What are mutual funds?
A mutual fund, also known as an investment fund, is an investment instrument where an asset management company takes money from many investors and pools it together into one large pot.¹ A portfolio manager will then invest the money in different classes of assets including bonds, stocks, commodities, and sometimes real estate.
Professional money managers allocate a fund’s assets in order to generate income or capital gains for investors² Mutual fund portfolios are structured and maintained so as to match the investment objectives outlined in the fund’s prospectus.²
Acquiring shares in a mutual fund grants a buyer an ownership interest in a portion of the fund’s assets.³ What makes mutual funds attractive to investors is that a typical mutual or investment fund is widely diversified. And diversification is one of the best strategies to limit market volatility and investment risk.
What types of mutual funds exist?
There are many types of mutual funds, using different investment strategies and asset groupings. They are generally divided into the following groups: stock, index, bond, and money-market funds.
There are also different fee structures for mutual funds, the two main types are retail series and fee-based series (F-series). An ongoing trailer fee of a retail series is paid by the retail mutual fund to the advisor because of the advice that they provide. On the other hand, an F series fund does not pay a trailer fee to the advisor because the client will directly pay a negotiated fee to the advisor.
Self-directed brokerage firms are no longer permitted to receive trailer fees and will only offer mutual funds without trailer fees. Some firms will charge a percentage fee or a commission for the purchase of mutual funds.
What is a trailer fee?
A trailer fee is a payment made to a broker by a mutual fund manager for selling the fund to an investor and providing the investor with investment advice and services.
As the term suggests, a stock fund invests principally in equities. Within stock funds, there are many different subcategories based on company size, investment strategy and geographic distribution.⁴
Some funds’ names reflect the size of the companies they invest in: small-, mid-, or large-capitalization. Other equity or stock funds describe the investment approach: aggressive growth, income-oriented, or value. These can also be categorized according to whether they invest in domestic stocks or foreign equities.
Some mutual funds will employ a strategy that mixes investment style, company size and the geographic distribution of the assets under its management.
Index funds, also known as passive mutual funds, invest in securities that correspond to fluctuations in the value of a major market index, such as the S&P 500 or the Dow Jones Industrial Average (DJIA). Index funds replicate an index with a goal of providing a return equal to the index minus the management expense ratio (MER). As a result, fewer expenses are passed on to the funds' shareholders.⁴ The lower management fees are a big draw for more cost-sensitive investors.
Also referred to as debt funds, bond funds invest primarily in different types of government, municipal, corporate, or convertible bonds and other debt instruments, such as mortgage-backed securities (MBS).⁵ Generating monthly income for investors is typically the primary goal of a bond fund.
Money market funds
Built on lower-risk, short-term debt instruments, a money market fund is a type of mutual fund that typically includes cash, cash equivalent securities, and high-credit-rating, debt-based securities with a short-term maturity. Money market funds offer investors a balance of high liquidity and a very low level of risk-generating income that is usually on par with short-term interest rates.⁶
What are the advantages and disadvantages of mutual funds?
|Diversification||Not meant for the short term|
||No control over the portfolio|
|Risk management||Higher fees
|Smaller initial amount required||Not fully invested because mutual funds hold cash for redemptions|
|Liquidity (easy to sell)|
Mutual funds vs exchange-traded funds: What’s the difference?
Self-directed investors also have the option of investing in exchange-traded funds (ETFs) to build their portfolios. In the last 15 years, the selection of ETFs has greatly expanded and there has been growing interest from investors.
In many ways, mutual funds and exchange-traded funds (ETFs) share many similar features but there are important differences between them that investors should be aware of:
||Typically, active but also passive||Typically, passive but also active|
|Holds different asset classes||Y
|Traded on an exchange||N||Y|
||Free with NBDB
|Minimum investment||Higher (varies by mutual fund firm)
||Low (Min 1 unit purchase)
How do mutual funds trade?
When an investor buys or sells a mutual fund, they transact directly with the fund holding those assets. Unlike stocks and ETFs, which are traded on the stock market, mutual funds trade once per day, and only after the markets close at 4 p.m. ET. When you enter a trade to buy or sell a mutual fund's shares or units, your trade is executed at the next available net asset value (NAV). The NAV is calculated once the market closes and is typically posted by 6 p.m. ET. Be aware, however, that this price may differ from the previous day’s closing NAV.⁶
How are mutual funds priced?
The value of a mutual fund share, or unit, is easy to find on a financial site like the NBDB trading platform.⁷ Because of the lack of intraday trading, today’s NAV price will not be the same as the listed price.
To calculate the NAV of an equity fund⁷:
- Take the closing price or last quoted price of each stock held in the fund and multiply it by the number of shares held
- Add any additional assets such as cash and subtract any fees or expenses, commonly called liabilities
- Then, divide the result by the number of outstanding units.
Net asset value (NAV) = (assets-liabilities) / total number of outstanding shares
How are returns calculated for mutual funds?
Mutual funds are calculated based on annual rates of return. For example, if you bought a unit or share of a mutual fund at $100 in January, and in the following December the value of that mutual fund went up to $110, the annual rate of return would be 10%.
New price - Original price = Amount of Return / Original Price = Annual rate of return %
$110 - $100 = $10 / $100 = 10%
How do mutual funds perform in bear vs bull market?
Because mutual funds tend to be aimed at long-term investors, they typically aim for gradual growth. As a result, they are less volatile than the market.⁸ Historically, bull markets have seen mutual funds underperform compared to the market average. In contrast, during bear markets, mutual funds have tended to outperform the market average.⁸
How can a mutual fund fit into a self-directed investment strategy?
Mutual funds can be well suited to a self-directed investment strategy because:
- They are actively managed by fund managers who are legally obligated to work in the best interest of the mutual fund's shareholders.⁹
- They are highly diversified and a good way of managing risk and market volatility.
- They represent another asset choice available to investors versus ETFs or purchasing individual securities.
- Clients can set up automatic investing to buy mutual funds.
- While some direct brokers may charge a commission to buy mutual funds online, NBDB does not.
Like all investment decisions, self-directed investors buying mutual funds must do their homework. Mutual funds may be easier to manage than focusing on buying individual securities, but given the array of mutual fund options available, it's essential to do your research before buying. Investing in mutual funds can make a lot of sense. With a little due diligence, you’ll see the difference—providing a measure of comfort while helping your money grow.