Last week I encountered an email from one of my readers on how mutual funds work. The exact question was, “how do mutual funds work?” I thought it would be good to share this with everyone else.
What is a Mutual Fund?
Going with mutual funds definition, a mutual fund entails a company that normally pools money from different investors and takes the initiative to invest the funds in varied securities. Investments that tend to make up a mutual fund mostly include bonds, stocks, and money market funds.
The mutual fund is directed by a professional investment manager who buys and sells securities with the objective of growing the fund.
As an investor, you are a “shareholder” of the mutual fund company.
As a result, when the company generates profits, you earn dividends, and when the company suffers losses, your shares decrease in value.
How do Mutual Funds Work?
Mutual funds are run by companies that are required to register with the Securities and Exchange Commission (SEC).
By investing in a mutual fund, you buy shares in the fund. The funds can be purchased from the fund itself or through a broker or any other investment professional.
Every share represents your percentage of ownership of all the investments in the mutual fund’s portfolio.
Your investment in a mutual fund can earn you money in some ways.
When the mutual fund sells securities in the course of the year and generates a profit referred to as a capital gain of that sale, the gains (without capital losses) might be distributed to the shareholders at the close of the year.
The securities in the fund’s portfolio may also pay dividends, which are distributed to investors.
If the market value of the mutual fund’s portfolio increases, the value of your shares could also increase.
The increased value is, however, on paper and not directly accessed, unless you were to sell your shares at a higher rate compared to how you bought them.
Benefits of How Mutual Funds Work
Having learned how mutual funds work, it is also good to know the benefits that you can accrue from them.
Mutual funds are a great way through which people grow their wealth and save up for retirement.
According to the Investment Company Institute (ICI), nearly 100 million individual Americans had $18.9 trillion invested in mutual funds in 2018.
The five main benefits of investing in mutual funds include:
- Professional management
Managers of these funds make daily decisions on buying and selling the fund, decisions that they base on the fund’s goals.
For instance, if a fund’s goal is high growth, the manager may strive to achieve better returns than that of a major stock market like the S&P 500.
Equally, a bond-fund manager attempts to get the highest returns with the lowest risk.
- Simplicity
When you find a mutual fund with a good record, you play a small role as the fund managers execute all the tough roles.
- Liquidity
Unlike other assets such as your car or home, mutual funds are easier to buy and to sell.
It is important to note, though, that selling mutual fund shares that are held in tax-advantaged accounts such as a 401(k) or IRA before the age of 59 1/2 may lead to early withdrawal penalties.
- Affordability
Mutual funds have a set minimum of between $500 and $5,000; many brokers, however, waive minimums if you make direct monthly deposits to purchase more fund shares.
- Diversification
This is a key investing principle. If one company fails, and you happen to have invested all your money in that company, you lose all your money.
However, if a company fails within your portfolio of many companies, then your loss is minimal.
Mutual funds allow access to a diversified portfolio without the strain of having to purchase and monitor many assets yourself.
Shortcomings of How Mutual Funds Work
1. When you invest in two mutual funds that overlap investments, you get a less diversified portfolio.
For example, if you have two funds that both hold Microsoft and Microsoft implodes, then you get hit twice in case things went wrong.
There is a chance to correct this though by getting an index fund that invests in the whole market.
2. Most funds charge an expense ratio and possible upfront fees so as to be run by an “expert.”
3. You are paying an “expert” to take charge of your money (which you did toil to make), yet they hardly ever beat the market.
If you fail to be keen, you may end up investing in a mutual fund that
- Is managed by someone who could lead to the loss of your money.
- Charges you a lot of fees.
How Mutual Funds Pay
Above, as I tried to explain “how do mutual funds work,” I touched a little on how people get money from mutual funds. Mutual funds tend to pay out in two different ways:
Capital gains
You accumulate capital gains when you sell your mutual fund for more than what you bought it.
Distributions
If a mutual fund has an asset that pays dividends, the fund manager is mandated to distribute the dividends to the fund owners. The distributions can also be in the form of interest.
It is important to note that the amount you are likely to earn from every fund depends on various factors among them, your mutual fund manager.
I think this is the most important factor since he/she is the one responsible for making the buy or sell decision for the inherent securities.
I know the manager has a vested interest in achieving and choosing good assets for the mutual fund, but this does not necessarily mean that majority of mutual fund managers have the ability to beat the market.
Also Read: 9 Reliable Assets That Produce Income: Passive Income Streams
I am sure by now, you are not asking how do mutual funds work? You already know how mutual funds work and the pros and cons involved.
Now let us focus on the mutual fund types.
Types of Mutual Funds
Some mutual funds concentrate on one asset class, such as stocks or bonds, while some invest in a variety.
The main types of mutual funds include:
Bond (fixed-income) funds
These are not as risky as stock funds.
There are many different types of bonds, and you should, therefore, research every mutual fund individually in order to know the amount of risk it comes with.
About 22% of all U.S. mutual funds are bond funds; this is shown by Investment Company Institute stats.
Stock (equity) funds
These bear the greatest risk as well as the greatest possible returns. Variations in the market can largely affect the returns of equity funds.
Equity funds are of various types, including growth funds, income funds, and sector funds.
Each of the groups strives to maintain a portfolio of stocks with specific features.
Equity funds are the most common type of mutual fund, accounting for 55% of all mutual funds owned in 2017, as per the ICI.
Read: Discover When to Sell a Stock
Money market funds
These have the least returns because they carry the lowest risk.
Money market funds are lawfully required to invest in high-quality, short-term investments that are issued by the U.S. government or U.S. corporations.
These funds form 15% of the mutual fund market.
Balanced funds
These involve investment in a mix of stocks, bonds as well as other securities.
Balanced funds are mainly a “fund of funds,” investing in a group of other mutual funds. A good example is a target-date fund, which directly selects and reallocates assets toward safer investments as one nears retirement age.
Hybrid funds make up 8% of the mutual funds market, according to the ICI.
You have learned mutual funds definition and how mutual funds work. It is apparent that mutual funds work to make you money and are very popular. You, however, have to be cautious and keen not to end up in losses instead. Anyone who had the question “how do mutual funds work” I know it has now been answered.