Mutual Funds – What You Need To Know

Mutual Funds - What You Need To Know

Mutual Funds – What You Need To Know

If you have a work place retirement account, you are likely investing in mutual funds. While other investment vehicles like exchange traded funds (ETFs) have grown in popularity, mutual funds haven’t been replaced. At least not yet. Here’s what you need to know.

What are mutual funds?

Mutual funds are companies that pool money from investors. They use the funds to invest in stocks, bonds, short term debt instruments, and real investment trusts (REITs) to name a few. The mutual fund uses professional investment managers to select investments and build a portfolio for a specific investment objective like growth, income, or a combination of both. The share value of the mutual fund is based on the underlying value of the securities within the portfolio and is referred to as Net Asset Value or NAV.

The investors of a mutual fund receive a rate of return based on appreciation or depreciation of the fund’s NAV and dividends paid by the fund if any. The share price of the fund (NAV) is calculated daily at the close of trading. That is very different than how stocks are priced continuously throughout the trading day. Mutual funds have existed since the 1930s and are a way for smaller investors to invest in diversified portfolios with small initial investments.

Active or passive:

Active or passive refers to the investment approach used within the fund. Active management utilizes managers to identify investments that are likely to perform better than others. This is based on the idea that through research and models, a good manager can identify investment opportunities that lead to above average returns. Passive investing simply tries replicate the returns of an index like the S&P 500.

Investment style or category:

When people hear the term mutual fund, the first thing that comes to mind is stocks and the stock market in general. The reality is that mutual funds can invest in a variety of different investments. There are bond mutual funds, stock mutual funds, and even funds that invest solely in real estate investment trusts (REITs).

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When you are considering making and investment into a mutual fund, you MUST know what you are investing in. There is a big difference between a short term bond fund and a high yield bond fund. Both are mutual funds that invest in bonds, but their risk and return characteristics couldn’t be more different. A large cap value stock mutual fund is very different from a small cap stock fund. Both are mutual funds that invest in stocks, but they vary significantly in terms of risk and return.

Asset allocation:

Even when you compare two mutual funds in the same category, there can be significant differences. Consider an actively managed US large cap value fund. Despite what the name suggests, it can have exposure to securities that vary significantly. Below is a table of three funds in that category that shows just how different they are despite being in the same category. All three funds are from well known mutual fund companies and each carries a four star rating out of five from Morningstar.

Mutual Funds - Asset Allocation

Mutual Funds – Asset Allocation

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There are special rules which govern how mutual fund companies are taxed. So long as mutual fund companies distribute at least 90% of their income and capital gains to shareholders, it won’t be taxed itself. That means the mutual fund company must pass through the capital gains and income to you. The result? You get to pay the tax. This isn’t really a big deal if you are investing in mutual funds through a tax deferred or tax free retirement account because you don’t have to report it on your taxes. However, if you’re investing in a non-retirement account that is subject to taxation you need to be prepared for the arrival of a 1099. This will be used to report dividends and capital gains on your taxes whether they were reinvested or not.

Mutual fund dividends and capital gains distributions:

The way mutual funds distribute dividends and capital gains to shareholders is often misunderstood by investors. Within a mutual fund, there could be hundreds of stocks or bonds that issue dividends and/or interest respectively. The mutual fund will receive those dividends from the securities they invest in. When a mutual fund declares a dividend, it is distributing a portion of the dividends and interest it has received to its shareholders.

Capital gains are distributed to mutual fund shareholders in a similar way. When the investment managers of the mutual fund sell shares of appreciated securities within the portfolio, a portion of those gains are passed on to shareholders. This is known as a capital gain distribution.

With dividend and capital gains distributions, it is important to understand how the value of the mutual fund shares are affected. If a mutual fund NAV is $30 per share and it declares a $2 per share dividend, the NAV will drop to $28. Let’s say you own one share of XYZ mutual fund and it is worth $30. If it pays a dividend of $2. You will still own one share worth $28 and have received $2 in dividends. If you reinvest the $2 dividend back into the fund, you will now have 1.0714 shares with a total value of $30.

The take away here is that there is no added benefit to buying into a mutual fund just before it is about to pay out a dividend. In fact, if a financial advisor has encouraged an investor to purchase shares of mutual fund on the basis that it is about to issue a dividend, the advisor has violated conduct rules. This prohibited practice is known as “selling dividends.”

Expense ratios:

Mutual funds are for profit businesses. How much you pay to invest in a fund is known as an “expense ratio.” This is simply the cost expressed as an annual percentage. Not all funds are created equal and some are more expensive than others. Index funds tend to have much lower expense ratios than actively managed funds. In general, the lower the expense ratio, the better. If two funds have a similar rating, investment objective, and portfolio you should consider the fund with a lower expense ratio.

Share classes:

Before you invest in a mutual fund, it is critical that you understand the cost structure of the fund. Mutual funds are offered in a variety of share classes. The share class determines how and when the investor is charged for investing in the fund. It is important to note that it is not a grading scale so A does not mean better than C. A few years back I wrote an article The ABCs of Mutual Fund Share Classes which provides more detail on this subject.


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