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Strengthening Your Financial Toolbox Series: What is a Mutual Fund?


Many people are looking for ways to increase their financial literacy, but it can be overwhelming knowing where to start. In our experience, investors with some degree of familiarity with basic investment concepts have better long-term results and reduced anxiety when the markets are volatile. We like to look at significant investment categories like tools in a toolbox. You first need to understand your financial planning goals to know which tools to select for the job. In our toolbox series, we will cover several of the investment tools available and highlight what role they may play in your financial plan. As you know from DYI projects at your home, having the right tool can make the job go much smoother. The third installment of our financial toolbox series are mutual funds, so let's jump right in.


What is a Mutual Fund?

A mutual fund is an investment company that pools funds from multiple investors to collectively invest in various securities. When you purchase into a mutual fund, you now own one of its shares, meaning you have an ownership interest in a portion of the assets owned by the mutual fund. The money from your share is put together with other investors' money, and the money managers of the fund use it to invest in varieties of assets, including bonds, stocks, and real estate. The performance of a mutual fund is usually tracked as the changes in the net asset value of the fund—this is found by evaluating the performance of the underlying investment assets.


By pooling investments in a mutual fund, the shareholder gets the advantage of broad diversification that might otherwise be cost-prohibitive for a small, individual investor. The typical mutual fund can hold hundreds of securities and have modest investment minimums.


How Mutual Funds Make You Money

We briefly touched on how mutual funds make money for investors in the paragraph above. However, there is much more to this process and different ways to earn money from your mutual fund shares. Here are the three ways your investment into a mutual fund can increase in value:

1. Dividend Payments: When a mutual fund receives dividends or interest from its invested securities, it distributes a proportional amount of those dividends to its investors. Typically, when you purchase shares in a mutual fund, you can choose to receive your dividend payments directly or have them reinvested into the fund.

2. Capital Gains: If a mutual fund sells one of its securities and makes money from that sell, they earn capital gains. Most funds will take their capital gains at the end of each year and distribute them to investors.

3. Net Assets Value: The price per mutual fund share is known as its net asset value, or NAV for short. As the value of the fund increases, so does the price per share or the NAV per share, similar to how the price of stock increases. A rise in the NAV per share is excellent news for investors because the value of their investment is growing, and they will make more money when they decide to sell.


5 Types of Mutual Funds

Like the varieties of stocks and bonds, many different types of mutual funds are available to investors. Below we will discuss six of the most common types of mutual funds:

1. Equity Funds: Equity funds are the largest category of mutual funds. This type of mutual fund primarily participates in stock investments. So, you invest your money into the fund, and then the fund invests that into various equity stocks on your behalf. Equity funds can be especially beneficial for investors with long-term goals in mind.

2. Index Funds: An index fund has a portfolio of holdings that mirror the securities of a particular index, such as the S&P 500. Index funds attempt to copy the investment profiles of a significant index with hopes that the fund’s performance will match. These funds are often designed with cost-sensitive investors in mind.

3. Balanced Funds: Balanced funds invest in a mix of asset classes, including things such as stocks, bonds, and money markets. Typically stocks account for 50% to 70% of the investment blend, and other assets make up the remainder. A balanced fund provides diversification because an investor’s money isn’t tied up in a single type of investment.

4. Money Market Funds: Money market funds tend to invest in secure short-term maturity assets from governments, banks, or corporations. For example, a U.S. Treasury bill is a typical investment under money market funds. These funds can be suitable for investors looking for a safe investment option, but they typically offer low returns.

5. Income Funds: Income funds aim to provide a steady income to their investors. These funds achieve their purpose by primarily investing in government and high-quality corporate debt. Typically, income funds are attractive to conservative investors and retirees because of the steady income flow they may provide.


How Mutual Funds Trade and How They’re Priced

You may be familiar with the process in which stocks or exchange-traded funds are traded, but mutual funds work differently. Mutual funds only trade once a day, after the markets have closed, whereas stocks and ETFs can be sold throughout market hours.


After the market closes, the price of the funds is determined. This price is the net asset value, or NAV, which we previously discussed. To find the net asset value of a fund, the liabilities are subtracted from the total value, and that is then divided by the number of outstanding shares. This process is much different from calculating stocks and ETFs as those prices fluctuate during the trading day.


Fees of Mutual Funds

A mutual fund's expenses are divided into two categories: annual operating fees and shareholder fees. Annual fund operating fees are a yearly percentage of the assets under management that typically range from 1% to 3%. These annual operating fees are known as the expense ratio, and it is a sum of all yearly operating fees.


Investors pay shareholder fees directly when purchasing or selling mutual funds in the form of sales charges, commissions, and redemption fees. The "load" of a mutual fund refers to the sales charges or commissions. When a mutual fund has a front-end load, fees are assessed when shares are purchased. When a fund has a back-end load, mutual fund fees are assessed when investors sell their shares.


Classes of Mutual Fund Shares

There are many classes of mutual fund shares available to the public and institutional investors. The class of share the investor ultimately purchases will depend on various factors of the transaction. Ultimately, the goal is to achieve the lowest cost of ownership over the life of the investment. Here are some examples of mutual fund share classes:

1. A-Shares: The most prevalent share class in the mutual fund industry is Class A shares, which are primarily designed for retail investors. These funds have a front-load meaning the fee is charged upon purchase of the mutual fund.

2. I-Shares: Class I shares are institutional class shares usually reserved for large professional investors. Individual investors may have access to this share class in advisory or fee-based accounts. Generally, these shares will have lower internal fees than many share classes.

3. C-Shares: A level sales load is imposed on Class-C mutual fund shares, which is calculated as a fixed percentage charged each year. Compared to other mutual fund share classes, class C shares will often have higher ongoing expenses than front load or institutional class shares.


How to Buy Shares of a Mutual Fund

Mutual funds are a widely held investment tool that many people own in their 401k accounts. Mutual funds, unlike stocks and ETFs, are not readily traded on the market exchanges. They can sometimes be obtained straight from the financial firm that manages the fund, known as the fund sponsor. The most common way to invest in mutual funds is to go through a brokerage firm. Individuals often chose to use a broker when investing in mutual funds due to the added benefits they can offer, such as purchasing and trading experience, record keeping, professional guidance and advice, and so much more.

Schedule A Consultation with an Experienced Financial Advisor

Here at Fourth Avenue Financial, our first priority is your overall financial success. We want to help you develop, implement, and monitor a strategy that's designed to address your individual situation. If you are ready to start planning for your financial future, we are here to help. Contact us today at (304) 746 7977 to schedule a meeting with one of our experienced financial advisors or schedule online: https://calendly.com/fourthavenuefinancial/introductory-zoom.

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