A mutual fund is a type of investment where a money manager takes your cash and invests it as he sees fit, usually following some rough guidelines. For example, the Fidelity Group has a fund that specializes in finding high dividend paying [ts]stocks[tm]Stocks are “equity investments”, which means that individuals that own stock shares of a company actually own part of that company.[te], one that specializes in bank stocks, and one that specializes in European stocks, etc. You simply find a fund that matches your objective, you review its past performance and its management team, and then you write a check to that mutual fund.
Most mutual funds are called “open-ended” funds because they will continue to take your cash, manage it for you, and issue shares to show your ownership. Each night the mutual funds calculate the value of all of their holdings and divided that value by the number of shares they have issued, and that number is called the Net Asset Value or [ts]NAV[tm]Net Asset Value of a mutual fund at the end of the business day. It is the equivalent of a share price of a stock.[te]. So if the Fidelity Bank Fund had a value of $10.00 and your write them a check for $5,000 you would now own 500 shares of this fund. Gains, losses, and earnings are mutually shared with investors in proportion to the size of their investment.
Since one of the primary rules of investment is to diversify portfolios, a mutual fund can be a simple and successful way to accomplish this goal. With one investment, you will own shares of stock in many corporations.
How Does a Mutual Fund Work?
[mark]Mutual funds are a great way to start investing but, because they are so easy, they also carry a cost. Mutual Fund companies have to make money, of course, and they do that by taking some of the funds assets to cover their salaries and other expenses. These are called Management Fees. As noted in the Introduction, mutual fund companies have to pay salaries and marketing expenses and they always get paid FIRST before the investors/owners get paid! The other negative about mutual funds is that if you invest $10,000 in 5 different funds, then you probably own small amounts of as many as 1,000 different stocks! It becomes harder to outperform the market when you own so many different stocks.[endmark]
To research mutual funds, Morningstar.com is one of the top web sites to check out. The Morningstar website:
- rates funds on a 1-5 scale so you can quickly review a fund’s performance
- shows mutual fund performance against relevant sectors and other funds
- shows the top holdings (what stocks they own) in all mutual funds
- shows the people who manage these funds
- shows the expense fees for each fund
Below is a screen shot from Morningstar of the Fidelity Monthly Income Series.
Management fees are one of the key metrics to watch
out for as an investor because they can quickly and devilishly eat into your profits over time. Do higher management fees correlate to higher returns and better performance? As it turns out, the answer is NO. In fact, many studies have been done that show higher fees generally correlate to lower performance.
Mutual Funds are not traded on an open market like stocks and the prices of mutual funds are calculated just once a day, at the end of every trading day. The price for a mutual fund is called the Net Asset Value (NAV) because it is a calculation of the entire value of stocks and other assets held by the fund divided by the total number of shares outstanding:
Since Mutual Fund NAV’s are calculated just once a day, mutual funds can’t be traded several times during the day like a stock. In fact, it is generally discouraged to trade several times in and out of mutual funds. Most mutual funds impose penalties and redemption fees upon withdrawal from the mutual fund to discourage active trading.
[mark]As I said, mutual funds are a great way to start investing in the stock market, but at some point, it is to your advantage to start investing in individual stocks. More and more research is coming out showing that owning lots of mutual funds leads to over-diversification and paying too much in management fees. This is because you will rarely outperform the market because you are the market (you will end up holding so many different stocks).[endmark]