Mutual Funds: Different Types and How They Are Priced – Investopedia
Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.
A mutual fund is a financial vehicle that pools assets from shareholders to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.
Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market cap of the fund—derived by the aggregating performance of the underlying investments.
Most mutual funds are part of larger investment companies such as Fidelity Investments, Vanguard, T. Rowe Price, and Oppenheimer. A mutual fund has a fund manager, sometimes called its investment adviser, who is legally obligated to work in the best interest of mutual fund shareholders.
The value of the mutual fund depends on the performance of the securities in which it invests. When buying a unit or share of a mutual fund, an investor is buying the performance of its portfolio or, more precisely, a part of the portfolio’s value. Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give their holders any voting rights. A share of a mutual fund represents investments in many different stocks or other securities.
The price of a mutual fund share is referred to as the net asset value (NAV) per share, sometimes expressed as NAVPS. A fund’s NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Outstanding shares are those held by all shareholders, institutional investors, and company officers or insiders.
Mutual fund shares can typically be purchased or redeemed at the fund’s current NAV, which doesn’t fluctuate during market hours, but is settled at the end of each trading day. The price of a mutual fund is also updated when the NAVPS is settled.
The average mutual fund holds different securities, which means mutual fund shareholders gain diversification. Consider an investor who buys only Google stock and relies on the success of the company's earnings. Because all of their dollars are tied to one company, gains and losses are dependent on the company's success. However, a mutual fund may hold Google in its portfolio where the gains and losses of just one stock are offset by gains and losses of other companies within the fund.
When an investor buys Apple stock, they are buying partial ownership or a share of the company. Similarly, a mutual fund investor is buying partial ownership of the mutual fund and its assets.
Investors typically earn a return from a mutual fund in three ways, usually on a quarterly or annual basis:
When researching the returns of a mutual fund, an investor will see "total return," or the change in value, either up or down, of an investment over a specific period. This includes any interest, dividends, or capital gains the fund generated as well as the change in its market value over some time. In most cases, total returns are calculated for one, five, and 10-year periods as well as since the day the fund opened, or the inception date.
There are several types of mutual funds available for investment, though most mutual funds fall into one of four main categories which include stock funds, money market funds, bond funds, and target-date funds.
As the name implies, this fund invests principally in equity or stocks. Within this group are various subcategories. Some equity funds are named for the size of the companies they invest in: small-, mid-, or large-cap. Others are named by their investment approach: aggressive growth, income-oriented, value, and others. Equity funds are also categorized by whether they invest in domestic (U.S.) stocks or foreign equities. To understand the universe of equity funds is to use a style box, an example of which is below.
Funds can be classified based on both the size of the companies, their market caps, and the growth prospects of the invested stocks. The term value fund refers to a style of investing that looks for high-quality, low-growth companies that are out of favor with the market. These companies are characterized by low price-to-earnings (P/E) ratios, low price-to-book (P/B) ratios, and high dividend yields.
Conversely, growth funds, look to companies that have had strong growth in earnings, sales, and cash flows. These companies typically have high P/E ratios and do not pay dividends. A compromise between strict value and growth investment is a “blend,” which simply refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle.
Large-cap companies have high market capitalizations, with values over $10 billion. Market cap is derived by multiplying the share price by the number of shares outstanding. Large-cap stocks are typically blue-chip firms that are often recognizable by name. Small-cap stocks refer to those stocks with a market cap ranging from $250 million to $2 billion. These smaller companies tend to be newer, riskier investments. Mid-cap stocks fill in the gap between small- and large-cap.
A mutual fund may blend its strategy between investment style and company size. For example, a large-cap value fund would look to large-cap companies that are in strong financial shape but have recently seen their share prices fall and would be placed in the upper left quadrant of the style box (large and value). The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects: small-cap growth. Such a mutual fund would reside in the bottom right quadrant (small and growth).
A mutual fund that generates a minimum return is part of the fixed income category. A fixed-income mutual fund focuses on investments that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments. The fund portfolio generates interest income, which is passed on to the shareholders.
