What are Mutual Funds In Stock Market?

A mutual fund is an open-end investment fund that has the responsibility of pooling money together from many investors to purchase a security or securities. It can also be said to be a collection of securities such as stocks and bonds, in which investors can own shares of a mutual fund by buying a mutual fund. These investors are institutional or retail investors. Nevertheless, small or individual investors can still access professionally managed investment portfolios through mutual funds.

It is important to know that not all investment funds are mutual as there are exchange-traded funds (ETFs), unit investment trusts, and closed-end funds. Each of these investment funds is characterized by their individual preferences. However, they share certain similarities with mutual funds such as liquidity and diversification.

Mutual funds offer its investors a lot of benefits; such as diversification, liquidity, economies of scale, and professional management. On the flip side, these benefits come at a cost—mutual fund fees and expenses. Mutual funds can also be classified by their principal investments as are equity funds, fixed-income funds, hybrid funds, and money market funds.

Mutual Funds Explained

A mutual fund functions both as an actual company and an investment fund. When an investor buys into a mutual fund he/she is not only buying shares of the mutual fund but also partially buying into the mutual fund company. Just like how investors buy into public-listed companies by buying their stock, thereby, gaining partial ownership of a company and its assets. However, unlike investing in stocks, mutual fund shares do not give investors or holders voting rights.

A typical mutual fund is in the business of pooling money from investors to purchase securities and make investments. In turn, the holders of the mutual fund earn returns at the end of the investment. These returns can be earned through dividend distributions, capital gains, and selling shares of the mutual fund. The price of a mutual fund share is referred to as the net asset value (NAV).

The NAV is calculated by dividing the total value of all the securities in a single portfolio by the total amount of share outstanding. These outstanding shares are shares that are held by all company officers, shareholders, and institutional investors. In mutual funds, shares can be purchased or redeemed at the fund’s current NAV. The NAV does not fluctuate during market hours compared to stock prices but it is adjusted at the end of every business day.

In the US, mutual funds NAV can be redeemed within seven days. The transactions are done after the market closes. The mutual fund uses a net asset value that has been calculated with the closing prices of that particular day. Most times, due to variations in time zones (foreign stocks) and delay in trade clearing, the actual value may not be reflected by the calculated net asset value immediately. This results in late trading since the variations in mutual funds don’t encourage active trading.

Some investors prefer mutual funds over stocks for the reason that mutual funds provide investors with immediate diversification. As a result of that, mutual funds are less risky compared to stocks. In a situation where one company experiences a financial decline or bankruptcy, the investor wouldn’t lose all his/her investments. It also saves investors the stress of researching companies’ financial statements. In a nutshell, we can say that mutual funds provide investors with some of the benefits of stock investing without bearing the risks.

Mutual Fund as an Open-end Investment Fund

Like all other open-end funds, mutual funds must be able to buy back or redeem its shares from its investors at the net asset value (NAV) calculated at the end of a business day. In the US generally, open-end funds must be willing to buy back or redeem shares at the end of every business day. While in some other places, open-end funds are allowed to buy back shares at long intervals either weekly or bi-monthly. Open-end funds also have the liberty to sell shares that are priced at NAV to the public every business day.

Types of Mutual Funds

• Stock or Equity Funds

These type of funds deals with public listed corporations that trade on any of the stock market exchanges. There are different factors that determine mutual fund investments such as company growth, company size, and company type. Each fund places its focus on strategic characteristics of the object of investment. For example, value funds are more concerned with companies that have been undermined by other investors—companies that have great potentials of increasing in value over time. Growth funds are more involved with innovative firms that have more potentials to expand at a fast rate. It is almost common to find blue-chip funds investing more in value companies while high-tech funds focus more on growth companies. There are also domestic funds that focus on investing in companies within the region the funds are based. While international funds selectively invest in performing countries around the world.

• Bond or Fixed-Income Funds

Bond funds or fixed-income funds focus on securities that return a fixed income. Funds in this category focus on investments that pay a fixed rate of returns such as corporate bonds and government bonds. It is expected that the fund portfolio generates income interest and distributes it to the shareholders. They have more tendencies of paying shareholders higher returns compared to money market and certificates of deposit investments. These funds target relatively undervalued bonds, buy and sell them to make a profit. Bond funds may offer a lot of benefits to its investors but it comes at a risk. Almost all bond funds are faced with interest rate risks, meaning that if rates increase the value of the fund decreases.

Other types of mutual funds include:

• Index Funds: Here, the index fund manager buys stocks that correspond with any of the major market indexes like the Dow Jones Industrial Average or the S&P 500. The funds use this as an investment strategy to beat the market.

• Balanced Funds: These funds focus on investing in asset classes of either stock, bonds, or other money market instruments. They are also known as asset allocation funds.

• Money Market Funds: The funds in this category focus on investing in super-safe assets. They also focus on money market instruments which offer safe short-term debt instruments like Treasury bills. Investors sometimes use money market funds as a substitute for bank savings accounts.

