The A, B, C’s of Mutual Funds

Are you curious how mutual funds work? All of your retirement savings are probably invested in them so you may want to understand their key dimensions and features. If so, this note is for you.

First, what is a mutual fund?  I’ll borrow Fidelity’s definition:

Mutual funds are investment strategies that allow you to pool your money together with other investors to purchase a collection of stocks, bonds, or other securities that might be difficult to recreate on your own… The price of the mutual fund, also known as its net asset value (NAV) is determined by the total value of the securities in the portfolio, divided by the number of the fund’s outstanding shares…

Let’s take a look at some details:

1. Investment style

Mutual funds can be invested in different asset classes.

• US and international stocks
• US and international bonds
• balanced (a mix of stock and bonds)
• money market
• commercial real estate
• target date funds (designed for retirement investing)

Mutual funds are either actively or passively managed. Passive funds simply try to match a benchmark index and do so at the lowest possible cost; they’re also known as index funds.

Actively managed funds try to outsmart the market and beat their benchmark index by using proprietary techniques to select securities that they think will outperform the overall market. Fidelity’s Magellan fund is the most well-known of these actively managed funds.

Actively managed funds incur much higher costs to do their research. Over the long run, most actively managed funds don’t outperform a well-managed index fund, net of the fees they charge.

2. Expense ratio

Mutual funds disclose the costs that investors pay to manage the fund. The key expense is the expense ratio. It’s expressed as a percentage of your assets that you pay to the management company (e.g., Fidelity or Vanguard) each year to run the fund.

Actively-managed high-cost funds may have expense ratios of greater than 1%. By comparison, low-cost index funds have fees that are 0.1% or less. This makes a big difference over time.

3. Performance

Mutual funds disclose their performance and compare it to an appropriate benchmark. Don’t pay attention to short-term performance, but 10+ year performance comparisons may be meaningful.

4. Pricing

You purchase shares in a mutual fund and their value is re-calculated at the end of each trading day. This is known as the net asset value and it is the price to either sell existing shares or buy new ones. If you transact before 4 PM ET, you receive the price as of the end of that trading day; for trades after 4 PM, you receive the net asset value as of the end of the following trading day.

5. Taxable Distributions

Mutual funds generate income several ways — dividends from stocks it owns, interest from bonds that it owns, and capital gains from selling any of its stocks or bonds and realizing a profit.

The fund is required to distribute these profits to the shareholders (i.e., you and me) at least one time per year to ensure that the shareholders pay taxes on this income. For non-retirement accounts, you’ll receive a 1099 tax form each year. For IRAs, these distributions don’t matter.

Some funds — typically money market and bonds — distribute these earnings every month; other funds — typically stocks — may only schedule these distributions once or twice a year. The frequency of the distributions does not affect the value of your holdings.

You can choose to either reinvest the distributions back into the same fund or take them in cash. If you don’t need to spend the funds, you’ll probably want to reinvest the distributions.

If you’re wondering, these distributions are unrelated to the required minimum distributions that you may be required to take from a retirement account.

6. Redemptions — i.e., getting your money back

The money you have invested in these mutual funds is yours and you can generally redeem any portion of your balance at any time. To do so, you would sell the shares at the next closing price and you can immediately send those funds to your bank account.

7. Money market funds (MMFs) — special case #1

MMFs are designed to mimic a bank account and be safe. With a MMF, the net asset value is pegged to remain at $1 per share with the interest paid out every month as a distribution.

While this fixed price of $1 per share is not guaranteed, it is unlikely to change and financial panic might ensue if the $1 share price were devalued. This is known as “breaking the buck” in the industry lingo. It happened briefly during the 2009 financial crisis after Lehman Brothers failed and the Fed stepped in to stop what could have been a run on MMFs.

Generally speaking, MMFs are safe investments but they lack an explicit FDIC guarantee. Their yield is usually similar to what you would earn from a high-yield bank savings account.

8. Real estate investment trusts (REITs) — special case #2

REITs are mutual funds that invest in commercial real estate such as office buildings, apartment buildings, shopping malls, and land. They can be a great way to get investment exposure to this asset class without having to be a landlord, paint a hallway, or understand the real estate business at all.

However, the taxation of these funds is more complex. To avoid these tax complications, I recommend that if you choose to invest in a REIT, do it inside of a retirement account (such as an IRA) where you don’t need to worry about the tax treatment.

You’re now on your way to understanding the world of mutual funds and should be able to hold your own while drinking a quarantini at your next Zoom cocktail party.