Mutual Funds: Definition, Types, NAC Calculation
Mutual funds are investment vehicles that pool money from many investors to buy a diverse portfolio of assets like stocks, bonds, or a combination of both.
Managed by professional fund managers, mutual funds aim to achieve a specific investment goal, such as growth, income, or stability.
Investors in mutual funds share in the profits or losses of the portfolio. Mutual funds are popular because they offer diversification and professional management.
Key Takeaways
- Mutual funds pool money to invest in a variety of assets.
- They offer diversification, reducing the risk of losing money on one investment.
- Mutual funds are managed by professionals aiming for specific goals.
- There are many types of mutual funds, each with different strategies.
- They are accessible and suitable for both beginners and experienced investors.
Types of Mutual Funds
There are several types of mutual funds, each designed to meet specific investor needs. Knowing the different kinds helps you choose the right one for your goals.
Equity Funds : Stock-Based Mutual Funds
Equity mutual funds primarily invest in stocks.
They aim for long-term growth and can be classified into different categories, such as large-cap, small-cap, and sector funds.
Large-cap funds invest in well-established companies, while small-cap funds focus on smaller, growing businesses.
Sector funds invest in specific industries like technology, healthcare, or energy.
Bond Funds: Fixed-Income Mutual Funds
Bond mutual funds invest in bonds to generate steady income for investors.
These funds are less volatile than stock funds and are suitable for conservative investors.
Bond funds can be further classified into government bond funds, corporate bond funds, and municipal bond funds.
Money Market Funds: Low-Risk Mutual Funds
Money market mutual funds invest in short-term, low-risk securities like Treasury bills and certificates of deposit (CDs).
They offer lower returns but provide high liquidity and safety.
These funds are ideal for investors looking to park their cash with minimal risk.
Balanced Funds: Mixed Stock and Bond Mutual Funds
Balanced mutual funds invest in a mix of stocks and bonds, aiming to provide both growth and income.
The asset allocation is typically balanced, reducing risk while offering potential returns.
These funds are good for investors who want moderate risk and steady returns.
Index Funds: Mutual Funds That Track an Index
Index mutual funds aim to replicate the performance of a specific market index, such as the S&P 500.
They are passively managed, meaning the fund manager makes fewer decisions about buying and selling.
These funds have lower fees and offer exposure to the overall market.
How Mutual Funds Work
Mutual funds collect money from multiple investors and use it to buy a portfolio of securities.
Each investor owns shares of the fund, representing a portion of the fund’s holdings.
Net Asset Value: How Mutual Fund Value Is Determined
The value of a mutual fund is determined by its Net Asset Value (NAV).
The NAV is the total value of the fund’s assets minus its liabilities, divided by the number of outstanding shares.
The NAV fluctuates daily based on the market value of the securities in the fund.
Formula to Calculate NAV:
NAV = (Assets – Liabilities) ÷ Total Shares Outstanding
Example:
If a mutual fund has $1 million in assets, $100,000 in liabilities, and 10,000 shares outstanding, the NAV would be:
NAV = ($1,000,000 – $100,000) ÷ 10,000 = $90 per share
Professional Management: Role of Fund Managers
Mutual funds are managed by professional fund managers who make decisions about which securities to buy or sell.
Their goal is to meet the fund’s objectives, whether that’s growth, income, or capital preservation.
Investors pay a management fee, typically a percentage of the fund’s assets, for this service.
Mutual Fund Advantages and Risks
Risks of Mutual Funds
Like any investment, mutual funds come with risks. It’s important to understand these before investing.
1. Market Risk
Mutual funds are subject to the ups and downs of the financial markets. Equity funds, in particular, are vulnerable to stock market volatility, while bond funds are affected by interest rate changes.
2. Management Risk
The success of a mutual fund depends on the skill of the fund manager. Poor management decisions can lead to lower returns or losses.
3. Liquidity Risk
Some mutual funds invest in assets that are not easily sold, which can make it harder to get your money out quickly in certain market conditions.
4. Fees and Expenses
Mutual funds charge management fees and other expenses, which can eat into your returns over time. Index funds tend to have lower fees compared to actively managed funds.
Why Invest in Mutual Funds?
Despite the risks, mutual funds offer several advantages for investors.
1. Diversification
Mutual funds invest in a wide variety of securities, reducing the risk of losing money if one investment performs poorly. This diversification makes mutual funds a safer option compared to investing in individual stocks.
2. Professional Management
Mutual funds are managed by experts who have experience and knowledge of the markets. For investors who don’t have the time or expertise to manage their own portfolios, mutual funds provide a convenient solution.
3. Affordability
Many mutual funds have low minimum investment requirements, making them accessible to investors with smaller amounts of money.
4. Liquidity
Mutual fund shares can typically be bought or sold at the end of each trading day at the NAV price. This makes it easy to access your money when needed.
Understanding Mutual Fund Returns
Mutual fund returns come from three sources: dividends, interest income, and capital gains.
Dividends and Interest Income: Earning Income from Mutual Funds
When the securities in a mutual fund pay dividends or interest, that income is passed on to the shareholders.
Stock funds distribute dividends, while bond funds distribute interest payments.
Investors can choose to receive these payments or reinvest them in additional shares of the fund.
Capital Gains: Profits from Selling Securities in the Fund
Mutual funds also earn returns by selling securities that have increased in value.
These capital gains are distributed to investors as well.
Capital gains distributions typically occur at the end of the year.
Example of Mutual Fund Return:
Let’s say you invest $1,000 in a mutual fund with a NAV of $100 per share, so you own 10 shares.
If the NAV increases to $110 by the end of the year, your investment is now worth $1,100.
If the fund distributes $50 in dividends and capital gains, your total return would be $1,150.
How to Invest in Mutual Funds – Steps to Start Investing
Investing in mutual funds is straightforward, and there are multiple ways to get started.
Buying Directly from Fund Companies
You can buy mutual funds directly from the companies that offer them, such as Vanguard, Fidelity, or Charles Schwab.
These companies provide a wide range of funds with different investment goals and risk levels.
Buying Mutual Funds Through Brokers
Many investors use brokerage accounts to buy and sell mutual funds.
Brokers like TD Ameritrade and E*TRADE offer access to thousands of mutual funds.
Some funds may have transaction fees, so it’s important to compare costs before investing.
Automatic Investment Plans
Many mutual funds allow investors to set up automatic investment plans.
This lets you invest a fixed amount of money on a regular basis, such as monthly or quarterly.
Automatic investments can help you build wealth over time and reduce the impact of market fluctuations.
Expense Ratios and Fees – Understanding Mutual Fund Fees
Mutual funds charge fees, known as the expense ratio, to cover the cost of managing the fund.
The expense ratio is expressed as a percentage of the fund’s assets and is deducted from the fund’s returns.
How to Calculate Expense Ratio
Expense Ratio = (Fund Operating Costs ÷ Total Fund Assets) × 100
Example:
If a fund has $1 billion in assets and $10 million in annual operating costs, the expense ratio is:
Expense Ratio = ($10,000,000 ÷ $1,000,000,000) × 100 = 1%
Impact of Fees on Returns – How Fees Affect Your Earnings
Higher expense ratios reduce your overall returns.
For example, a fund with a 1.5% expense ratio would need to earn at least 1.5% just to break even.
Index funds generally have lower expense ratios than actively managed funds because they require less trading and management.