• Income Funds: These funds focus their investment majorly on government and standard corporate debt. The income interest is generated on the investments by holding the bonds until they appreciate in value.

Mutual Fund Returns

As earlier stated, mutual fund investors can earn returns in three different ways:

• Dividends: investors receive distributions from income generated from dividends. Most funds pay a large percentage of the income they earn to their investors.

• Capital gain: investors receive distributions of capital gains if the fund sells securities that have increased in price

• Sell shares: Investors can decide to sell their mutual fund shares at a profit when the fund’s shares increase in price.

Mutual Fund Fees

Mutual fund fees can be categorized into two parts, namely;

• Annual operating fees: these are the annual percentage of the funds under management. They range from 1-3% and are collectively known as expense ratio. The expense ratio is a summary of the management fee and administrative costs.

Management fees are paid by the fund to the management company or sponsor responsible for organizing the fund and provides the portfolio management or investment advisory services. The management fees may differ by funds. For example, index funds usually charge a lower management fee compared to actively-managed funds.

• Shareholder fees: these are the fees expected of the shareholder to pay. They consist of commissions, sales charges, and redemption fees. Investors pay these fees when they are buying or selling funds. Some funds may charge investor redemption fees when they sell fund shares shortly after buying them, usually within 30-90 days of purchase. The redemption fees are then calculated as a percentage of the sale amount. Some funds go to the extent of charging investors penalty fees for early withdrawals or selling a holding prior to the time it ought to elapse. Also, a fund may decide to charge an investor a fee for maintaining the investor’s individual retirement account.

A mutual fund is also likely to pay for other services such as;

• Custody fee: a fee paid to a custodian bank that holds the fund’s portfolio and collects income owed on the securities.

• Fund administration fee: involves all administrative affairs such as SEC filings, preparing financial statements and shareholder reports, calculating total returns, filing tax returns, and monitoring compliance.

• Fund accounting fee: for carrying out investment accounting services and calculating the net asset value

• Board of directors fees and expenses

• Shareholder communication expenses

• Professional services fees: for handling all legal and auditing fees

Advantages of Mutual Funds

• Diversification: This is one of the top benefits of mutual funds. Many securities are held together in a fund and the chances of risks are decreased.

• Professional investment management: when it comes to investment management, funds always stick to professionals who would function as portfolio managers in supervising the fund’s investments.

• Lower Cost: It is relatively less expensive for an individual investor to invest in different securities through a mutual fund rather than purchase different securities to include in their portfolio

• Individual investors have an opportunity to participate in investments that are often only available to large investors. Especially individual investors who have difficulty investing directly in the foreign market.

• Mutual funds are able to move with the tide of the market. They are able to change their portfolio when market conditions change

Disadvantages of Mutual Funds

• Delayed trading due to certain variations

• Fees and commissions

• Unpredictable income

• Lack of transparency in holdings

• No room for customizing investments

Mutual Funds Key Terms

Average annual total return: An annual report required of US mutual funds which shows the average annual compounded rates of one-year, five-year, and ten-year periods. The formula is:

P(1 + T)n = ERV

Where:

P= a hypothetical initial payment pf $1,000

T= average annual total return

n= number of years

ERV= ending redeemable value of a hypothetical $1,000 payment made at the beginning of the one-year, five-year or ten-year periods at the end of the one-year, five-year, or ten-year periods.

Market capitalization: it indicates the size of a company. Market capitalization equals the number of shares outstanding in a company multiplied by the market price of the stock. Market capitalization can be classified into;

• Nano cap – companies worth less than $50 million

• Micro cap – companies worth between $50 million and $300 million

• Small cap – companies worth between $300 million and $2 billion

• Mid-cap – companies worth between $2 billion and $10 billion

• Big cap – companies worth between 10 billion and $200 billion

• Mega cap – companies worth $200 billion or more

Net Asset Value (NAV): It is the price of a mutual fund share. The NAV is calculated by dividing the total value of all the securities in a single portfolio by the total amount of share outstanding.

Share classes: the various types of shares offered to investors based on different combinations of front-end loads, back-end loads and distributions, and service fees. Though all mutual fund investors may invest in the same portfolio, each investor would have different expenses, different performance results, and different net asset value. These share classes include:

• Class A shares: consists of a front-end sales load alongside a small distribution and services fee.

• Class B shares: high contingent deferred sales charge (CDSC) that declines over a couple of years combined with a 12b-1 fee. After they have been held for a long period of time, class B shares automatically become class A shares.

• Class C shares: modest contingent deferred sales charge that declines after one or two years combined with a high distribution and service fee. They are also called “level load” shares.

• Class I: also known as institutional shares, they are subject to very high minimum investment requirements.

• Class R: they are reserved for retirement plans such as 401(k) and IRA. They charge a small distribution and services fee.

Portfolio Turnover: this is a measure of the volume of a fund’s securities trading; expressed as a percentage of average market value of the portfolio’s long-term securities.