Sometimes referred to as bond funds, these funds are often actively managed and seek to buy relatively undervalued bonds in order to sell them at a profit. These mutual funds are likely to pay higher returns and bond funds aren’t without risk. For example, a fund specializing in high-yield junk bonds is much riskier than a fund that invests in government securities.
Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest and all bond funds are subject to interest rate risk.
Index Funds invest in stocks that correspond with a major market index such as the S&P 500 or the Dow Jones Industrial Average (DJIA). This strategy requires less research from analysts and advisors, so there are fewer expenses passed on to shareholders and these funds are often designed with cost-sensitive investors in mind.
Balanced funds invest in a hybrid of asset classes, whether stocks, bonds, money market instruments, or alternative investments. The objective of this fund, known as an asset allocation fund, is to reduce the risk of exposure across asset classes.
Some funds are defined with a specific allocation strategy that is fixed, so the investor can have a predictable exposure to various asset classes. Other funds follow a strategy for dynamic allocation percentages to meet various investor objectives. This may include responding to market conditions, business cycle changes, or the changing phases of the investor's own life.
The portfolio manager is commonly given the freedom to switch the ratio of asset classes as needed to maintain the integrity of the fund's stated strategy.
The money market consists of safe, risk-free, short-term debt instruments, mostly government Treasury bills. An investor will not earn substantial returns, but the principal is guaranteed. A typical return is a little more than the amount earned in a regular checking or savings account and a little less than the average certificate of deposit (CD).
Income funds are named for their purpose: to provide current income on a steady basis. These funds invest primarily in government and high-quality corporate debt, holding these bonds until maturity to provide interest streams. While fund holdings may appreciate, the primary objective of these funds is to provide steady cash flow to investors. As such, the audience for these funds consists of conservative investors and retirees.
An international fund, or foreign fund, invests only in assets located outside an investor’s home country. Global funds, however, can invest anywhere around the world. Their volatility often depends on the unique country’s economy and political risks. However, these funds can be part of a well-balanced portfolio by increasing diversification, since the returns in foreign countries may be uncorrelated with returns at home.
Sector funds are targeted strategy funds aimed at specific sectors of the economy, such as financial, technology, or healthcare. Sector funds can be extremely volatile since the stocks in a given sector tend to be highly correlated with each other.
Regional funds make it easier to focus on a specific geographic area of the world. This can mean focusing on a broader region or an individual country.
Socially responsible funds, or ethical funds, invest only in companies that meet the criteria of certain guidelines or beliefs. For example, some socially responsible funds do not invest in “sin” industries such as tobacco, alcoholic beverages, weapons, or nuclear power. Other funds invest primarily in green technology, such as solar and wind power or recycling.
A twist on the mutual fund is the exchange-traded fund (ETF). They are not considered mutual funds but employ strategies consistent with mutual funds. They are structured as investment trusts that are traded on stock exchanges and have the added benefits of the features of stocks.
ETFs can be bought and sold throughout the trading day. ETFs can also be sold short or purchased on margin. ETFs also typically carry lower fees than the equivalent mutual fund. Many ETFs also benefit from active options markets, where investors can hedge or leverage their positions.
ETFs also enjoy tax advantages from mutual funds. Compared to mutual funds, ETFs tend to be more cost-effective and more liquid.
A mutual fund has annual operating fees or shareholder fees. Annual fund operating fees are an annual percentage of the funds under management, usually ranging from 1–3%, known as the expense ratio. A fund’s expense ratio is the summation of the advisory or management fee and its administrative costs.
Shareholder fees are sales charges, commissions, and redemption fees, that are paid directly by investors when purchasing or selling the funds. Sales charges or commissions are known as “the load” of a mutual fund. When a mutual fund has a front-end load, fees are assessed when shares are purchased. For a back-end load, mutual fund fees are assessed when an investor sells their shares.
