What are mutual funds

So what are mutual funds? 

Mutual funds are investment vehicles that pool money collected from multiple investors to invest in diverse securities, like stocks, bonds, and other instruments.  A mutual fund is usually actively managed by professional portfolio managers. mutual funds were created to actually try to beat the market. They are managed by experienced portfolio managers who choose instruments that they feel will outperform benchmarks. Though most mutual funds are actively managed, a type of mutual fund known as index mutual funds were created to track- as opposed to ‘beat’- a specific index, like the S&P 500. Index mutual funds typically charge lower fees than actively managed mutual funds and may also be considered a low-risk way to invest.

A typical mutual fund holds dozens, or even hundreds, of instruments as this structure allows investors to spread their risk in a consistent and managed way. A mutual fund roughly works like an investment company, in which individual investors hold shares. The mutual fund is governed by a set of rules- called an investment mandate- that dictates which investments the fund manager can make. This mandate can be based on geography, asset classes or instruments, sectors, currencies, or any combination of strategies. Once defined, the mutual fund manager invests the fund's money in assets that adhere to the guidelines of the mandate. 

The different types of mutual funds

There are several types of mutual funds, including: 

• Money market mutual funds: These mutual funds invest in short-term, low-risk, high-quality bonds
• Bond mutual funds: These have a higher risk than money market mutual funds and invest in  bonds specified in the mutual fund investment objective.
• Stock mutual funds: These mutual funds invest in equity securities or stocks.
• Balanced mutual funds: These mutual funds invest in a combination of assets – stocks, bonds and other mutual funds.
• Complex mutual funds: These mutual funds invest in non-traditional assets like direct-infrastructure, derivatives, private equity, non-listed products, etc. Complex funds can be leveraged.

Mutual funds can be either distributing or accumulating funds. A distributing fund will distribute dividends received from the investee companies back to the fund’ shareholders usually on a quarterly basis. While accumulating funds will reinvest the dividends back into the fund, leading to a higher value per share versus a comparable distributing fund. The tax treatment of these funds may differ so it is important to understand the tax system of your country of residence.

A helpful way to determine what kind of mutual fund you want to choose is by looking at a mutual fund’s KID (Key Information Document). The KID holds basic information about the instrument, such as its investment objective, fund, cost and charges, historical performances, whether it is accumulating or distributing and other key characteristics. 

How are mutual funds priced and traded? 

A mutual fund holds several assets, which can be individual stocks, bonds, cash positions, and other investments. At a set time each day, the value of all individual holdings in the mutual fund minus the fund’s liabilities is calculated. This value is known as the fund’s net asset value. The price of a share of a mutual fund is the fund’s net asset value divided by the number of shares outstanding. This price or net asset value per share is typically calculated once day after closing but certain instruments may be calculated less frequently, for example on a weekly or monthly basis.  
When an order to purchase shares of a mutual fund is placed, the price per share is unknown until after the closing when the mutual fund net asset value is calculated and the net asset value per share is known.

Let’s say the net asset value of the entire investment in a mutual fund is EUR 10,000,000. The investor wants to invest EUR 5,000. The EUR 5,000 goes to the mutual fund the retail investor then holds 0.5% of the fund, mutual fund at EUR 10,005,000, including the new investment.

In some cases, the new investor simply takes over the shares from another investor, who is about to exit the mutual fund.
Either way, this means that you own a fraction of the entire portfolio.

If you want to sell your shares of the mutual fund, you simply put in a “sell” order and your share in the mutual fund is liquidated by the end of the day. The money is then wired back into your account.

The cost of investing in mutual funds

Investing in mutual funds involves various fees and charges. Fees matter because they eat away at a fund’s performance and the higher the fees, the greater the impact on the fund’s performance over time. Therefore, it is important to review and understand a fund’s fee structure before making an investment.

1. Sales commissions: Sales commissions are one-off charges levied at the time of purchase and sale of shares of a mutual fund. Some brokers charge it, others don't so it's important to review the trade ticket before finalizing the purchase or sale of mutual fund shares.
   
   
2. Ongoing costs: This cost represents the annual fee for managing the mutual fund. This covers operational costs, administrative expenses, and management fees. The ongoing cost is expressed as a percentage of the fund’s net asset value and is deducted from the mutual fund’s assets and is reflected in its net asset value. The fee that an investor pays is a percentage of his/her investment in the fund.

To learn more about mutual funds, please refer to our 2nd chapter which provides a comprehensive overview of the advantages and disadvantages of investing in mutual funds.