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Mutual Funds Explained

Mutual Funds [1] are an investment scheme that pools money from many different investors to invest in stocks, bonds [2], or other assets [3].  Typically, there are thousands (if not millions) of different investors who own shares of that mutual fund [1], which collectively make up the mutual fund’s holdings.

Mutual funds are also the most popular type of investment schemes to the general public because they are available in retirement accounts like a 401k [4] or IRA, as well as taxable investment accounts.  The main advantages of mutual funds are the professional management and the inherit diversification [5] that it provides.

Explanation of How Mutual Funds Work

In simplistic terms, investors buy shares of the mutual fund, and the money is in turn used by the fund manager to invest in some type of assets (for example, stocks).  Therefore, investors are in effect buying a share of the underlying asset [3] that the fund purchases when they buy a share of the mutual fund.

At times, the mutual fund will issue more shares to sell to investors to cope with demand [6].  However, some funds may become closed to new investors when its portfolio simply becomes too large to manage.  While it can’t be proven, it is interesting to note that many believe that as the size of the fund grows, it eventually comes to a point where returns suffer.

Prices of a Mutual Fund

Much like a stock, the share price of a mutual fund fluctuate.  However, unlike the former two where the securities [7] are traded constantly during market hours, the share price of a mutual fund is typically calculated on the end of every business day.

Since orders for mutual funds can only be entered during market hours, it implies most investors won’t know the exact price of the fund until the transactions go through.  However, since the share price is highly correlated with the assets that it owns and the volatility is lower than a typical stock, investors generally are not as sensitive about market timing a mutual fund.

Advantages of Owning a Mutual Fund Explained

It’s not popular for no reason.  Mutual funds offer many benefits for the average investor:

  1. Professional Management – Unlike the average investor who probably don’t have time to monitor and research each particular holding, mutual fund managers do this on a full-time basis to maximum returns.
  2. Simplicity – Mutual funds offer a very simple way for the average investor to invest.  This appeals to the buy it and forget it type of investor who still wants to be involved in the market.
  3. Liquidity – Unlike investment vehicles such as a certificate of deposit [8], mutual funds are highly liquid.  If you really want your investment liquidated, it generally takes only a couple of days to do so.
  4. Diversification – Since mutual funds own a huge collection of assets, investing in it inherently gives you a diversified portfolio.  However, take caution that most mutual funds are sector or class specific, so while there are different types of assets within the portfolio, they are all correlated to each other.

Disadvantages of Mutual Funds

There are many reasons not to like mutual funds as well.  Let’s explore a few here:

  1. Cost – Theoretically, mutual fund managers help increase your returns and reduces your risk.  However, many believe that those managers are no better at finding the right investment than you or I.  The worst part is that whether they make or lose money, they still take a cut (known as management fees).  Other possible fees include: sales charges, administrative fees, marketing expenses.  These funds definitely is more expensive than a do-it-yourself approach.
  2. Tax Implications – Because you do not control the buy and sell of each security [7], you might be stuck with a tax bill when the fund made money on the sale of some stocks when the whole portfolio has  negative return!
  3. Size of the Fund – Mutual funds control so much money that whenever they decide to buy an asset, they increase the demand so much that they end up having to pay more for the asset.  This obviously hurts your return as an investor.  Additionally, the fund managers are sometimes forced to buy assets at terrible prices because they have so much money to invest.
  4. Inflows and Outflows of Money – Fund managers uses the investor’s cash to invest, so the fund is sometimes forced to sell some assets to pay back money to the investors.  However, mutual funds usually have the highest redemptions when the fund does extremely bad (when asset prices are at their lowest), forcing them to sell at the worst possible time.

What This Means For Us

While mtuual funds are an easy way to invest in the market, I generally advise people to stay away because there are better alternatives such as an index fund [9].  The high fees, coupled with the lack of control is simply too high a barrier for fund managers to overcome.

However, some (your 401k for instance) only have mutual funds as the only option to invest.  In these cases, make sure you pick funds where the fees are as low as possible.  Otherwise, the fees will eat away at your return which can add up to significant amounts over long periods of time.