What are mutual funds?
What is a mutual fund?
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A mutual fund is built on multiple parts:
- Asset management company (AMC)
- Registered at the securities exchange commission (SEC)
- Investment advisors registered at the SEC
- Unit holder
The portfolio represents the combined holdings of the mutual fund. The portfolio is managed by an investment advisor registered at the SEC.
When you buy a share from a mutual fund, you are purchasing a piece of the portfolio. You are not buying shares from the securities that are listed in the portfolio. Meaning, if the mutual fund has Coca Cola in their portfolio, that does not mean you now own Coca Cola shares if you buy mutual fund shares. You own mutual fund shares.
You have zero control over the securities that are in and added to the portfolio over time. But at the same time this might be an advantage because mutual funds are run by professional investors that do the hard work (research) for you.
You can buy shares directly from the fund or through a broker. Mutual funds are required by law to price their shares each business day. This price is based on per-share value minus all liabilities and is called “net asset value” (NAV). The NAV price is mostly calculated after closing time of exchanges. When an investor wants to buy shares during the day, they don’t know what price they will pay until the next NAV is calculated.
Mutual funds are also redeemable or callable. Meaning that the company that is running the mutual fund can ask investors to sell the shares back to the company. An investor that holds shares through a mutual fund is also called a unit holder.
There are three types of investing companies:
- Unit investment trusts (UITs)
- One time offering with a fixed number of shares which will terminate at the date specified
- Closed-end investment companies
- Sells a fixed number of shares at one time that can be traded on the second market
- Open-end investment companies
- Continually sells shares through the fund or a broker
A mutual fund is an open-end fund.
19.1 Many types of fees
When investing in a mutual fund you have to pay fees. These fees have no effect on the price of the shares or the market. Meaning, no matter how good or bad the mutual fund is performing, you’ll always have to pay these fees. The fees depend on the mutual fund and the securities it purchases. Let’s have a detailed look at all the fees you might encounter:
- Sales charge on purchase or front-end load
- Deferred sales charge or back-end load
- Purchase fee
- Exchange fee
- Account fee
- Redemption fee
- Distribution fee
- Management fee
19.1.1 Sales charge on purchase or front-end load
This fee is paid when buying shares of the mutual fund and is mostly paid to the broker. You can compare this with buying other securities like bonds and stocks when buying through a broker.
19.1.2 Deferred sales charge or back-end load
A fee that is charged when investors sell their shares or when shares are redeemed (when the company wants their shares back, the investor has to sell them). This fee is mostly paid to the broker. The most common type of back-end load is contingent deferred sales load (CDSL).
The amount of load is typically bound to how long an investor is holding shares. This fee may drop to zero if an investor is holding shares long enough. If the mutual fund is charging CDSL then there is usually no front-end load charge. Assuming there are no other costs, the full amount of money is used to buy the shares. But investors are charged when they sell them within a specific period.
19.1.3 Purchase fee
It might be a bit confusing at first but a purchase fee is not the same as a front-end load. The purchase fee is not paid to a broker but to the fund itself. This fee is usually charged when the transaction costs for the mutual fund to buy the required securities (adding securities to the portfolio) are high. As mutual funds also have to pay fees to buy securities, this fee helps to guard the investment of investors that have already invested in the fund. Otherwise transaction costs would cause diminishing returns for other investors.
19.1.4 Exchange fee
A fee charged when investors are exchanging their funds for other funds of the same family of funds/company/group. A family of funds is a group of funds that share administrative and distribution systems.
19.1.5 Account fee
A fee paid for account maintenance. This might be the case when the account value is below a certain threshold.
19.1.6 Redemption fee
The redemption fee is paid when the shares are redeemed or sold. While the broker charges the back-end load, the redemption fee is paid to the mutual fund. There is a maximum limit of 2%.
19.1.7 Distribution fee
This fee covers the costs of marketing and selling fund shares and sometimes to cover the costs of providing shareholder services. Think about printing and mailing new brochures and other literature to new investors.
19.1.8 Management fee
Management fee is paid to manage the portfolio of the fund (done by the fund investment advisor).
An overview of all fees:
|Type of fee||Paid to|
|Front-end load||Broker when buying shares|
|Back-end load||Broker when selling shares|
|Purchase fee||Mutual fund with high transaction cost shares|
|Exchange fee||Mutual fund|
|Account fee||Mutual fund|
|Redemption fee||Mutual fund (max 2%)|
|Distribution fee||Mutual fund|
|Management fee||Mutual fund|
Sometimes mutual funds call themselves “no-load”. Meaning they don’t charge any fees. But that does not mean there are zero fees. They only refer to the sales load charged for front-end and back-end. I will discuss the importance of fees in a later chapter.
