Pooled investments for individual investors
In short:
A mutual fund is an investment vehicle which pools money together from many investors in order to implement an investment strategy which could include buying stocks, bonds, or other assets. Mutual funds give investors access to professional money managers who allocate the funds money on behalf of its investors, often giving investors access to better diversification (reduced risk) than they could have on their own.
Mutual funds aim to make money for their investors from the increase in value of the securities they invest in. Each investor thereby participates in the gains or losses of the fund in proportion to their investment.
Essentially, mutual funds allow investors to bet on a group of companies by buying into the fund instead of having to go out and buy all those companies individually. There are several benefits that will be discussed later, but some of the major benefits include saving investors time, money, and giving them access to a full time professional.
Well-known examples of mutual funds include Vanguard 500 Index Fund Admiral Shares (VFIAX), which is designed to mirror the performance of the S&P 500, or Fidelity 500 Index Fund (FXAIX), also designed to perform like the S&P 500. Both funds have been in operation for 20+ and 9+ years respectively and have more than a $100B market cap.
Key Points
- Mutual funds are investment vehicles that pool money together from many investors for a money manager to invest on behalf of the investors.
- Mutual funds can invest in stocks, bonds, and other assets.
- A Mutual funds share price is typically calculated once a day (at 4 pm).
- Annual fees are charged – called the expense ratio.
- Mutual funds are the main form of investment in most employer-sponsored retirement plans.
In-depth:
Brief History and Benefits
Mutual funds have been around for a very long time, the first starting in the 1920s. Originally and not that long ago mutual funds provided individual investors access to quite a few benefits. One benefit was the reduced cost to own a diversified portfolio. Before commission-free trading, stock trading was very expensive. Investors would get charged commission every time they wanted to buy and sell stock. Mutual funds allowed investors indirect access to larger transaction sizes which lowered trading costs. This means that more of their money went to work for them instead of going to the broker.
Additionally, investors who bought mutual funds would get access to full-time professional investors who would manage their money in the fund. These professional investors not only worked full time on behalf of the funds investors but had better skill and access to information than most individual investors. Without mutual funds, the only investors who really had access to money managers would be the wealthy who could afford them.
Finally and maybe most importantly, mutual funds provided an easy way for individual investors to diversify their portfolios by outsourcing this process. Instead of directly owning shares of a company, investors would indirectly own shares of a company through their mutual fund.
Today, mutual fund investors still get many of the benefits listed above, however, with the introduction and adoption of commission-free trading, some of the benefits are no longer meaningful. Building a diversified portfolio of individual stock is readily available and extremely affordable to individual investors.
The real advantage today lies in the diversification mutual funds provide. An investor wanting to simply perform as well as the market can buy a mutual fund that tracks the S&P 500. What they will get when they do that is an already created portfolio of 500 stocks. While they don’t directly own the stock they’ll own a proportional representation of the stock. Meaning each dollar invested is distributed as best as possible across the 500 stocks.
If an investor were to construct the same S&P 500 portfolio on their own not only could it be too expensive for the investor, rebalancing the portfolio would be very time-consuming.
Why diversification is important – the main benefit of mutual funds
For the passive investor looking to put minimal effort into investing and wanting average results, diversification is their friend. Here’s an example of what exactly is going on with diversification.
Say you live in a town where you have the ability to purchase any business you would like. You can either buy an entire business or a small portion of ownership in each business in the town. On top of that, you have two choices. First, you can go find the best business in your town and put all your investment into that business which leaves you with no diversification. Or Second, you can buy a small portion of every business, including the best and worst, giving you diversification.
Option 1 leaves you with no diversification; however, your entire investment will feel the full effect if the business continues to be successful. Option 2 gives you diversification-you’ll own a portion of the best business- but you’ll also own a portion of the worst business, which may go broke. What is the better option?
Clearly, option 1 is the better option. This illustration, while appearing very simple, is actually similar to the opportunity the stock market provides investors. The challenge, as you might have guessed, is finding the best business. In the example above, if you couldn’t find the best business, option 2 was the better option giving you the ability to own a portion of the best business without having to explicitly identify it. However, the tradeoff is that you also have to own a portion of the worst business.
Buying a mutual fund allows for you to select option 2. Instead of spending a large amount of time looking for the best company with no guarantee of success, mutual funds allow you to easily buy a small portion of many.
