Mutual Funds 101
Mutual funds are the most held type of investment vehicle, with over half of US households owning shares of at least one. At Yeske Buie, mutual funds are the foundational investments we use in our Client portfolios to, among other things, ensure our Clients’ investments are broadly diversified. But what exactly are mutual funds? How are they priced, bought, and sold? How do they differ from other investments? Let’s learn more about mutual funds in this in-depth review to help you better understand the makings of your portfolio.
What are mutual funds?
A mutual fund is a “basket” of stocks, bonds, or other securities that have been selected and managed by a third party. These funds each have different objectives, sometimes looking to track the performance of a certain index (such as the S&P 500 or the NASDAQ), and sometimes focusing on specific areas such as emerging markets or smaller-sized companies. This is accomplished by the mutual fund company holding a collection of many different assets and allowing individuals to purchase shares of this larger pooled investment. This structure allows investors to instantly diversify their portfolio, since they are indirectly holding a piece of each asset the mutual fund owns.
How are mutual funds priced?
Since mutual funds hold many different assets, their pricing can sometimes be confusing. This is done by calculating the value of one share, also referred to as the “net asset value” or NAV. This value is obtained by adding up the total value of all holdings, subtracting out fees, and then splitting this value equally among the number of shares of the mutual fund. This calculation is only performed once per day when the market closes. This means that there is no change in the value of mutual fund shares throughout the day, so the value will remain constant from the time the market opens until the end of the day, when the NAV is recalculated.
Like most investments, the price of a mutual fund will change over the course of the year as they trade securities. Industry regulations state that all mutual funds must distribute their net capital gains to shareholders. This means that when the mutual fund sells any securities or receives any dividends from its holdings, this money must be distributed at least once per year to all investors who hold the fund. As these distributions occur every year regardless of whether you buy or sell shares, it is important to stay aware of any tax implications that may arise. These regular distributions, however, can also be a powerful tool that allows you to capitalize on the benefits of a growing portfolio without requiring you to sell any of your holdings.
What kinds of fees are associated with mutual funds?
Mutual fund managers, like any business owner, must generate enough money to cover their expenses. The way that they cover these costs is through the use of fees embedded in the fund. There are many different types of fees that these companies can use, but they are always listed in the fund’s prospectus, which also includes many details about the fund, such as the investment objective, performance, management structure, and tax information.
Fees generally fall into one of two categories: Shareholder Fees or Annual Fund Operating Expenses. Shareholder fees include those that are incurred at the time of purchase or sale (also called Loading fees), as well as fees on smaller account sizes or transference between funds. Annual Fund Operating Expenses, as the name implies, are used to cover the yearly cost of keeping the Mutual Fund running. This includes management fees, any marketing and distributions costs, and miscellaneous expenses such as legal or accounting costs.
Total fees often vary from fund to fund even within the same company and can range from 0.015% for very large, mostly static funds like the Fidelity S&P 500 fund to over 1.5% for smaller companies that change holdings often. The company that Yeske Buie prefers for mutual funds, Dimensional Fund Advisors (DFA), has an average expense of about 0.35% and does not include any kind of loading fees, so you’re never charged by DFA for buying or selling.
How are mutual funds traded?
Mutual funds are traded on exchanges just like normal stocks, and can be easily identified by their ticker symbol, which are always five letters and end with an ‘X’. This means that you can buy mutual funds with any of your brokerage or retirement accounts. Mutual funds differ from individual company stocks in how they are bought and sold, however, as mutual fund shares can only be traded with the issuing mutual fund, who is required to buy them – this is referred to as a “redeemable security.” The benefit of a redeemable security is that there is never a concern of needing to find a buyer or seller, as the mutual fund will always purchase shares back from investors and is the only place that the shares can be purchased from. The drawback, however, is that the share transfers are performed at the same time the NAV is calculated. This means that regardless of when the order is placed, any purchase or sale of mutual funds will not take place until the end of the day when the market closes.
What are the differences between mutual funds and ETFs?
Mutual funds are often compared to a closely related investment called an Exchange-Traded Fund, or ETF. ETFs, like mutual funds, are baskets of stocks that allow the purchase of shares to increase exposure to certain sections of the market and provide portfolio diversification. ETFs differ from Mutual Funds in a couple important ways, however. The first is that they are priced throughout the day based on the market, which also allows them to be bought or sold at any time the market is open, rather than once per day at the market close. Second, ETFs do not have regular distributions of gains like mutual funds do. This means that all gains will be realized when the shares are sold (and only when they are sold), rather than being distributed to shareholders on a regular basis.
While it is true that ETFs give you more control over the timing of realizing capital gains, Yeske Buie manages its Clients’ accounts to take advantage of these regular capital gains distributions. For accumulating clients, these distributions are taken at the end of the year to invest and rebalance the portfolios without the need to sell any other securities (ETFs, on the other hand, would require you to sell shares to rebalance). For spending clients, these capital gains distributions act as an ideal starting point for annual cash needs, again reducing the need to sell any securities and thereby minimizing the potential taxable gains from the trades.
Closing Comments
Overall, mutual funds are an extremely powerful and versatile way to invest that give individual investors the ability to both focus on specific markets and instantly diversify their holdings, all while benefiting from a professionally managed fund. This combination of features along with how easy they are to trade allows them to fit in with many different investment portfolios, from early saving years to retirement and beyond. The team at Yeske Buie can assist you in deciding what’s best for you and your financial future. Please don’t hesitate to contact us to learn more!