Sometimes, however, an investment company offers a no-load mutual fund, which doesn't carry any commission or sales charge. These funds are distributed directly by an investment company, rather than through a secondary party. Some funds also charge fees and penalties for early withdrawals or selling the holding before a specific time has elapsed.
Currently, most individual investors purchase mutual funds with A-shares through a broker. This purchase includes a front-end load of up to 5% or more, plus management fees and ongoing fees for distributions, also known as 12b-1 fees. Financial advisors selling these products may encourage clients to buy higher-load offerings to generate commissions. With front-end funds, the investor pays these expenses as they buy into the fund.
To remedy these problems and meet fiduciary-rule standards, investment companies have started designating new share classes, including “level load” C shares, which generally don’t have a front-end load but carry a 12b-1 annual distribution fee of up to 1%.
Funds that charge management and other fees when an investor sells their holdings are classified as Class B shares.
There are a variety of reasons that mutual funds have been the retail investor's vehicle of choice with an overwhelming majority of money in employer-sponsored retirement plans invested in mutual funds.
Diversification, or the mixing of investments and assets within a portfolio to reduce risk, is one of the advantages of investing in mutual funds. A diversified portfolio has securities with different capitalizations and industries and bonds with varying maturities and issuers. Buying a mutual fund can achieve diversification cheaper and faster than buying individual securities.
Trading on the major stock exchanges, mutual funds can be bought and sold with relative ease, making them highly liquid investments. Also, when it comes to certain types of assets, like foreign equities or exotic commodities, mutual funds are often the most feasible way—in fact, sometimes the only way—for individual investors to participate.
Mutual funds also provide economies of scale by forgoing numerous commission charges needed to create a diversified portfolio. Buying only one security at a time leads to large transaction fees. The smaller denominations of mutual funds allow investors to take advantage of dollar-cost averaging.
Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions. A mutual fund can invest in certain assets or take larger positions than a smaller investor could.
A professional investment manager uses careful research and skillful trading. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments. Mutual funds require much lower investment minimums so these funds provide a low-cost way for individual investors to experience and benefit from professional money management.
Investors have the freedom to research and select from managers with a variety of styles and management goals. A fund manager may focus on value investing, growth investing, developed markets, emerging markets, income, or macroeconomic investing, among many other styles. This variety allows investors to gain exposure to not only stocks and bonds but also commodities, foreign assets, and real estate through specialized mutual funds. Mutual funds provide opportunities for foreign and domestic investment that may not otherwise be directly accessible to ordinary investors.
Mutual funds are subject to industry regulation that ensures accountability and fairness to investors.
Minimal investment requirements
Variety of offerings
High fees, commissions, and other expenses
Large cash presence in portfolios
No FDIC coverage
Difficulty in comparing funds
Lack of transparency in holdings
Liquidity, diversification, and professional management all make mutual funds attractive options, however, mutual funds have drawbacks too.
Like many other investments without a guaranteed return, there is always the possibility that the value of your mutual fund will depreciate. Equity mutual funds experience price fluctuations, along with the stocks in the fund’s portfolio. The Federal Deposit Insurance Corporation (FDIC) does not guarantee mutual fund investments.
Mutual funds require a significant amount of their portfolios to be held in cash to satisfy share redemptions each day. To maintain liquidity and the capacity to accommodate withdrawals, funds typically have to keep a larger portion of their portfolio as cash than a typical investor might. Because cash earns no return, it is often referred to as a “cash drag.”
Mutual funds provide investors with professional management, but fees reduce the fund's overall payout, and they're assessed to mutual fund investors regardless of the performance of the fund. Since fees vary widely from fund to fund, failing to pay attention to the fees can have negative long-term consequences as actively managed funds incur transaction costs that accumulate over each year.
“Diworsification“—a play on words—is an investment or portfolio strategy that implies too much complexity can lead to worse results. Many mutual fund investors tend to overcomplicate matters. That is, they acquire too many funds that are highly related and, as a result, lose the benefits of diversification.
