Introduction to Mutual Funds

Mutual funds are very popular types of investment funds in the US. They are known as an open end company under federal securities law.

What is a mutual fund?

To elaborate, A mutual fund is a pool of funds professionally managed for the benefit of all shareholders. A Mutual fund can be seen as a company which invests in diversified portfolio of securities to minimize risks. Mutual funds get the money they invest from shareholders, and they use this money to purchase securities such as stocks and bonds with the goal of bringing higher returns to the shareholders.

A mutual fund can make money from its securities in two ways. These are through the payment of dividends, and through capital gains (Rise in the value of the security). Before investing in a mutual fund, it is important to know that although there is a greater possibility of earning returns on your investment, there is also a possibility of losing money invested if the mutual fund makes wrong investment decisions.

Categories of a mutual funds

They are three basic categories of mutual funds. They are:

• Money market funds
• Bond funds
• Stock funds

Money market funds: Money market funds invest primarily in short term securities. They are among the safest and most liquid financial instruments in the market. Money market funds are most suitable for short term investments and saving goals. They invest in money market instruments which have a low term to maturity term to maturity, usually not exceeding 365 days. They are highly liquid and they preserve the value of the investment while still bringing in income.
To preserve the value of the investment, money market funds must meet stringent credit quality diversification standards and maturity. It is good that the money market funds are stable and preserve the value of the investment, but there is an inflation risk inherent in it. This is a situation whereby the investment fails to keep up with the inflation rate.

Bond funds: Bond funds or fixed income funds on the other hand invest primarily in bonds.  A Bond is a security held by the purchaser, It represents a loan to the issuer of the bond. A bond can be issued by corporate organizations, sovereign bodies, non-sovereign bodies and supranational entities. In a bond the issuer promises to repay the principal also known as the face value while also promising to make periodic interest payments over the life of the loan.

The interest of a bond is fixed and it is usually a certain percentage of the principal amount. It is paid periodically, usually twice in a year. Bond funds tend to be less volatile than stock funds and often produce regular fixed income.

Bonds get ratings from rating agencies such as moody’s, fitch rating and others. They give ratings ranging from Aaa to D. Aaa being the most stable with regular interest payments and little or no risk of default, they are called investment grade bonds. D represents unstable bonds with default in interest payments, they are called junk bonds or non-investment grade bonds. With guidance from these rating agencies, a bond fund can choose widely the bond to invest in.

Stock Fund
Stock funds invest primarily in stocks. Stock represents ownership in a company, people who buy stocks are known as shareholders. They bear the risk of failure of a company and they also share excess profits in case of returns.

Shareholders can benefit in two ways which are:

• Payment of dividends to shareholders
• Increase in the value of the stock

Stock is highly risky because as mentioned above, a shareholder bears all the risk. If a company fails, shareholders can lose the entire value of his or her shares; a shareholder is although not liable for the debts of the company. Stocks historically have performed better than other securities such as bonds and money market instruments, but the risk that comes with it is significantly higher than the others.

When you buy shares of a stock mutual fund, you essentially become a part owner of each of the securities in the fund’s portfolio.

Advantages of investing in a Mutual Fund

Some of the advantages of investing in a mutual fund includes:

1) Professional Management: In a mutual fund or funds generally, there is a limited partner and a general partner. The limited partner is the ordinary investor, investing in the fund, while the general partner is the professional committed to managing the fund.

In a mutual fund, professionals manage a portfolio of securities full time. They are involved in the active management of the funds and they decide which securities to buy and sell based on extensive research.

The general partner is always on his toes, exploiting opportunities and adjusting the portfolio based on changing economic conditions.

2) Diversification: In investments they are two concepts of risk you have to deal with when selecting your portfolio. They are systematic risk and unsystematic risk. Systematic risks are risks inherent to the entire market or an entire market segment; they are known as un-diversifiable risks. They are uncontrollable or unavoidable. They affect the overall market and not just a particular stock or industry. Unsystematic risk on the other hand is an industry specific or firm specific risk. They can be reduced through diversification.

Unsystematic risk can be reduced by diversifying into different companies and industries and not putting all “your eggs in one basket”. In a mutual fund, assets are pooled together and the fund can diversify by holding securities which would have been inaccessible to an individual investor.

3) Liquidity: Liquidity represents how readily an asset or an investment can be converted into cash. Mutual fund shares are tradable and can be sold. Mutual funds are required by law to buy or redeem shares each business day.

4) Cost Effective: Mutual funds provide professional management and diversification for a fraction of the cost of making such investments independently. They also make shares or investments which would have been inaccessible to the individual investor readily accessible. i.e they create collective buying power that may help you achieve more than you could on your own.

5) Regulation: Mutual funds are subject to compliance with self imposed restrictions and limitations. They are also highly regulated by the federal government and the securities and exchange commission of the country in which they operate.The regulation and laws are established to protect investors from fraud and abuse.

 

FEES AND EXPENSES

Operating a mutual fund involves some costs. These costs may include transaction costs, investment advisory fees or management fees and marketing and distribution expenses.

As you would expect, mutual funds pass on these costs to the shareholders. They are required to disclose the costs which can be grouped into shareholder’s fees and operating expenses.

Operating Expenses
These are costs involved in running the fund. They include:
1) Management fees: They are the cost of the investment adviser who manages the fund.
2) Distribution and service fees: They are marketing, selling and distribution costs
3) Other expenses : They are all other fees incurred in managing the fund. They include costs such as: Custody charges , legal and accounting expenses and so on.

Shareholder fees
Shareholder fees are fees imposed when an investor buys, sells or switches mutual fund shares. They include:
1) Purchase fees: Fees charged to pay for the cost of purchase
2) Redemption fees: This is charged when an investor sell their shares
3) Exchange fees: Fees payable when an investor wants to switch to another fund within the same group of funds
4) Sales charge on purchases: Sometimes referred to as front- end load. They are amounts payable when shares are bought

Taxation of Mutual funds
In the us, the tax treatment of mutual funds depends on the type. There are tax exempt mutual funds and non tax exempt funds. Tax exempt funds for example municipal bond fund’s dividends are exempt from federal and sometimes state income tax; but tax is due on capital gains.Income tax is payable on dividends and capital gains for other mutual funds.

 

Recommended Reading

John C Bogle., David F. Swensen.,Common Sense on Mutual Funds.