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What are Mutual Funds? How do they work?If you are an investor or looking into doing some investing, chances are you have heard the term "mutual fund" thrown around. For less sophisticated investors, this can be a confusing word - what is it, what does it mean? Technically, a mutual fund is one of 3 types of investing companies legally defined by the government and the IRS. A mutual fund is an open ended company that sells shares in itself to the public, and then pool those funds and invest in a variety of investment vehicles, ranging from muni and money market funds, to bonds and stocks (there are also closed-end funds, which sell a fixed number of shares which then trade in a secondary market, and Unit Investment Trusts, where a fixed number of shares are issued (units) with a planned dissolution or ending date). When you invest in a mutual fund, you buys shares directly from the company running it, not from another individual. You can redeem or sell your shares at any time at the then current NAV (see below). Mutual funds are run by professional fund managers who make all the buying and selling decisions as to what the fund should invest in. And they get paid for this. Most mutual funds have what's called an expense ratio, meaning what portion of the funds assets go to pay for the managers' compensation and the other fund operating expenses.
So unlike a stock price that goes up or down based upon how many people are trying to buy or sell it that day, a mutual fund price, or NAV, depends upon the value of all the underlying securities, bonds, and holdings that it owns -- add all those up, divide by the number of shares outstanding, and you have the mutual fund NAV or price. That's another difference between stocks and mutual funs - stocks are priced in real time and can be traded all day, any time. Mutual funds can only be traded at the end of a trading day, after the NAV is calculated from all the other closing prices.
Mutual Fund FactsSo we've seen one way in which mutual funds are different from stocks - they are a little less liquid, with no real-time prices or trades. For most people this doesn't matter - selling or buying at the end of the day is normally just about the same as being able to trade during the day. Another thing to remember about mutual funds is that unlike a bank account, mutual funds are not guaranteed or backed by anyone. Their value can go up and down and is based solely on the value of the fund's holdings. If your aggressive fund manager decides to stock up on Enron stock and Enron goes bankrupt, you would lose all your money. One problem that comes up here is that mutual funds do not have to regularly publish what their holdings are comprised of -- so you never really know for sure where your money is being invested. In annual and semi-annual reports, you will sometimes get a listing of how much they held of various securities, but that information could be months old by the time you see it. Most mutual funds have stated investment goals and criteria, meaning an energy fund will normally allocated at least 80% of its investments to energy related businesses -- so you have a general idea where the money is going. But keep in mind that these funds try to stay invested where they are supposed to be invested, and they will not try to time the market for you and move into cash holdings when things look bad. If you look at the track records for all the technology mutual funds back in 2001 and 2002, you will see that each one stayed heavily invested in tech stocks throughout the dot-com bust, and lost 60-95% of their investors money. You bought into a technology fund, they stay invested in technology, they don't move to cash positions and wait for better prices. That is your job - if you think tech stocks are headed for trouble, YOU need to take the money out of that fund and put it into a money market account or something else - the fund manager won't do that for you. One thing a mutual fund can do for you is help you diversify. Most mutual funds invest in anywhere from several dozen to many hundreds of different companies and stocks. By buying one health-sector mutual fund, you are instantly invested in perhaps 50 leading healthcare companies, without having to discover and research each individual company or buy 50 separate stock positions - one mutual fund buy can do it all. By picking 10 different types of mutual funds, you can effectively diversify yourself into thousands of different securities and gain exposure to all facets of the foreign and domestic economies, balanced just the way you want it.Another thing you may run across is a closed fund. Some successful mutual funds that become overly popular will eventually close themselves to new investors. This means they are no longer accepting additional investments and issuing new shares. Mutual funds sometimes struggle to find adequate investments for the tens of billions on dollars of inflowing money they may receive from investors, and not wanting to park it in cash, they simply turn off the incoming flow of money by closing it down. The fund itself continues to operate, but they no longer have to worry about finding places to invest additional money. Also, remember as the fine print says, past results do not guarantee future performance. Many investors have been bamboozled into chasing after the big winners from last year, only to find the trend is reversing and they become the big loser of this year. Always make your investment decisions based around sound financial principles, like meeting your portfolio mix and diversification goals, sticking with good management teams, and investing for the long term. Mutual Funds Capital GainsA lot of investors are surprised to see their mutual fund NAV prices suddenly fall in December each year. This is because of a certain accounting rule required by the IRS. How do mutual funds handle capital gains? Just like you and me, when a mutual fund sells a position and earns a capital gain during the year, that gain has to be declared and taxed. This happens by distributing the gain to you, the mutual fund shareholder. So even though YOU didn't buy or sell any mutual fund shares this year, the fund themselves bought and sold a bunch of stocks, and you have to pay taxes THIS YEAR on those gains. So at the end of the year, the mutual fund companies calculate their gains and then distribute additional shares to you in the value of those gains. So if they recorded 20% capital gains this year, in your December mutual fund statement you would see 20% of additional shares issued to you, and the NAV of the fund would drop by about 20%. This is why some people advise not to buy into mutual funds at the end of the year - you buy them, they don't go up at all, yet you are hit with a tax distribution and tax bill. Of course you are being issued these additional new shares as your proceeds from the capital gains so you come out break-even at worst from that standpoint, but the tax bill can instantly turn your investment into a temporary loser. This is one way to make money from investing in mutual funds - the annual payouts of dividends and gains. The other way is when the underlying assets appreciate and the NAV goes up, allowing you to sell at a higher price than you bought.
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