Mutual funds are companies that operate a portfolio containing a diverse range of securities fueled by pooled capital. They are attractive to investors due to their diversification, which translates to lower risk. Due to their fee structures, they are suited for long-term investing.
They are usually categorized based on their market capitalization rate. Market capitalization (called “market cap” for short) is calculated by multiplying the number of a company’s outstanding shares by its stock price per share. Publicly traded companies are typically grouped into three categories: small-, mid-, and large-cap. Large-cap companies are roughly considered those with market caps of 10 billion and above; mid-cap companies, those with market caps of between two and 10 billion; and small-cap companies, those with a market cap of under two billion.
In this article we’ll explore the various types of mutual funds; how they’re formed; how they’re bought, sold, and traded; pricing; transparency; the minimum required to invest; associated costs; distributions; taxes; and their performance.
How Are Mutual Funds Structured and Classified?
Mutual funds are structured as open-end funds and are classified according to whether they’re actively or passively managed and based on the types of securities their invest in.
Note that some sources also include closed-end funds and unit investment trusts as types of mutual funds, but others refer to them as distinct categories. To me, it doesn’t seem correct to refer to them as mutual funds, so I will treat them as separate.
What Is an Open-End Fund?
Investors and fund companies buy and sell open-end funds directly with each other. There is no limit to the number of shares an open-end fund can issue, and additional shares are issued to meet investor demand. Share prices are adjusted on a daily basis as required by federal regulation in a daily valuation process called “marking to market,” which bases the share price on the most current changes to the portfolio (asset) value.
In closed-end funds, on the other hand, shares are issued only once, in an “initial public offering,” after which they are listed for trading on a stock exchange. While the number of shares is therefore independent of investor demand, share prices fluctuate accordingly, driven up by increased demand. Investors cannot sell shares back to the fund, and instead have to sell shares to other investors in the market. The price they sell for can be different than the net asset value.
For good measure, the third category of investment companies are unit investment trusts (UITs). Unit investment trusts (UITs), like closed-end funds, only issue shares to the public once. They have a limited lifespan, set when they are created. As with open-ended funds, investors can sell shares back to the fund, or they can redeem them when the trust terminates.
Active vs Passive Management of Mutual Funds
Mutual funds can be either actively managed funds or passive index funds.
Passive or “index” mutual funds are a subset of mutual funds that try to mimic, rather than outperform (hence their often being referred to as passively managed), the before-fee returns of a benchmark/index such as the Standard & Poor (S&P) 500 as closely as possible, purchasing all or a representative sample of its securities. They are generally significantly less costly to operate because, unlike actively managed funds, they don’t require a team of managers and analysts to curate portfolio holdings in an attempt to produce above-market average returns.
Some sources refer to ETFs as a type of mutual fund, and the majority of ETFs are passively managed. ETFs are largely the same as a regular mutual fund, except for a key difference: they trade on an exchange like stocks.
In 2016, actively managed funds comprised about 70% of funds. However, an increasing amount of capital has been flowing into passively managed funds: In 2011, passive funds received $140 billion more than their active counterparts. In 2015, that number leaped to $576 billion.
Types of Mutual Funds
Mutual funds are further categorized by their principal investments; the main types are:
- Money market funds – These invest in short-term fixed-income securities.
- Fixed-income funds – These invest in bonds and tend to have higher yields than money market funds and lower volatility than equity funds.
- Equity funds – These invest in stocks, which are a riskier investment than fixed-income and money market funds.
- Hybrid funds – Also known as target-date funds and asset allocation funds, these invest in both bonds and stocks, or in “convertible securities,” which (as you can probably guess) can be converted to other types.
- International funds – These refer to funds that invest in companies outside of the investor’s home country. They add diversification to a U.S.- (or wherever you are located) based portfolio.
- Global funds – Not to be confused with international funds, global funds are those that invest in companies anywhere in the world, including the investor’s home country.
- Sector and specialty funds – These focus in on a specific industry, e.g., gold, real estate, energy, or health care. They hold a higher risk due to their concentrated scope.
Mutual Fund Formation
Mutual funds are formed by a fund “sponsor,” which can be a company specializing in mutual funds, a bank, or a brokerage firm. Mutual fund managers are required by the Securities and Exchange Commission (SEC) to be registered investment advisors (RIAs).
How Are Mutual Funds Bought, Sold, and Traded?
Mutual fund trading occurs between a fund and its investors. To buy shares in a mutual fund, investors put cash into the fund, and shares are later issued to the investor. Shares are always sold at their net asset value.
How Are Mutual Funds Priced?
Net asset value (NAV) is the per-share value of a mutual fund and is based on the total value of assets (including stocks, bonds, cash, and other securities) in its portfolio less any liabilities (such as the manager’s salary and operating expenses) it may have, the total of which is divided the number of shares outstanding (the total amount of shares being held by shareholders). It provides a good picture of a fund’s per-share fair market price. Mutual and funds’ NAV is updated once per day, following the closure of markets at 4:00 p.m. ET.
