a broker for the fund, rather than from other investors. The price that investors pay for the mutual fund is the fund’s per share net asset value plus any fees charged at the time of purchase, such as sales loads.
Mutual fund shares are “redeemable,” meaning investors can sell the shares back to the fund at any time. The fund usually must send you the payment within seven days.
Before buying shares in a mutual fund, read the prospectus carefully. The prospectus contains information about the mutual fund’s investment objectives, risks, performance, and expenses. See How to Read a Mutual Fund Prospectus Part 1, Part 2, and Part 3 to learn more about key information in a prospectus.
Benefits of Investing in a Mutual Fund
There are several key benefits to investing in a mutual fund:
1. Professional Management
Mutual funds are actively managed by a professional who constantly monitors the fund’s portfolio. In addition, the manager can devote more time selecting investments than a retail investor would.
2. Investment Diversification
Mutual funds allow for investment diversification. A mutual fund invests in several asset classes and not just a single stock or bond.
Mutual funds possess high liquidity. In general, you are able to sell your mutual funds within a short period of time if needed.
Disadvantages of a Mutual Fund
There are important disadvantages to consider when investing in a mutual fund:
1. Management Fees and Operating Expenses
Mutual funds typically charge a high MER (management fee and operating expenses). This would lower the overall return. For example, if the mutual fund posted a 1-year return of 10%, the MER would lower this return.
2. Loss of Control
Since mutual funds are managed by a manager, there is a loss of control when investing in a mutual fund. Remember that you are giving someone else your money to manage to when investing in a mutual fund.
3. Poor Performance
Mutual fund returns are not guaranteed. In fact, according to research, a large majority of mutual funds fail to beat major market indexes like the S&P 500. In addition, mutual funds are not insured against losses.
Example of a Mutual Fund
One of the most notable mutual funds is Fidelity Investments’ Magellan Fund (FMAGX). Established in 1963, the fund had an investment objective of capital appreciation via investment in common stocks.
The fund’s height of success was between 1977 and 1990 when Peter Lynch served as its portfolio manager. Under Lynch’s tenure, Magellan’s assets under management increased from $18 million to $14 billion.
Fidelity’s performance continued strong, and assets under management (AUM) grew to nearly $110 billion in 2000. By 1997, the fund had become so large that Fidelity closed it to new investors and would not reopen it until 2008.
As of March 2022, Fidelity Magellan has nearly $28 billion in assets and has been managed by Sammy Simnegar since Feb. 2019.
The fund’s performance has tracked or slightly surpassed that of the S&P 500.