What is a Mutual Fund?
Mutual Funds are a way you can buy into a wide range of stocks, bonds, money markets, or other securities all at once. They are professionally managed, so when you invest in a mutual fund, you’re buying a piece of a larger portfolio.
Mutual Funds come in several different flavors, but the core concept is always the same. The fund is a pool of money contributed from many different investors. These funds are used to purchase a bundle of securities. All contributors to the fund are given shares in proportion to how much they contributed, and they receive returns based on the performance of the underlying securities.
Mutual funds are also sold in shares, just like stocks. However, unlike stocks, there may or may not be a limit to the number of shares outstanding at any given time (depending on the type of mutual fund), and it can be very common to own fractions of a share of a mutual fund.
Types Of Mutual Funds
Mutual Funds typically fall into one of three categories: open-ended, closed-ended, and unit investment Trusts.
Open Ended Mutual Funds
Open-ended means that there is no limit to the number of shares that can exist at any given time. However much money investors have contributed will be issued shares, and that money will be used to buy more underlying securities.
Investors can cash out any day they want, selling off their shares in the fund at the market price for that day. This means that investors cannot day trade mutual funds. Since the distribution of assets is managed by professional portfolio managers, the actual value of each share is not known until the end of the day. Investors can only buy and sell their shares from the fund managers themselves. They’re not tradable on the open market.
In practice, this means you buy open-ended mutual funds for a fixed dollar amount, rather than as a number of shares. Most likely, you’ll receive these shares at the end of the day (around 6:00PM New York Time), with a decimal value (for example, 10.1252342 shares). Conversely, when you want to sell your shares, your order will execute at 6:00PM New York Time, when the transactions for the fund settle.
Closed Ended Funds
Closed-ended means that there is a fixed number of shares, so these funds can trade on exchanges similar to ETFs. These funds are still professionally managed, but the total amount invested is determined only once, at the Initial Public Offering (IPO).
Unit Investment Trusts
These are much less common than the other types of funds, and are also closed-ended. These funds are special in that they have a limited lifespan. They are issued once, but the fund eventually expires, and all investors are paid out based on their investment, and the returns of the underlying assets.
These funds are also special in that they are not professionally managed. The holdings are determined at the IPO and are fixed while the fund is active. However, investors can redeem their shares from the fund managers at any time, or even sell shares on the open market (although this is very rare).
Advantages To Using Mutual Funds
Mutual funds can be a very easy way to diversify. Since there are many different types of mutual funds, it’s usually possible to find a selection to complement your portfolio. Mutual funds have historically been an important part of retirement planning. They don’t require as frequent attention, compared to a self-selected portfolio of stocks, because the fund manager does that for you.
Mutual funds also pass through dividends to their shareholders. This means that if a stock owned by the mutual fund pays a dividend, it is paid directly to the mutual fund shareholders.
Disadvantages To Using Mutual Funds
The biggest disadvantage is that the professional management of the fund comes at a price. There are fees charged based on the initial capital invested. This can add up quickly, especially if the fund is underperforming. A major issue with retirement accounts during a financial crash is that mutual funds still charge fees on your capital, even if the value of the fund itself was decreasing. Acting as a double-penalty.
Another major disadvantage is that you have no option to customize the holdings of a mutual fund. You’re stuck with what the fund manager chooses. Of course, you should always diversify your portfolio outside owning a single (or even multiple) mutual funds. However, you could be in a position where you’re simultaneously short and long on a stock across mutual funds you own.
Differences with ETFs
At first glance, there is very little difference between a closed-ended mutual fund and an ETF. Both trade on an exchange, and both hold a wide range of assets. However, there are some important key differences:
- ETFs are typically not managed, while mutual funds have managers who actively shift the holdings.
- Because they are not actively managed, the fees associated with ETFs are typically much lower.
- The tax structure for owning an ETF is much more similar to owning stocks than Mutual Funds.
When choosing between ETFs and mutual funds, all of these are important considerations. Because of the lower fees alone, ETFs have become increasingly popular in the last 10 years. However, the fact that mutual funds are actively managed may make them more attractive for long-term retirement planning, depending on your personal tastes.
Trading Mutual Funds
If mutual funds are enabled in your session, you’ll be able to trade them from the mutual fund trading page.
There are a few things to keep in mind when buying or selling mutual funds:
1. When you buy a mutual fund, you’re buying a dollar amount, not a number of shares!
The NAV is not known while placing your order. The market price is based on the last trading day. The quantity you enter is a dollar ($) amount. Then, when your order executes, it will buy as much of the fund as you can afford with that amount.
2. Mutual fund orders execute when the markets are closed!
If you place a mutual fund order before 4PM New York Time on a trading day, your order will execute around 6PM. If you place your order after 4PM, or on a non-trading day, your order will execute around 6PM on the next trading day. If you place your order and decide against buying that fund, you can cancel your order on the order history page.
3. You can own fractional shares of a mutual fund!
Since you’re buying a dollar amount, you’ll probably end up with fractional shares of a fund in your portfolio when your order executes. If you want to sell off your entire holdings at once, click “Liquidate Position” on the trading page.