Mutual Funds play an important part in long-term investing, most notably retirement planning. It is no wonder then that in the U.S. the mutual fund industry has over $15 trillion in assets under management, accounting for half of the $30 trillion in mutual fund assets worldwide as of year-end 2013. Mutual funds can be broken down into a variety of asset classes, including domestic equity funds, world equity funds, bond funds, money market funds and hybrid funds, which have exposure across a variety of different asset classes.
A mutual fund is made up of a pool of funds collected from more than one investor for the purpose of investing in the asset classes listed above. Controlled by a money manager, the investments are selected to create capital gains and income for the investors. Before investing, an investor can always see the structure and investment objectives stated in the mutual fund prospectus to see if they match with their own investment objectives. The fee breakdown, number of assets and which assets are invested in are also stated within the prospectus.
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One of the main advantages when investing in mutual funds is that it allows individual investors access to a managed and diversified portfolio of assets within the capital markets, which would otherwise be difficult to do with a small investment. Furthermore, each investor can share in the gain and/or loss of the fund. Mutual funds have different fee structures and can be back ended or front ended and open or closed.
How and Where You Can Buy Mutual Fund Shares
Investors can buy some mutual funds by contacting the fund companies directly. Other funds are only available through brokers, insurance agents, or through an investor’s own bank. Extra fees may apply if you go through a third party – brokers will often add extra fees like sales charges and a financial planner may do the same.
Mutual funds can be held within 401(k)s and IRAs, and investors should take full advantage of the benefits from these tax-sheltered retirement accounts. In a regular brokerage account, certain mutual funds can generate substantial tax bills from capital gain distributions and/or dividends. These are typically the more active funds, namely high yield junk bonds, corporate bond funds and REIT funds, or actively managed stock funds.
There are two types of mutual fund sales commissions, called loads, paid to brokers for purchasing or selling shares in a mutual fund: front-end sales loads and back end sales loads.
Behind the Scenes of Buying a Mutual Fund
In regards to buying a mutual fund, front-end sales loads may apply; these are essentially marketing fees paid upfront at the time of the investment. For example, if an investor invests $1,000 and the mutual fund has a 5% sales load, then $50 is automatically deducted when they purchase the mutual fund to pay the broker and other distributors. The disadvantage of front-end sales loads is that the fee is taken from day one, meaning there is less money creating an investment return.
It is important to note that how mutual funds are traded depends on if it’s an open-end fund or closed-end fund. With open-end funds, they only trade at the end of the day because you trade mutual funds based on their net asset value (NAV), which is very different than stocks which can be traded anytime during market hours. The NAV is only calculated after market close. If it’s a closed-end fund it must be bought through a broker and you can watch the price change during the day.
Behind the Scenes of Selling a Mutual Fund
There can also be fees when selling a mutual fund, called back-end sales loads; again, these are essentially marketing fees paid when selling the investment using a broker. This fee structure, in comparison to the front-end load, allows for more money in the investment account meaning more compounding and more money down the line; the fee is only taken when the mutual fund is sold. However, there are some mutual funds that have no sales loads, but may charge other fees to compensate for that.
Be sure to see the Cheapest Mutual Funds for Every Investment Objective
Selling a mutual fund is much like buying a mutual fund in the sense that if it’s a closed-end fund you have to use a broker, but if it’s an open-end fund you deal directly with the fund through your trading account. Mutual fund shares in open-end funds are bought from the mutual fund and sold back to the fund.
Buying a Stock vs. Trading a Mutual Fund
Unlike a stock that has a limited number of shares on the market and can be bought and sold anytime, mutual funds are broken down into closed-end funds and open-end funds. Closed-end funds are a type of fund that has a set number of shares available to the public through an initial public offering. These shares trade on the capital markets, but because of the lack of accessibility to these funds, they often trade at a discount to their true value.
The alternative, which represents the majority of mutual funds, consists of open-ended funds. This fund does not have a set number of shares; instead, whenever an investor decides to purchase that mutual fund, the fund will issue new shares to the investor based upon the current net asset value, and redeem the shares when the investor decides to sell. Open-ended funds always reflect the net asset value of the fund because the shares are created to satisfy any demand.
Before buying any mutual fund, first assess what your main investment objective is, so that the proper asset allocation can be determined – investors will want the right mix of stocks, bonds, and cash. The proper allocation will reflect an investor’s own level of risk tolerance, which can be aggressive, moderate or conservative.
Once the risk tolerance is determined, then take a look at a mutual fund’s past five to 10 year performance, management experience, and expense ratios. Past performance is not a good indicator of future performance, but by familiarizing oneself with the investment returns, management experience, and expenses of the fund, an investor can determine for himself or herself if it is worth the risk.
Be sure to read the 7 Questions to Ask When Buying a Mutual Fund
In fact, strong performance can also be a negative indicator, because strong performance over a long period of time is rarely sustainable. Watch for mutual funds with non-abnormal returns that boast a proven track record over a long period of time with a low expense ratio. Good fund managers usually close funds to future investors as well; the more money they have to manage the harder it is to navigate the markets.
The Bottom Line
In the world of investing, mutual funds are a great way for a person to invest for the long-term. The benefits include a diversified and professionally managed portfolio that is fairly liquid and bought and sold through brokers or your own investment account. Furthermore, mutual funds can be held within registered savings accounts such as 401(k)s and IRAs.
As with any investment decision, potential investors should do the due diligence in regards to investment performance, fees, asset classes, and amount they want to dedicate to the investment. By following these guidelines, you will increase your chances of success over the long-haul.