What is a mutual fund and how do they work?

Investing Aug 25, 2021 / Reading Time: 6 mins
What is a mutual fund and how do they work?
By Alex Wong Reading Time: 6 mins

What is a mutual fund?

A mutual fund is a financial vehicle that lets investors pool their money together to create a portfolio of securities. This allows investors to take advantage of liquidity, diversification, and professional portfolio management at a low cost that they wouldn’t be able to do alone without millions of dollars.

Advantages of mutual funds

Liquidity: Unlike other assets, mutual funds are easy to buy and sell just like stocks which means you can always reliably exit your investment if you need to use that money elsewhere.

Diversification: Since mutual funds are managing a large pool of money, the fund’s ability to invest in hundreds of different companies with relatively smaller brokerage fees provides you with exposure to entire sectors instead of only a handful of companies. This eliminates the company-specific risk (known as unsystematic risk) which is unrelated to the market, meaning if one company in your portfolio collapses, the loss doesn’t significantly impact your investment’s returns. However, this means that if a single company the mutual fund is invested in performs extremely well, your returns will also be much smaller. For example, assuming all other factors remain constant if a company’s share price rises 50% but only makes up 2% of the mutual fund, the mutual fund’s value will only increase by 1%.

Professional portfolio management: Mutual funds have dedicated portfolio managers who rebalance the fund’s portfolio. This enables you to spend relatively less time doing maintenance research on your investments and still realise reliable returns compared to investing in a handful of companies which will require your increased involvement to generate the best returns.

What’s the difference between mutual funds and company stocks?

When an investor buys shares in a mutual fund, the shares represent part ownership in the fund’s assets and its returns. Unlike owning common shares in a company, mutual fund shares do not offer voting rights. Whilst most securities change in price throughout the day, mutual fund shares are priced at the end of each day through the fund’s net asset value which is calculated through the following formula:

NAV per share = (total value of the fund’s assets – any liabilities)/ total shares outstanding

How do you make money from mutual funds?

  1. An increase in NAV: Since mutual fund shares are priced based on NAV, if NAV increases, you can sell your shares for a profit.
  2. When the fund sells securities at an increased price, the fund either invests it into new securities or distributes the capital gain to investors.
  3. Earnings from dividends and coupon payments from stocks and bonds in the fund’s portfolio are distributed to the mutual fund’s shareholders.

Mutual fund fees

All mutual funds charged management fees which are deducted from the Mutual Fund’s Net Asset Value (NAV). A mutual fund’s fees will be charged irrespective of whether the fund makes a profit or a loss. Subject to a fund’s terms which can be found in its prospectus, these fees can be increased or decreased.

These fees are broken down into management and shareholder fees.

Management/Operating fees: charged for the fund manager’s work maintaining the mutual fund’s portfolio of assets as well as the necessary legal fees and accounting work required by the fund.

Shareholder fees: primarily comprised of the sales charges, account fees, and redemption fees paid directly by investors when purchasing or selling the funds. These charges tend to be front-loaded meaning when they are charged when you purchase the shares.

The size of a mutual fund’s fee can vary from 0.5%-2.5% per year and is automatically deducted from the fund itself. These fees vary on the type of fund being managed and can play a significant role in what funds you might want to invest in. Ultimately, fees reduce the returns of a managed fund and can even increase your losses when the fund is performing poorly. For example, if the mutual fund’s portfolio makes annual returns of 7% and it has fees totaling 0.5%, your total return would be 6.5%. Whereas if the mutual fund returned 7.5% with fees of 1.5%, your total return would be 6.0%. Therefore, investors should not only consider the gross returns of mutual funds but also their fees, as over several years these minor differences in return will be much more visible through compounding.

What is a mutual fund and how do they work?

Active vs passive mutual funds

When looking for the mutual funds you want to invest in, you should pay attention to which ones best align with your investment philosophy. Like all investors, the fund managers behind the mutual funds take two approaches – Passive Investing and Active Investing.

Passive mutual funds

Passive mutual funds focus on minimising fees and generating long-term returns by replicating an index or sector either completely or weighted based on factors such as risk and exposure. Passive mutual funds are not concerned with the short-term fluctuations in an individual investment’s price. Due to this approach, the fund managers overseeing passive mutual funds tend to be less involved with the reweighting process mostly being automated. As a result, passive mutual funds tend to have lower fees than their active counterparts.

Active mutual funds

Active mutual funds focus on constructing portfolios that will achieve higher returns than the target sector or index through numerous trades to capitalise on short-term fluctuations and company-specific trends. The fund manager is highly involved in the investment process in active mutual funds, performing research and purchasing specific stocks with conviction. As a result, active mutual funds tend to have higher brokerage expenses as well as higher management fees due to the fund manager’s increased involvement in controlling the fund’s positions.

In theory, active mutual funds should consistently beat the market and exceed the returns of passive mutual funds. However, you should be cautious of investing in active mutual funds under this rationale. The increased fees deducted from the fund will mean that the mutual fund will need to outperform a passive mutual fund by at least the difference between their fees for it to make you a superior return. Whilst some active mutual funds successfully do so, their performance varies from year to year and past results don’t guarantee their future performance.

How to choose a mutual fund?

Your investment goals and risk tolerance: How old are you? Are you a young adult just starting your career or planning to retire in the next decade and live off your current savings? These factors are likely going to play a significant role in what your investment goals and risk tolerance are like. For example, if you are planning to retire you likely want a reliable stream of income through consistent and more frequent returns from the mutual fund. On the other hand, if you are younger, you may be more open to exposing yourself to a higher level of risk with the potential of making higher returns.

Your investing time horizon: If you are planning on exiting your investment in a couple of years, active mutual funds are probably not the best strategy for you. Instead, you might consider a fund that is more reliable such as one that invests in bonds. However, if you have a long-term investment strategy exceeding a decade, you will be less impacted by market cycles and have more time to recover from losses if the mutual fund makes losses during certain periods.

Think about what benchmark you want to follow: Since mutual funds tend to use indexes and sectors as benchmarks for their investment targets, you should consider what types of benchmarks you want to track by looking at their performance and their relevant macroeconomic factors. Then, you can decide between mutual funds which use that respective index or sector as a benchmark. For example, the Aberdeen Australian Equity Fund aims to outperform the S&P/ASX 200 Accumulation Index (AXJOA) through long-term capital appreciation by investing primarily in ASX-listed equity securities.

Funds Management team: To decide between mutual funds you should check who is managing the mutual fund and see whether they have a relatively consistent performance without massive losses when the benchmark was performing well. Furthermore, check how much skin in the game they have – do they themselves also have a substantial amount of their own money invested into the fund?

In closing

Mutual funds are a great investment vehicle that provides you access to a variety of benefits. When deciding which mutual funds you want to invest in, it is imperative that you do your research and find one in which you are confident based on their target benchmark, management team, and investment strategy. Finally, remember that mutual funds are more focused on long-term growth than other forms of investing. Consequently, make sure to think carefully when deciding to sell your position in a fund and it isn’t due to a short-term fall in value since exiting mutual funds do incur redemption fees.