What is a Mutual Fund?

This is the second article in a short series. You may want to read the introduction to the series: Three Really Good Questions

When it comes to professionally managed investments, mutual funds are the preverbal 800 pound gorilla. According to the Investment Company Institute, at the end of 2010 of the 16,090 investment companies 8,545 were mutual funds which held a collective $24.7 trillion in assets under management world-wide. In the U.S. alone, 90.2 million individuals from 51.6 million households (44%) own, on the average, 4 mutual funds. But how many of those 90.2 million individuals could explain what a mutual fund is?

What is a Mutual Fund?

Simply put, a mutual fund is a group of people who pool their money together and use a professional manager to make the investment decisions on their behalf. Every mutual fund has a written set of rules, limitations, and criteria called the prospectus which the money manager must abide by. Mutual funds can be Open-End funds or Closed-End funds. Since 98% of the market share is in Open-End funds we will focus on them for now but we may come back to Closed-End funds when we get to Exchange Traded Funds since there is a lot of similarity between the two.

The key to a mutual fund is its Net Asset Value or NAV. The NAV is calculated each day after the market closes by adding up the value of all the investments in the fund, subtracting out that days fees and expenses, and then dividing that resulting value by the number of shares of the mutual fund. For example, if a mutual fund has $100 million of cash and investments in the pool and there are 10 million shares of the pool owned, the Net Asset Value of each share is $10.00. Once the NAV has been calculated all requests to buy and sell shares of the fund can be processed. In our $10.00 NAV example, if someone wanted to sell their 123.456 shares the fund company would send them a check for $1,234.56 and now the fund has 9,999,876.544 shares outstanding.

Buying shares of a mutual fund is almost as straightforward but you may have to take the funds load, or sales charge, into consideration. If a fund has a front-end load, then you have to pay a sales charge before your money is invested. The SEC limits the sales load to never exceed 8.5% but loads are typically in the 5.75% – 4.5% depending on the particular fund and the type of investments it holds. So a load fund has a POP, or Public Offering Price, and an NAV. The POP is simply the NAV marked up by the sales charge. Going back to our fictitious example with a $10.00 NAV, if the fund also has a 5% front-end load the POP would $10.53. So on that given day shares are purchased for the $10.53 POP and sold for $10.00 NAV. When shares are purchased the total shares of the fund outstanding are increased accordingly for the next NAV calculation.

Once your money is in the investment pool there are additional expenses. You have to pay for the professional management of the investments. Management fees will vary quite a bit (but are always disclosed in the prospectus) and are charged to the fund daily by subtracting out a small percentage of the funds value when the NAV is determined. In addition to the management fees the fund also has to pay for its administrative, distribution, and investment expenses which are also drawn out of the investment pool.

Mutual Fund Advantages

There is a reason why mutual funds are so popular.

• They make investing easy. You pick the fund or funds which offer the mix of different investment categories you want and that is all you have to do. The day to day decisions of what investments to buy, which to sell and when to do it are handled for you by the portfolio manager.
• It doesn't take a lot of money to get started. Most mutual funds have very low account minimums of $1000 but I have seen them even lower. Some funds allow you to get started with as little as $50 as long as you commit to investing at least $50 each month (which leads us to the next advantage of…)
• Dollar Cost Averaging is a natural fit for mutual funds. In dollar cost averaging you regularly invest a fixed amount of money in to the same investment regardless of the market conditions. It tends to work because when the price of the investment is high, you buy fewer shares and when the price is low the same money purchases more shares.

Mutual Fund Disadvantages

• You are never quite sure of what you own. Mutual Funds provide a complete disclosure of holdings to the shareholders twice a year, usually 60 days later. Sometime around March they tell you what the fund owned on December 31^st and then around September they tell you what the fund owned at the end of June. This is often referred to as a lack of transparency.
• Mutual Funds are forward priced. That means that when you place your order to buy or sell shares of the fund during the trading day, you will not know what the NAV will be until after the market closes. For example, if I want to invest $10,000 today and place my order with the mutual fund, I will not know until tomorrow how many shares I purchased because I must have my order placed before the NAV is calculated. The reverse is true when selling. I must finalize my decision to sell my shares before I can know exactly what they are worth.
• Embedded Tax Gains. As a mutual fund shareowner, you own a part of every investment in the fund regardless of when you bought your shares. So if your fund purchased a stock ten years ago for $15 a share and today it is worth $100 per share, there is $85 per share of gain which has never been taxed. When the fund manager sells the stock you, as the shareholder, have to pay taxes on the gain the fund recognized regardless of if you enjoyed the benefits of the gain. While this does not affect a tax qualified account such as an IRA or a Roth IRA, in taxable accounts this can be quite an issue. Because fund managers tend to sell appreciated investments when the markets start to fall it was not uncommon for mutual fund owners to see their values decrease significantly in down markets like 2001 or 2008, but yet during those years the shareholders had to pay taxes on the fund's capital gains. Many investors find this frustrating.
• You don't know in advance how much it is going to cost. The prospectus can tell us the sales charges and management fees, but the expenses of the fund are not known in advance. All we can get from the prospectus is the history of expenses and this year's expenses may or may not be consistent with past year's expenses.

The odds are that you are one of the 90.2 million mutual fund owners. Does this help you understand what you own? If you want additional details let me know. I am always willing to take suggestions for future articles.

Next up… Unit Investments Trusts

Photo Gorilla – Bronx Zoo by Katy Silberger