Sometimes mutual funds give a discount on the front-end load when the size of the investment increases. These discounts are called breakpoints (or sales charge discounts). Mutual funds have no requirement to offer breakpoints but when they do they need to be listed and brokers must apply them. Also, brokers are not allowed to sell shares in an amount that is just below the breakpoint just to earn a higher commission.
As each mutual fund can decide for themselves if they want to offer breakpoints, you should be looking for them if you decide to invest in mutual funds. Each fund can apply their own rules and can have a (big) impact on the future of your portfolio.
19.3 Role of the sponsor
The sponsor is the promoter of the mutual fund. The sponsor gathers capital and sets up an AMC (Asset management company). Every mutual fund needs a sponsor before it can start selling shares to the public. Sponsors can be:
- Financial institutions
Before becoming a sponsor, the company or institution needs to have the following requirements (among others):
- At least a 5 year track record in financial service business
- At least 3 out of 5 years in profit
- Need to hold 40% or more net worth in the AMC
Beware that the rules and requirements may be different for the country you live in.
19.3.1 Role of trustees
The role of trustees is very important. They protect the unit holders (the investors) from the AMC. The board of trustees oversees and monitors the AMC. They assign a custodian to keep the assets safe. The board of trustees also monitors new investments and ensure full compliance with regulations are met.
19.4 Different class shares
Because a mutual fund is a company providing financial products, you can choose what kind of expertise you want. These packets of expertise are called class shares. Each class will provide different kinds of services and therefore have different risk/reward ratios. This class structure allows investors to pick a class that fits their investing mindset/portfolio. These classes are:
- Class A
- Class B
- Class C
- And sometimes there are more classes
19.4.1 Class A shares
Class A shares typically charge front-end sales load. While other fees like distribution fees are lower. They generally also have lower annual fees vs other classes.
19.4.2 Class B shares
Class B shares don’t have a front-end sales load. They do have a back-end load. Typically, when holding B shares for a longer period of time back-end load decreases. Also, if B shares are held long enough, they convert to another class type with lower costs and no load charges.
19.4.3 Class C shares
Class C shares might have distribution fees, annual expenses and front and back-end sale loads. But the costs for back-end and front-end load are typically lower than class A and B shares. Class C shares won’t convert to other classes and tend to have the most annual costs of all classes.
19.5 Different types of mutual funds
There are four different types of mutual funds:
- Stock funds
- Bond funds
- Money market funds
- Target date funds
19.5.1 Stock funds
Mutual funds that invest in stocks are called stock funds. These mutual funds have a specific or specified stock portfolio:
- Stocks that pay regularly pay dividends (income funds);
- Stocks with more growth potential (growth funds);
- Stocks based on an index like the S&P 500 (index funds);
- Stocks from a specific market (market funds).
I will go in-depth about dividends later on. For now you just need to know that dividends are excess money that the company divides between investors that bought their stock. Dividend stocks can provide a steady amount of income on top of the potential capital gains from stock prices rising.
Stocks with growth potential are smaller companies that might grow very fast in the upcoming years. This also increases the risk. Huge established companies lack growth potential. Especially if they already control the current market.
Mutual funds that track an index means that they follow a specific market index like the S&P 500. They buy a small piece from every company in the S&P 500. This is very efficient and has moderate amounts of risk. Overall, index funds are the best performing funds in the long term.
Market funds follow a specific market and are focussing on hot or underperforming markets. They invest in real estate or the financial market (banks).
19.5.2 Bond funds
Bond funds are the same as stock funds only they invest in bonds instead of stocks. You can read all about the different type of bonds in previous chapters.
19.5.3 Money market funds
A money market fund invests in highly liquid assets. Liquid assets are assets that are very easily bought and sold. Think about cash and bonds. Money market funds are considered very low risk. There are multiple types of money market funds:
- Prime Money Fund
- Government Money Fund
- Treasury Fund
- Tax-Exempt Money Fund
19.6 Target date funds
Target date funds let’s you specify a specific date called the target date. When the fund is coming close to the target date, it will gradually reduce the risks. Target date funds usually invest in other mutual funds but they can also hold individual stocks or bonds. These funds are structured to decrease the amount of growth stocks while nearing the target date and focus more on income. That does not mean these funds provide fixed incomes or have no risks. These bonds are typically chosen by younger people setting the end date at the year they retire from work. After the target date is reached, the conservative investments will still be there. Reaching the target data also does not guarantee you have enough money to retire.
As target date funds are just mutual funds investing in stocks and bonds, the same risks and rewards apply to this kind of mutual funds. You can still lose money and the target date does not guarantee anything.