Oxford Dictionary

Mutual Fund — [noun] An investment program funded by the Mutual Fund shareholders that trades in diversified holdings and is professionally managed. Mutual funds are regulated by the Investment Company Act of 1940 and are registered with the SEC (Securities and Exchange Commission).

ELI5

A mutual fund is an investment that pools money from several investors and invests the money in stocks, bonds, or combinations of them. The total list of securities in the mutual fund compose a portfolio that can be actively or passively (track a fixed Index of stocks) managed by a brokerage such as Schwab, Vanguard, Fidelity, etc. The portfolios can be diverse – they can consist of stocks or bonds from similar industries, similar sizes (market capitalization), or consist of the entire stock market (index funds).

Okay, neat so your money gets pooled into a bunch of stock, what’s useful about mutual funds over a typical stock? A handful of reasons, but here are some main ones:

1/  It’s a great simple way to minimize the amount of risk you are exposing yourself to compared to investing in an individual stock. This process is known as diversification.

2/ Remove the need to do a deep valuation of every investment, the responsibility is passed on to the fund managers. Mutual funds are a simpler way to participate in the equity market.

Here’s an example – during the dotcom boom you invest $10K in Company A’s stock that’s very promising, but know it’s a high risk investment. To reduce the amount of risk, a decent alternative would be to invest in a mutual fund that is pooling money together in similar companies including the one are thinking of investing in. In this hypothetical scenario, let’s say Company A makes some poor product decisions and ends up filing for bankruptcy — and being a common stockholder you don’t get anything back. In this case, your $10K is worth…nothing. Looking at the mutual fund alternative, that $10K is invested in Company A, and B, C, etc. Since only a portion of the investment is in Company A, you will be less exposed to the bankruptcy and retain more of your initial $10K investment.

 

Detailed Definition

There are some other important concepts associated with mutual funds include how they are priced, who designs and manages them, and various costs associated with them compared to investments in standard stock.

How are the prices of a mutual fund determined? We look closely at the net asset value (NAV) the calculation involves taking the total assets minus liabilities divided by the number of outstanding shares. The assets would be the active investments, cash, and accounts receivables while liabilities would include operational expenses. The fund’s share price won’t be exactly 1:1 with the NAV (due sales load and other expenses), but are fundamentally tied to it.

There are a variety of different funds – bond, equity, balanced, index, specialty funds, and ETFs. If interested in a more detailed breakdown of the various types of funds, let us know!

Some downsides to mutual funds are the costs that are associated with them. For a standard stock the only typical fee is commission on trading. However, a mutual fund expenses includes the following major fee categories: management fee, distribution fee, operational fees, and sales loads.

Management fees are the costs associated with keeping a team of researchers and a portfolio manager who makes the decisions on what stays and goes in the fund. These range from 0.5-2% of total assets on average. A higher management fee is not indicative of better fund performance as well! Active funds have higher Management Fees than Passive funds.That may not sound significant, but long term, depending on the amount invested can significantly bite away at investor’s profit margin.

Distribution costs (aka 12b-1 fee) are the expenses that occur when the fund manager buys and sells the underlying assets. Depending on the trading frequency of the fund, this can also be a cost to consider when purchasing a mutual fund. This category also includes marketing and promotional costs – which ultimately help the fund manager increase their asset pool with more investor’s money.

Operational fees include legal, accounting, and administrative fees – this is typically the most minor of the three, but will vary based on the fund’s operational expertise.

These three are the main components of the expense ratio which tends to be between 0.5-2.5% for most mutual funds. Based on what you seek from the fund you are considering investing in, this number can play a big part. In the case you are seeking long term income, it would be worthwhile to find a low expense ratio fund so you keep most of your gains. In the case you want to invest short-term and expose yourself to a higher risk fund, it might make sense to participate in a fund with a higher expense ratio.

The final fee associated with a mutual fund, not included in the expense ratio, are sales loads. They are part of the shareholder fees and normally used to compensate the broker during the buying and selling of the fund.

The front-end load is the amount charged when the fund is purchased while the back-end load is the amount charged when the fund is sold by an investor. Front-end loads are fairly straightforward – let’s say a fund has a 2% front-end load. When you invest $100, $2 will go towards the sales fees and $98 will turn into actual assets for the fund.

The back-end load is a little different and tends to vary as a function of the length of investment in the fund. Typically, if an investor tries to sell in a short term timeframe they’ll have to pay a higher back-end load while a longer term timeframe will have a lower back-end load. This is to incentivize the investor to keep their money in the fund, so the fund manager knows the underlying asset won’t be highly dynamic.

Index funds which invest in well known stock indices like the S&P 500 or the Total Market have the lowest fees of about .10% or less and have no-load.

Mutual funds without loads are referred to as No-load funds and are generally preferred over funds with a load.