What is a Mutual Fund?

 

A Mutual Fund is a professionally managed fund that pools money from many individual investors and invests that money into a diversified set of securities.

 

Investors buy shares of a mutual fund where each share represents a portion of the assets owned by the fund.

 

 

Mutual funds offer investors an easy way to diversify – or hold many securities, which reduces risk for an investor.

 

For decades mutual funds were the go to investment for individual investors, with tens of trillions of dollars invested into the tens of thousands of different mutual funds. Today, mutual funds are still very popular, but slowly being overtaken in popularity by ETFs.

All Information on a specific mutual fund, such as its expense ratio, holdings, past performance, etc. can be found in the fund’s prospectus or webpage.

For example, let’s take a look at the world’s most popular mutual fund; Vanguard’s Total Stock Market Index Fund (Symbol VTSMX).

 

The webpage shown below can be found on Vanguard’s website here: https://personal.vanguard.com/us/funds/snapshot?FundId=0085&FundIntExt=INT

Note that a link to the prospectus is there as well.

VTSMX_1

 

VTSMX_2

 

The lower image really shows the power of mutual funds. Notice that an investor who buys this mutual fund actually is buying 3622 different stocks! Mutual funds allow the ordinary investor to diversify their portfolios in a way that would be nearly impossible without them. Imagine taking the time (and paying the commissions!) to buy 3622 stocks.

 

But this convenience comes with a small cost, and that is the fund’s Expense Ratio.

 

Mutual Fund Fees

 

The Expense Ratio is the amount that investors pay each year to be invested in the fund. For VTSMX above, that is 0.17%. That means for every $10,000 invested in the mutual fund, an investor would pay $17. Very reasonable. But beware, some funds can charge as much as 2% or more! Brokers and fund managers such as Vanguard, Fidelity, Blackrock and State Street are known for some very cheap ETFs and Mutual Funds.

 

Some mutual funds also charge a one-time upfront fee to investors. These are known as Load Funds. The “load” is shown as a percentage, and represents the percent of your assets you will pay upon purchasing the funds. For example, a fund with a 2% “front end” load fee will cost an investor $200 per $10,000 invested at time of purchase. (Or, a “back end” load is a percentage fee an investor pays upon selling)

 

 

Mutual Funds exist for nearly any type or category of investment that you need. Bonds, Small Cap stocks, international stocks, international bonds….you name it, a mutual fund probably exists for it.

 

How do you decide on a mutual fund? We feature a variety of funds in our Fund Spotlight Series. Check it out here:

 

Buying a Mutual Fund

The process of buying and selling a mutual fund is different than buying an ETF or regular stock. When an investor submits an order for an ETF or stock, the order is executed right away. You will be able to see the shares in your brokerage account nearly instantly.

However with a mutual fund, the order is executed at the end of the day. Mutual funds cannot be bought and sold during the day like stocks and ETFs and you will not see the share price change during the day, only once at the end of the day. In fact, most mutual funds actually take an extra fee from investors who hold shares of a mutual fund less than 60 days (Check the fund’s prospectus for the specific details for that fund).

 

Advantages of Mutual Funds

Besides making it easy for investors to diversify, mutual have one other great property that benefits new investors:

The ability to easily reinvest dividends automatically and the capability to own fractional shares.

 

This lets compounding interest work even harder for your investments, because literally every dollar in your account is working for you.

Consider an example:

An investor just beginning to invest with $2,000. For simplicity, let’s say this investor has just 2 choices for their first investment; First, a $130 per share stock that pays $2.50 per year in dividends, or a $15 per share mutual fund that pays a dividend of $0.28 per share per year. (Each investment has a 1.9% dividend yield)

 

Besides the mutual fund being able to offer the investor increased diversification, the investor can also effectively invest more money, here’s how:

For the $130 per share stock, the investor can buy 15 shares. 15 shares costs the new investor $1950, so $50 is left as cash, earning nothing.

For the mutual fund, the investor can purchase 133.33 shares and put every cent of their $2000 to work.

 

So a new investor with $2000 can effectively invest an extra $50 picking a mutual fund in this scenario…big deal right? That $50 extra per year compounded at 7% for 30 years is more than $5,000!

 

But there is more.

 

When dividends roll around, the investor who bought the shares of stock will receive $37.50 per year in dividends, not even enough to buy any extra shares until 4 years of collecting dividends! That means that cash sits in your account, not to mention that you have to pay commission to your broker each time you reinvest to buy more shares.

 

But because you can own fractional shares in mutual funds, every cent of your dividend can be immediately reinvested, with no commission charge! Each dividend you receive buys more shares (even if it is just a fraction of a share), which means the next dividend you receive is larger, which means you buy more shares, which means you get a larger dividend….and now compounding interest is working for you.

 

Where to Buy Mutual Funds

 

You will be able to buy mutual funds at any broker, however there is a significant advantage to using a broker with its own mutual funds such as brokers like Vanguard, Fidelity, Charles Schwab and T. Rowe Price. Most of the time, if you have your brokerage account with a broker like those listed above, you will be able to buy that company’s mutual funds (and ETFs) without being charged a commission (you will still pay the fund’s expense ratio).
Discount brokers typically charge much more to buy and sell a mutual fund than shares of stock. Commission is usually between $10 and $20, with some being even higher. For a new investor just starting out with a few thousand dollars and looking to invest in 2 or 3 mutual funds, these fees represent a large portion of their assets.

 

More on Mutual Funds

For more information on Mutual Funds and some more detailed information on brokers and their mutual funds, check out Part 3 of our “Getting Started Series”, found here.