A downside of investing in mutual funds is that mutual fund management sometimes deviates from the fund’s stated investment objectives or targets, known as “style drift,” or take on unwanted risks. Since mutual funds are only required by the Securities and Exchange Commission (SEC) to report their portfolio at the end of each fiscal quarter, investors are not able to know whether their mutual fund is being managed as stated.
Mutual funds typically have investment minimums of at least a few thousand dollars.
For example, two of Vanguard’s four share classes are Investor Shares and Admiral Shares (the other two are ETF Shares and Institutional Shares). Their Admiral Shares have lower expense ratios (see the section below), specifically, over 52% lower than their Investor Shares.
Their Investor Shares class minimum is $3,000. For its Admiral Shares class of index mutual funds, the minimum is usually $10,000, while the minimum for admiral shares of actively managed mutual funds are usually $50,000. See their mutual fund fees page for the most current data.
What Costs Are Associated with Mutual Funds?
There are five types of costs associated with mutual funds to consider: the expense ratio, 12b-1 fees, load fees, redemption fees, and account service fees.
Expense ratio – An expense ratio is a measure of a mutual fund company’s operating costs and is calculated by dividing its operating expenses by the average value of its assets under management (AUM), calculated on a yearly basis.
12b-1 fees – 12b-1 fees, included in the fund’s expense ratio, have two components: a large chunk (up to 0.75%) to cover marketing/distribution costs, and a service fee comprising up to 0.25%. You should try to find funds without 12b-1 fees. They have come under scrutiny by the Securities and Exchange Commission for being a means for mutual funds to conceal commission-type fees (the aforementioned 0.25%). Index mutual funds typically don’t have them, since as passive funds, they rely less heavily on marketing.
Loads – Most mutual funds have broker loads and commissions. A “load” is a commission or sales fee incurred by an investor when they buy into a mutual fund (a “front-end load”), when they redeem the mutual fund shares (a “deferred” or “back-end load”), over time (“level loads”), or on a yearly basis, in the form of a 12b-1 fee. Most index funds and a minority of actively managed funds don’t have loads, which funds are known as “no-load funds.” The Financial Industry Regulatory Authority (FINRA) does not permit mutual fund loads to exceed 8.5% of the offering price, according to the SEC. If a fund charges a 12b-1 fee greater than 0.25% of its assets, it cannot be considered a no-load fund, per Kiplinger.
Redemption fees – These may apply if you don’t hold on to your shares for long enough before selling them, set by mutual fund companies in order to discourage short-term trading. Trading shares held for one year or less incurs the short-term capital gains tax rate, which is higher than long-term capital gains tax rate, for those held for more than a year.
Account service fees – These may apply when your account dips below a certain threshold. For instance, Vanguard, the largest mutual fund company by assets in 2016, charges $20 per year to those who have a balance under $10,000 (which can be easily waived) according to their webpage.
Distributions are funds’ payment of capital gains (profit from stocks) and dividends (a portion of the mutual fund company’s profits). Mutual fund companies are legally required to distribute the dividends they receive from securities at least once per year, but sometimes they reinvest them—if the latter is the case, it will be specified on the prospectus. (A prospectus is a document legally mandated by the SEC for funds to provide to prospective investors, describing their investment risks, objectives, costs, and performance.)
Mutual funds require tax payment on their distributions (capital gains and dividend income). However, the original amount used to invest (the principal) does not incur taxes, since income taxes were already paid on it when it was earned.
How are capital gains taxed? Capital gains, profit from the selling of investments, are taxed at either the short- or long-term capital gains tax rate, and are calculated by subtracting the “cost basis,” the amount an investment was purchased for, from the amount an investment was sold for. The short-term capital gains tax rate, which applies to securities held on to for one year or less, is simply the normal income tax rate. For securities held onto for 366 days or more, long-term capital gains tax rate applies and is significantly lower, particularly for those in the upper and lower tax brackets.
Knowing what kind of dividend you receive from a mutual fund has important tax implications. Ordinary dividends will be treated as dividend income on your tax return. However, dividends received from municipal obligations are not taxed at the federal level, and those received from federal obligations are free of taxation at both the federal and state levels.
Additionally, actively managed mutual funds are tax disadvantaged because when an investor wants to redeem an amount of money, the fund sells that amount worth of stocks, and the taxes on capital gains are distributed evenly among shareholders.
Similarly, managers of managed funds tend to buy and sell securities frequently in an attempt to maximize returns, but this drives up the funds’ taxable capital gains distributions, reducing their post-tax return. Because money isn’t held on to as long, it’s more likely short-term capital gains tax will be charged.
Per the S&P Indices Versus Active (SPIVA) 2016 Scorecard, 91.91% of large-cap actively managed mutual funds underperformed the S&P 500 index over a five-year period, and 84.62% over a one-year period. Mid- and small-cap actively managed mutual funds also did poorly, with 87.89% of mid-cap fund managers underperforming the S&P MidCap 400, and 88.77% of small-cap managers underperforming the S&P SmallCap 600, indices over a one-year period, also per the SPIVA. Therefore, it’s generally better to go with index mutual funds, since they’re lower in fees and actively managed funds don’t tend to do better than market indices anyway.
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