Active vs Passive
The first choice when looking into mutual funds is to decide if you want an actively managed fund or if you want a passively managed fund. This is because the fees and performance of the fund will depend on if it is actively or passively managed.
Actively managed funds are funds where the money manager is actively looking for companies to bring into the portfolio or throw out of the portfolio. The idea here is that the money manager and their team will be able to identify companies that will help the fund outperform passively managed funds. As a result, these funds are typically more expensive to own as they have to hire more analysts and incur more trading fees. On top of that, there is no clear history of these funds performing better than passively managed funds on a broad basis.
Passively managed funds are funds where the money manager is not actively looking for new companies to add to the portfolio. Instead, the money managers job is to keep the fund in line with an index such as the S&P 500, the Nasdaq 100 or fixed investment strategy. Since this type of management typically requires less work fewer analysts need to be hired and fewer transaction costs are accrued. These fewer expenses get passed to the fund owners in the form of a lower expense ratio.
Types of mutual funds
Since mutual funds can invest the pooled money of their investors into stocks, bonds, or a variety of other securities based on the funds stated objective, there are a wide variety of mutual funds available to investors based on their investing goals and risk tolerance. Types of mutual funds available to investors include:
- Large-cap: These are companies who have $10 billion of market cap value or above.
- Mid-cap: Companies whose market cap is between $2 and $10 billion.
- Small-cap: Companies whose market cap is between $300 million and $2 billion.
- Growth: This category is aimed at companies with high earnings growth potential. Many times companies within this category may not have any positive earnings and are relying on expectations of future growth for their value.
- Value: This category refers to companies who have a steady and consistent history of earnings however are typically trading without a premium in the market. Often these companies also produce dividends.
- Blend: An investor who does not want to be strictly in either the growth or value category may choose to be somewhere in the middle. Incorporating both growth and value companies.
Morningstar Style Box
In 1992 Morningstar developed a visual presentation of these different subcategories for funds to help investors identify where a fund falls. The style box is widely used by many investors today when initially looking at new funds.
While these subcategories may help give an initial idea about the style of an equity fund they are often superficial. An investor would be wise to dig much deeper. A process for this could be to look at the funds top holdings, are their top holding very concentrated and if so would you feel comfortable owning those companies or asses outright, the turnover ratio (how much stocks are traded, lower is may be better), is there a specific sector they focus on or you would like more exposure to such as tech or industrials, and so on.
- Bond Funds (fixed-income): The goal of these funds are to provide their investors with consistent regular cash dividends. These are often “less risky” than equity funds over the short term as they are composed of several types of bonds such as government, corporate or other bonds. It should be noted though that these funds are heavily subject to interest rate risk. That is, when interest rates rise the value of the fund falls.
- Global Funds: The funds in this category focus on investing outside of their home country. For those in the United States global funds may invest in developed countries such as Germany or in developing countries such as those in Southeast Asia or South America. Often these funds are subject to a large amount of political risk and volatility.
- Specialty Funds: Many funds that do not belong to any fixed form classification fall within this category. These can be funds that focus on a specific part of the economy such as technology, industrials, utilities, and so on. Investing in funds such as these will reduce some of the diversification an investor has since they are effectively buying a basket of companies that are more highly correlated with one another.
- Exchange-Traded Funds (ETFs): These are quickly becoming the go-to fund for investors looking to get into funds. ETFs trade like regular stocks (throughout the day) allowing investors to get in and out much quicker. They also often have much lower fees with the same benefits as traditional mutual funds. We cover ETFs extensively in our article on exchange-traded funds.
Mutual Fund Fees
There are two main expenses investors need to be aware of when purchasing mutual funds. Those are annual operating fees (expense ratios) and purchase/sale fees (the load).
The expense ratio: Running the fund takes money. There are lawyers checking on new SEC rules, accountants calculating the Net Asset Value of the fund every day, the money manager making sure the funds capital is allocated correctly and then the analysts that help the money manager stay on top of everything.
In order to pay everyone, the fund charges an annual fee expressed as a percentage of total assets. Usually, this fee will be around 1%. So, on a $100 investment, $1 would go to pay the annual operating expenses.
The load: Some funds charge investors a fee when they buy or sell shares, these fees are referred to as “the load”. Front-end loaded means the investor pays the fee when they initially invest, back-end loaded means the investor pays the fee when they sell their shares.
No load: Some funds choose to charge no to almost no sales or asset-based fees (still has an expense ratio) these funds are referred to as no-load.