Dilution is also the result of a successful fund growing too big. When new money pours into funds that have had strong track records, the manager often has trouble finding suitable investments for all the new capital to be put to good use.
The Securities and Exchange Commission (SEC) requires that funds have at least 80% of assets in the particular type of investment implied in their names. How the remaining assets are invested is up to the fund manager. However, the different categories that qualify for the required 80% of the assets may be vague and wide-ranging. A fund can, therefore, manipulate prospective investors via its title. A fund that focuses narrowly on Congolese stocks, for example, could be sold with a far-ranging title like "International High-Tech Fund."
A mutual fund allows you to request that your shares be converted into cash at any time, however, unlike stock that trades throughout the day, many mutual fund redemptions take place only at the end of each trading day.
When a fund manager sells a security, a capital-gains tax is triggered. Taxes can be mitigated by investing in tax-sensitive funds or by holding non-tax-sensitive mutual funds in a tax-deferred account, such as a 401(k) or IRA.
Researching and comparing funds can be difficult. Unlike stocks, mutual funds do not offer investors the opportunity to juxtapose the price to earnings (P/E) ratio, sales growth, earnings per share (EPS), or other important data. A mutual fund’s net asset value can offer some basis for comparison, but given the diversity of portfolios, comparing the proverbial apples to apples can be difficult, even among funds with similar names or stated objectives. Only index funds tracking the same markets tend to be genuinely comparable.
One of the most notable mutual funds is Fidelity Investments' Magellan Fund (FMAGX). Established in 1963, the fund had an investment objective of capital appreciation via investment in common stocks. The fund's height of success was between 1977 and 1990 when Peter Lynch served as its portfolio manager. Under Lynch's tenure, Magellan's assets under management increased from $18 million to $14 billion.
Fidelity's performance continued strong, and assets under management (AUM) grew to nearly $110 billion in 2000. By 1997, the fund had become so large that Fidelity closed it to new investors and would not reopen it until 2008.
As of March 2022, Fidelity Magellan has nearly $28 billion in assets and has been managed by Sammy Simnegar since Feb. 2019. The fund's performance has tracked or slightly surpassed that of the S&P 500.
All investments involve some degree of risk when purchasing securities such as stocks, bonds, or mutual funds. Unlike deposits at FDIC-insured banks and NCUA-insured credit unions, the money invested in securities typically is not federally insured.
Mutual funds are considered liquid assets and shares can be sold at any time, however, review the fund's policies regarding exchange fees or redemption fees. There may also be tax implications for capital gains earned with a mutual fund redemption.
When investing in a 401(k) or other retirement savings account, target-date funds, or life-cycle funds, are a popular option. Choosing a fund that is dated around retirement, like FUND X 2050, the fund promises to rebalance and shift the risk profile of its investments, commonly to a more conservative approach, as the fund approaches the target date.
U.S. Securities and Exchange Commission. "Mutual Funds and ETFs," Page 4.
U.S. Securities and Exchange Commission. "Net Asset Value."
U.S. Securities and Exchange Commission. "Mutual Funds and ETFs," Page 22.
Vanguard. "What Is a Mutual Fund?"
Morningstar. "Fact Sheet: The New Morningstar Style Box™ Methodology," Page 1.
FINRA. "Market Cap, Explained."
U.S. Securities and Exchange Commission. "Mutual Funds and ETFs," Page 6.
U.S. Securities and Exchange Commission. "Mutual Funds and ETFs," Pages 33-34.
FDIC. "Insured or Not Insured?"
U.S. Securities and Exchange Commission. "Final Rule: Investment Company Names."
U.S. Securities and Exchange Commission. "Mutual Funds and ETFs," Pages 36-37.
Fidelity. "Fidelity Magellan Fund."
Fidelity. "Lessons From an Investing Legend."
Kiplinger. "Fidelity Magellan Reopens."
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FINRA. "Save the Date: Target-Date Funds Explained."
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