What Are Mutual Funds?
The basic definition of mutual funds: A big pool of investment money created by a large number of small investors who combine their funds to gain the advantages that are normally reserved for big investors.
This pool of investment money is managed by a professional who gets paid based on the amount of money they manage (some also get paid based on the fund's performance).
And finally, each fund is geared toward a specialized kind of security (index, growth, income, sector, etc.). This means you can choose the type of fund based on your own investment goals and risk tolerance -- with the assurance that the fund will maintain its focus on securities that fall within that predefined type.
Main Advantages of Investing in Mutual Funds
A wealthy investor can afford to purchase a diverse portfolio of securities (stocks, bonds, short-term money market instruments, etc.) -- thereby reducing the risk of losing money if a segment of the economy moves in the wrong direction.
With mutual funds, small investors can afford to do the same thing by taking a small amount of money (as little as $500 or less) and investing in a mutual fund that in turn invests the large pool of money into a diverse selection of securities within the framework of their advertised type.
Another of the many advantages of investing in mutual funds is that you can sell or add to your shares at any time. Plus, you can also switch from one type of fund within a fund family (different types of funds managed by the same company) to another type of fund at no cost -- and with just a phone call.
Disadvantages of Investing in Mutual Funds
While mutual funds offer many advantages, it's also important to realize that mutual funds are not federally insured -- even if you purchase them through a bank.
Also, be aware that management fees are charged by all mutual funds regardless of whether or not your mutual fund investment is gaining money or losing money.
For me, the biggest drawback to purchasing mutual funds (namely stock, or equity funds) is that I cannot control which funds make up the fund's portfolio. I don't like the thought of being a part owner of companies that I feel are detrimental to the health and well-being of their client base (credit card companies, tobacco companies, gambling companies, etc.). After all, where the money goes, so goes the power to influence (lobby). Like it or not, believe it or not, ...
How Do Mutual Funds Work?
When you invest in a mutual fund, you transfer money to the fund in an amount greater than the minimum required (varies from one fund to another). If the fund has a sales charge (front-end load), the fund deducts the charge from your initial payment and then issues the number of shares equal to the remaining balance divided by the NAV per share (Net Asset Value per share).
The Net Asset Value (NAV) is the fund's assets minus its liabilities. The NAV per share is calculated by dividing Net Asset Value by the number of shares outstanding.
NAV = Assets - Liabilites
NAV Per Share = NAV ÷ Outstanding Shares
So, as a simple example, suppose a fund's assets were $150,000, its liabilities were $50,000, and the fund had 10,000 outstanding shares. In that case, the NAV would be $100,000 ($150,000 - $50,000) and the NAV per share would be $10.00 ($100,000 ÷ 10,000).
You can use the following calculator to calculate the NAV of the fund you are researching.
Continuing with the earlier example, if you transferred $1,000 to the fund that had a 3% sales charge, you would be issued 97 shares of the fund ($1,000 - $30 sales charge = $970, ÷ $10 NAV per share = 97 shares).
From there, you can see that if the NAV rises (assets increase by a greater margin than any increase in liabilities), so does the NAV per share. So if the fund's NAV per share was to increase to say $12, this means you could sell your 97 shares back to the fund for $1,164 (97 x $12 NAV per share) -- leaving you with a gain of $194.00 ($1,164 - $970) -- less any deferred sales charges (back-end load) and annual operating costs.
Since it costs money to run a fund, all mutual funds charge an annual operating expense fee equal to a percentage (usually 1%-3%) of the value of your shares.
Some funds may also charge for sales and marketing (referred to as "12b-1" fees), management, and "other" expenses. The amount of these charges can be found in the prospectus that mutual fund companies are required to provide.
Of course, all of these fees will serve to lower your rate of return, so it's important to shop and compare the fees charged.
When and How to Buy Mutual Funds
Before investing in mutual funds, or any other type of risk-bearing investment, you should have 3-6 months of income saved up in an emergency fund and have no outstanding high-interest debt.
If you don't have a fully-funded emergency fund, I suggest you allocate all investment funds to creating that all important financial safety net.
Or if you do have a fully-funded emergency fund, but you have unpaid high-interest debt, I suggest you invest in your debt before you consider purchasing risk-bearing mutual funds that can't match the safe, tax-free, high rate of returns you can achieve with accelerated debt payoff.
If you do have a fully-funded emergency fund and you have managed to pay off all of your high-interest debt, and you are ready to start investing in mutual funds, you have one of two primary ways of purchasing shares:
- You can buy mutual fund shares directly from a fund. These are typically referred to as "no-load" funds -- meaning there is no sales charge for purchasing the shares since they don't use a commissioned sales force to sell their shares. In this case, you will need to do your own research in choosing which fund to invest in.
- You can buy mutual fund shares through brokers, banks, financial planners, and insurance companies. These are typically referred to as "load" funds -- meaning there is a sales charge since they need to compensate those that are selling shares on their behalf. In this case, you can get recommendations from the seller as to which funds to buy. Just be aware that they may recommend funds based on how much commission they make. Also, be aware that you will need to earn a higher rate of return to offset the sales charges.
Best Place to Begin to Learn About Mutual Funds
You should now have a rough understanding of what mutual funds are, how they work, and when and how to buy them. For more in-depth study I suggest you begin by visiting the Securities and Exchange Commission's (SEC) section on Mutual Funds (opens in a new window).