Mutual funds are investments made up of a pool of money collected from many members of the investing public to buy securities such as stocks, bonds, money market instruments, and other assets.  Typically referred to as a portfolio, the average mutual fund holds hundreds of different securities, allowing investors to gain a wide diversification at a low price, which may be impossible to achieve on your own.

Actively Managed Funds:

With actively managed funds, you also have the added benefit of a professional money manager continually reviewing the portfolio, to allocate the fund’s assets, producing capital gains or income for the fund’s investors. Professional portfolio managers and analysts have the expertise and technology resources needed to research companies and analyse market information before making investment decisions. The mutual fund portfolio is structured and maintained to comply with the investment objectives stated in the prospectus.  The objectives vary widley from focusing on bonds, Oil sector, tech, large cap or small cap, income producing vs growth. For investors who have neither the time nor the expertise to oversee their portfolio, this can be an invaluable advantage.

Index Funds:

Index funds, on the other hand, are not actively managed, as they simply seek to replicate holdings in an index like the FTSE 100, DOW 30, S&P 500 and the many more global indexes.

The vast majority of employer-sponsored retirement plans are invested in mutual funds.

The majority of mutual fund shares can be bought for as little as $2,500 each, although some shares are available for less than $100.

Each shareholder, participates proportionally in the gains or losses of the mutual fund.  Investors do not actually own the securities in which the fund invests; they only own shares in the mutual fund itself.

The price of the mutual fund, also known as Net Asset Value (NAV) is the price per share, the market value.  This value is calculated as the total value of the securities within the portfolio minus the liabilities, divided by the number of the fund’s outstanding shares.

This value is important to investors, because it represents the value of the fund.  Assume for example, that a fund has $100 million in assets, with liabilities of $10 million.  It would have a total value of $90 million.  Assuming that the fund has 9 million shares, the net asset value (NAV) would be $10 per share.

More specifically, the NAV is the price at which investors buy the shares (‘bid price’) from a fund company and the price that they can sell the shares (‘redemption price’) to a fund company.  The redemption price is always higher than the bid price and the difference between the two is referred to as the spread.  Thus, to make a profit, an investor must wait for the bid price to rise above the redemption price after buying the shares, before he can sell his shares and make a profit.  The opposite is true for shorting the fund: the redemption price must drop below the bid price before investors can make a profit.

This price fluctuates based on the securities value held by the portfolio at the end of each business day after the market closes. 

When you buy a mutual fund share, you are buying the performance of it’s portfolio, in other words, a part of the portfolio’s value. Investing in a mutual fund share is different from investing in stock shares, since unlike stocks, mutual fund shares do not give voting rights to it’s holders.

Mutual funds are divided into four types:

• open-end funds with load

• open-end funds with no-load

• close-end funds with load

• close-end funds with no-load

The two main types are open-end funds and close-end funds, which are each then subdivided into load and no-load.

Open-End Funds:

The majority of mutual funds are open-ended. In other words, the fund does not have a set number of shares. Instead, the fund will issue new shares to a prospective investor, established by the current net asset value (NAV), and then redeem the shares when the investor decides to sell.  So, the shares always reflect the fund’s underlying investment value (NAV), because the shares are created and destroyed as required.

Closed-End Funds:

This type of fund has a set number of shares that are sold to the public through an initial public offering. Since these shares are not created nor redeemed, they trade on the open market and are subject to the normal market forces of supply and demand.  Consequently, closed-end funds tend to trade at a discount to net asset value (NAV).

In addition to the above two types of fund, they can each be traded with a load or no-load.  A load, in mutual fund terminology, is simply a sales commission.  Consequently, a load fund charges the investor a sales commission in addition to the net asset value (NAV) of the fund’s shares; a no-load fund does not, and can generate higher returns for the investor.

There are other fees that investors need to be aware of too.  When dividends are paid out, the tax liabilities are generally passed to the holder, and are usually charged at your ordinary income tax rate.  Investors also pay ongoing fees to cover the expenses of operating the fund.  This includes paying the money manager and research staff an advisory fee for their services, as well as transaction costs associated with buying and selling shares within the fund.  You may also be charged a redemption fee if you sell your shares too soon after owning them for a short time only.  Remember that when evaluating a fund, fees and taxes play a significant factor in your calculations and may significantly degrade your fund’s performance over time.

Although investors are often tempted to evaluate a fund in the short term, financial experts recommend that it is always best to study the long term performance of a fund for returns of a minimum of three to five years.

Final Thoughts:

Mutual fund investing requires you to assess your own situation, your needs and goals. What you’re investing for and your comfort level with regard to risk, to assess what types of funds are right for you.

For example, if you’re choosing funds for your retirement account and have many decades until you reach retirement, a more aggressive mutual fund with low expenses would be ideal.  Plus, you aren’t liable for capital gains tax on investments in qualified retirement accounts, so you could consider funds with high turnover that annually distribute capital gains.

On the other hand, if you’re approaching retirement, you may require income producing mutual funds such as a bond or stock dividend paying mutual fund.  The bond is paid monthly and the stock dividend is paid once, twice or up to four times a year.