Mutual Fund Classes
Multiple share classes may be offered to investors with the main difference being the sales fee associated with the class. This gives the investor the choice of how they want to pay the sales charge. Here’s an example of how shares may be structured:
- Class A sales charge associate with share purchase (front-load)
- Class B sales charge associated with share sale (back-load)
- Class C lower continuous charge (level-load)
Advanced uses of mutual funds
While it may be easy to write mutual funds off as a quick way to a diversified and boring portfolio that will slowly move along and only track an index such as the S&P 500, making such an assumption would be unsound. Even for advanced enterprising investors looking to outperform the market, mutual funds can and do play a critical role in their portfolio construction.
In order to demonstrate this, we can look at an example using an exchange traded fund.
Example
Let’s say an enterprising investor who’s looking to outperform the market wants to add some riskier young electric vehicle companies to their portfolio. The investor already has a portfolio consisting of 80% long-term single stock picks that have consistently beaten the market in the past. In addition to this, the other 20% of the investor’s portfolio is currently cash. Now, the investor has proven to be a good investment analyst in the past but with young electric vehicle companies there’s just not enough to go off of to be sure of any single company. So the investor, wanting to participate in any upside and willing to invest 12% of their cash decides to look to an ETF that focuses in this space. This way, the investor doesn’t have to make one or two low probability speculations and instead is speculating on a group of companies.
In the example above, the investor was able to reduce the risk of an aggressive investment they wanted to make while not giving up all the potential upside by looking to an ETF that specializes in a certain area. This is an example of making a diversified investment on a certain industry, but it should not be confused with being balanced and diversified across the entire portfolio. The only diversification benefit the investor receives from the ETF is on the electric vehicle space.
Pros and Cons
Pros
Ease of Access
Availability of mutual funds is in no shortage and access to them could not be much easier for most people. Beginning with the vast majority of employer-sponsored retirement plans offering their employees access to mutual funds additional access can be easily obtained from online brokers.
The vast number of mutual funds that provides this ease of access also means a wide variety of investment objectives are available for investors to choose from. This could be funds whose objective is to match an index, provide stead income with low risk, or be very aggressive in much riskier assets.
Diversification
Mutual funds allow investors of all types access to the type of diversification they may be looking for. Whether looking for a broad diversification across the entire market or diversification when making a strategic bet on a specific industry. Mutual funds can be used by all types of investors even with very different investing strategies and levels of participation.
Professional Management
Odds are you wouldn’t try to plumb or wire up your house all from scratch. Unless you’re a plumber or electrician you probably don’t have the skillset to do this well or in a timely manner. This same logic goes with investing, professional money managers have built up this skillset over long periods of time and do the job day in and day out. Their job is to make you money in a consistent and reliable way – not guess and gamble.
While recent popular culture has certainly poked fun of money managers and there are countless stories of quick buck overnight millionaires, whereas fund managers only match the market, those folks don’t have to have an audited public record to say whether they’re lying or not, mutual funds do.
Cons:
Tax consequences
Given the structure of mutual funds, many face more capital gains tax ramifications than other investment forms available. When a fund manager sells a stock in the portfolio that has a gain this triggers a capital gains tax. These capital gains tax consequences can produce an overall net negative effect on an investors long term portfolio’s growth depending on their size.
Other investment forms such as ETFs rarely have capital gains tax consequences for their investors given an ETFs structure which allows them to more easily adjust higher their cost basis.
Cash drag
Once again, given the pooled investment structure of a mutual fund. Everyday thousands of investors are putting money into and taking money out of the fund. Since this is the case, fund managers must keep some of the pools investment capital liquid to avoid forced sales. This means that not all of the pools investment capital is at work all the time on behalf of the investors. The term for this is cash drag since cash earns no return.
Minimum investment requirements
Many mutual funds require a minimum investment in order to do business with them. These minimum requirements can range form only $100 to $10,000 or more. This may prevent smaller investors or those just starting out from having access to some mutual funds.
Diversification
As we’ve mentioned previously, diversification works in both directions – good and bad. With enough diversification, an investor will effectively have no hope of outperforming the market. For investors who want the least risk possible and still earn a return that typically beats fixed-income investments, this may be a great thing. However, investors who want to perform better than the market must be aware that too much diversification will reduce to possibility of doing so.
