Getting Started with Mutual Funds
Updated: Mar 3
In a world where there are so many different types of investments, you may find yourself asking, how do I sort through all the choices? Over our next two blog posts, we are going to better acquaint you with two commonly used investment vehicles - mutual funds and exchange-traded funds (ETFs). Knowing more about the features of these investments can help you evaluate if they are right for you.
Mutual Funds 101
What is a Mutual Fund?
A mutual fund is an investment vehicle in which investors pool their money together to invest in a portfolio of stocks, bonds, alternative investments, or a combination of these. The pooled funds are managed by a portfolio manager who ultimately makes the decision as to which investments should be purchased and sold within the fund.
How is a Mutual Fund Priced?
The price, or Net Asset Value (NAV) of a mutual fund is calculated by taking the total valuation of the securities that it holds and dividing it by the total number of shares outstanding. The NAV is determined once a day, at the end of the trading day.
How does a Mutual Fund Trade?
While shareholders are able to place a trade to buy or sell shares of a mutual fund throughout the trading day, the transactions are all settled at the end of the day when the price of the mutual fund has been determined.
Mutual Fund Expenses
Expenses for mutual funds fall into two categories – operating expenses and shareholder fees. Operating expenses, which are expressed as an annual percentage and usually range from under 1% to around 2%, represent the management and administrative costs of a mutual fund. These fees are not actually paid out of pocket, but instead are calculated into the pricing of the fund, so can have an effect on its performance. Shareholder fees, just as the name implies, are fees that a shareholder pays to purchase and/or liquidate a fund. They are typically referred to as either a front-end load, which is paid at the time of purchase or a back-end load, which one pays when the mutual fund is sold.
Classes of Mutual Funds
Factors defining mutual fund classes include how one pays fees to purchase, hold, and sell the mutual fund.
Class A Shares: Typically, have the highest upfront cost. For an equity mutual fund, this can be up to 5.75% at the time of purchase. However, Class A shares offer breakpoint pricing, so the more you purchase, the lower percentage you pay and will typically have lower 12b-1 (marketing and distribution fees) and operating expenses.
Class B Shares: Mutual Funds for which a back-end load is charged fall into this category. They can also include upfront sales charges as well. After a stated number of years, they generally convert to A shares, but in the meantime, these funds tend to be expensive to hold, as they carry high 12b-1 fees and operating expenses. They do not offer a discount or breakpoint pricing regardless of how much you invest.
Class C Shares: Do not have upfront sales charges and have a back-end load that is typically removed after a specified period of time. However, Class C shares will have operating expenses that are a bit higher than average, although less than Class B shares.
Class I Shares: Typically have no upfront sales charges and lower fees than the other shares but are only available through institutional investors making large purchases. There are ways that other investors may have access to Class I shares, such as through a retirement plan or working with an Investment Advisor that utilizes them.
Types of Mutual Funds
Actively Managed: These are mutual funds for which the manager of the fund portfolio chooses investments defined by the objective of the fund (i.e. Large Cap Value US Equity, Developed Markets International Equity, Corporate Bonds) in an attempt to outperform the index most closely representative of the assets held in the fund.
Index Funds: Instead of managing the fund with the goal of outperformance, the index fund manager purchases stocks that correspond with a particular index, such as the S&P 500 or Russell 2000. Because there is typically less portfolio turnover (buying and selling) that occurs to recreate an index, index funds will generate less in capital gains and are less expensive than their actively managed counterparts.
Balanced Funds: Are mutual funds that may hold more than one asset class (US Stocks, International Stocks, Fixed income), such as Target Date Funds and Asset Allocation Funds. The objective is to provide portfolio diversification with one investment, potentially reducing risk of exposure to holding just one asset class.
As with any type of investment, mutual funds have both benefits and disadvantages. They can offer a low cost of entry, provide portfolio diversification, offer professional investment management, as well as a variety of choices for investors. On the other hand, there is a high cost associated with some mutual funds (load and/or operating costs), it can be difficult for a fund to consistently outperform the index, and capital gains paid by some mutual funds at the end of the year (which are taxable) can mean they may be less tax efficient than other investment types.
Please contact us if you would like to have a more in-depth conversation about mutual funds that you own, are contemplating purchasing, or if you would like to more thoroughly discuss any of the topics reviewed. Next week, we will take a closer look at ETFs and highlight their features, as well as the similarities and differences with mutual funds.
Contact the Peninsula Wealth Team for a free consultation to begin building a financial and investment plan customized to your goals.