Mutual Funds: What Are They and How Do They Work

A mutual fund is a type of investment that pools together money from many different investors to invest in securities such as stocks, bonds, money market instruments, and other assets to earn a return for investors.

The purpose of a mutual fund is to create a diversified portfolio that is more advantageous than what the average investor could do themselves.

Investing in a mutual fund can provide stability and financial security due to the low risk that comes with it.

In addition to this, mutual funds are managed by professional money managers who are assigned to closely supervise and monitor the fund’s investment portfolio.

Mutual funds can be a great investment vehicle, but there are also some downsides to mutual funds that you should be aware of before you decide to invest.

Below is a summary of the different types of mutual funds and what to consider when deciding if they are the right investment for you.

Earning from a Mutual Fund

There are multiple ways that you can get a return on your investment with mutual funds.

Usually, the fund will give you the choice of how your earnings are handled.

The fund can pay you in the form of distributions or you can choose to have the money reinvested in the mutual fund to purchase more shares.

Dividends

Dividends are a distribution of profits that the fund gives out to its investors.

Mutual funds will typically pay out nearly all of the net income that they have received over the calendar year.

Not all mutual funds are created equal and not all of them will have a high dividend yield.

Instead of the objective of obtaining a high dividend yield, some funds aim to avoid dividend-generating assets and interest-paying bonds to lower the tax liability of their shareholders.

Depending on the investor and the objectives of the mutual fund, many will prefer to have their dividends reinvested in the fund rather than receiving a payout by establishing a dividend reinvestment plan, or DRIP.

Dividends can also be used to purchase shares of other mutual funds.

Capital Gains

Capital gains refer to the increase in the price of the security over time.

You will generally receive a capital gains distribution when the fund sells a security that has increased in value since it was purchased.

This increase is the capital gain, and there are many tax implications that come along with it.

Capital gains distributions are given out at the end of the year.

The fund will distribute all capital gains minus any losses to its investors who can then either take the distribution or reinvest it into the fund.

Increased NAV

The net asset value (NAV) is the representation of a fund’s per-share market value which tells investors how much a single share of the fund is worth today.

The net asset value impacts the return of your portfolio in the long run and is a key indicator that is usually next to mutual funds when you go to buy or sell shares.

Since a mutual fund is a pooled investment vehicle, the NAV measures the total value of all the investments in the mutual fund and is recalculated daily.

Any trade orders will always be executed at the price that is determined by the new NAV.

When the NAV increases, the value of the fund and its shares will increase as well, which you can then take out of the fund or use to reinvest back into the mutual fund.

Did You Know?

Distributions are different than dividends. Not all dividend-paying investments pay dividends but pay cash distributions instead, which can affect your tax liability.

Costs Associated with Mutual Funds

As with any managed investment vehicle, there are going to be fees associated with the investment. Mutual funds have two broad types of fees.

Annual Fund Operating Expenses

Annual fund operating expenses are ongoing fees that go toward paying the people that are involved with running the mutual fund.

This will typically include the managers, accountants, analysts, legal team, and marketing resources.

These fees are unavoidable and usually range from between 0.25% and 1.5% of your investment in the fund per year.

Shareholder Fees

Shareholder fees include management expense ratios (MERs) which measure how much of a fund’s assets are used for administrative purposes as well as other expenses.

The MER can be determined by dividing the operating expenses by the average dollar value of its assets under management.

In addition to MERs, shareholder fees can include sales loads, redemption fees, exchange fees, and account fees.

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Advantages of Mutual Funds

There’s a reason that mutual funds are one of the most popular and safest investment vehicles available to both beginners and sophisticated investors.

Risk Reduction

Risk reduction is the main selling point for mutual funds.

By diversifying your portfolio and investing in many different companies instead of just a few, you mitigate your risk.

If one of the companies falls in value, this will not affect your portfolio as much as it would if you depended on only a few stocks.

Convenience

Convenience and accessibility in mutual funds are something that makes beginner investors gravitate to this investment vehicle.

Mutual funds are easy to buy and easy to understand, allowing beginner investors to implement a “buy-and-hold” strategy where there is minimal involvement and managing for the investor.

Advanced Portfolio Management

Mutual funds are managed by professional portfolio managers who buy and sell assets with the goal of earning investors a return on the capital they invested.

Disadvantages of Mutual Funds

While the benefits of mutual funds will clearly outweigh the downsides, it is important to understand the disadvantages that come with investing in mutual funds.

High Fees

One of the potential downsides to mutual funds are the high fees charged.

Some expense ratios can be 1% or more, so it’s important to understand all the fees that are associated with the mutual fund that you plan to invest in.

No Intraday Trading

Lack of intraday trading is another disadvantage for some investors because mutual funds are only traded once per day.

This typically isn’t an issue for many passive investors, but active investors may want to take advantage of the opportunity for intraday trading which mutual funds do not allow for.

Management Issues

There can sometimes be cases where management issues plague new investors and their portfolios.

Churning and employee turnover can happen within the fund management company, resulting in changes in strategy for specific funds.

In addition, fund managers can be prone to human error if they try to time the market or by having short investment horizons.

Frequently Asked Questions

  • Can you lose money in mutual funds?
  • Can you hold mutual funds in your TFSA?
  • Can you hold mutual funds in your RRSP?

I have been investing for half a decade, using the perspectives gained from my work experience in the private, public, and non-profit sectors to shape my investment outlook. I have a specific interest in the potential of emerging disruptive technologies and their impact on the future.