How mutual funds work – mechanics
If you’re really looking to dig deeper into questions such as why mutual funds often have more capital gains tax consequences or why do they only trade once a day at 4 pm? These answers can be found in how mutual funds are set up and how they work.
Open-end
The vast majority of mutual funds are open-end.
An open-end mutual fund or “investment company” is a mutual fund that does not specify the exact number of shares it intends to issue. By not specifying the number of shares it wants to issue it is continuously open to more investments by issuing additional shares in the company.
As a result all shares purchased are always a primary offering meaning they are bought directly from the investment company itself instead of on the secondary market. The secondary market are exchanges such as the NYSE or Nasdaq, on those exchanges shares are traded between other investors not the companies themselves. This also means that when an investor wants to sell their shares they must sell their shares directly back to the investment company and cannot sell them on an exchange.
So how do you know what the mutual funds shares are worth? The mutual funds shares value is found by computing the net asset value per share (NAV). This price must be computed once per day and will be the price at which new shares will be created or old shares will be redeemed. By issuing new shares based off of the NAV the mutual fund ensures that additional capital is given shares only in proportion to what existing shares currently are valued. Meaning the value of current shares are not diluted by taking on additional capital.
This is the reason shares of open-end mutual funds only trade once per day and costs are typically higher with them than other investment forms. Computing the NAV every day requires accountants and directly dealing with investors increases the labor required to process all the orders. Additionally, given the fact open-end mutual funds must deal with the investors directly may give more explanation as to why many have a minimum investment requirement. Dealing with someone who only wants to invest $100 may just not be worth the hassle.
Why be open-end? Two primary reasons a mutual fund would want to be open-end. The first, they get paid related to the amount of money they have under management. Leaving your mutual fund open-end makes it pretty easy to raise additional capital. The second, since the price of the shares are determined by the NAV this means that the shares can never trade at a premium or discount to what they’re actually worth. The shares are worth what the underlying securities are worth which is calculated once per day.
Close-end
The primary difference between a close-end and open-end mutual fund comes down to the way capital is raised. A close-end mutual fund will register to issue a fixed number of shares, once those shares are issued that the total amount of shares available for that fund unless another offering is made. In addition to this, close-end mutual fund shares trade on secondary markets such as the NYSE and Nasdaq giving their shares greater ease of transaction. Close-end mutual funds can also raise money form preferred shares and bond offerings allowing them greater access to different forms of capital whereas open-end mutual funds only can offer common.
Why be close-end? A primary reason is to allow for their shares to trade more fluidly on the secondary markets and reduce the worry of capital outflow from the fund on any given day. The money raised is essentially locked in and will increase in total value if managed well. The drawback to close-end mutual funds is that it is possible for them to trade at a premium or discount to their true value since their shares trade between investors based off what investors are willing to pay and not the funds NAV.
Mutual funds have been around for a very long time, the first starting in the 1920s. Originally and not that long ago mutual funds provided individual investors access to quite a few benefits. One benefit was the reduced cost to own a diversified portfolio. Before commission-free trading, stock trading was very expensive. Investors would get charged commission every time they wanted to buy and sell stock. Mutual funds allowed investors indirect access to larger transaction sizes which lowered trading costs. This means that more of their money went to work for them instead of going to the broker.
Additionally, investors who bought mutual funds would get access to full-time professional investors who would manage their money in the fund. These professional investors not only worked full time on behalf of the funds investors but had better skill and access to information than most individual investors. Without mutual funds, the only investors who really had access to money managers would be the wealthy who could afford them.
Finally and maybe most importantly, mutual funds provided an easy way for individual investors to diversify their portfolios by outsourcing this process. Instead of directly owning shares of a company, investors would indirectly own shares of a company through their mutual fund.
Today, mutual fund investors still get many of the benefits listed above, however, with the introduction and adoption of commission-free trading, some of the benefits are no longer meaningful. Building a diversified portfolio of individual stock is readily available and extremely affordable to individual investors.
The real advantage today lies in the diversification mutual funds provide. An investor wanting to simply perform as well as the market can buy a mutual fund that tracks the S&P 500. What they will get when they do that is an already created portfolio of 500 stocks. While they don’t directly own the stock they’ll own a proportional representation of the stock. Meaning each dollar invested is distributed as best as possible across the 500 stocks.
If an investor were to construct the same S&P 500 portfolio on their own not only could it be too expensive for the investor rebalancing the portfolio would be very time-consuming.