Mutual Funds - Primer
A mutual fund is a pool of investments managed for a pool of investors. That is it. Nice and simple. The devil, as they say, is in the details.
Stock Mutual Funds
The most common type of mutual fund is a stock mutual fund. A stock mutual fund is a pool of stocks that are bought, sold, and held by an entity. This entity is the company that runs the mutual fund. The investors buy shares in the pool of stocks by purchasing shares of the mutual fund. These shares represent the investor's fractional ownership of the overall pool of stocks. Stock mutual funds come in many varieties including, domestic, international, world, large-cap, mid-cap, small-cap, micro-cap, as well as sector funds and specialty funds.
Bond Mutual Funds
Bond mutual funds, like their stock fund counterparts, are also a pool of investments. In this case, the investments are bonds instead of stocks. Bond funds tend to be less volatile than stock funds, though that isn't necessarily the case depending upon the type of bonds that are invested in. Again, a management company runs the bond fund for the investors who purchase shares in the pool of bond investments.
Other Mutual Funds
There are many other types of mutual funds, but the vast majority invest in either stocks or bonds even if they are attempting to replicate the movement of other investments. For example, a large number of gold funds do not invest directly in gold, but rather in companies that are in the gold industry. Thus, and investment is not in gold itself, but rather the stocks and bonds of gold related companies.
Open Mutual Funds
Generally, when someone says "mutual fund", they mean an open mutual fund. An open mutual fund operates by issuing and redeeming shares through the issuing company only. When someone wants to invest in the fund, new shares are created and issued to the new investor. The investors shares are valued based solely on the price of the underlying investments. The value of the fund shares does not respond to any supply and demand forces because the supply is theoretically infinate, thus any demand can be absorbed without affecting the price.
Closed-End Mutual Funds
Closed-end funds, in contrast to open-end mutual funds, issue a specific number of shares at the time of their inception. These shares represent the total number of shares that will be issued. If an investor wishes to invest in a close-ended fund, then they must purchase shares from an existing investor. Thus, supply and demand exerts a pricing force on the value of the fund shares in addition to the value of the underlying investments. It is possible, and common, for a closed-end fund's share price to be higher or lower than the value of the underlying assets.
Mutual Funds and Loads (and No Loads)
Some mutual funds are sold with what is commonly called a load. The load is a sales charge by the mutual fund company. A large percentage of this charge is usually paid out to the broker/dealer that arranged the sale of the fund. A variable percentage of the amount paid to the broker/dealer is usually paid to the specific broker or advisor that initiated the sale. The load is usually pro-rated based upon the total amount invested with the fund company. Most mutual fund companies look at the total amount invested in all mutual funds at the company when calculating the charge. Mutual funds with loads are traditionally sold by professional brokers and advisors.
No load mutual funds are those that do not have a load or sales charge. These funds are traditionally sold directly to the public without the asisstance of a broker, though a broker can recommend such funds. A broker may recieve compensation in other ways if they sell a no load fund.
Mutual Fund Share Classes
Many mutual funds come in different share classes. Share classes can have many functions but typically represent different pricing structures for different investors. The most common share classes are A shares, B shares, and C shares. Other share classes are generally specialized based upon the fund company's desire to offer various pricing structures and often include shares for retirement accounts or other plans.
Traditionally, A shares are "front load" shares meaning the investor pays a sales charge up front. B shares are "back load" shares meaning the investor pays a sales charge when selling the fund (the back of the transaction.) C shares are "level load" shares meaning the investor pays a level sales charge over several years. C shares are not the same as no load mutual funds.
Mutual Fund Expense Ratios
Virtually all mutual funds come with a fee known as an expense ratio. The expense ratio is the amount charged by the mutual fund company for managing the mutual fund and covers the expenses of trading, accounting, auditing, research, and overhead. The expense ratio is usually express as a percentage such as 1.0%. In this case, the investor pays 1.0% per year for the expenses of running the mutual fund. Expense ratios are not uniform and some companies charge more or less than others. Usually the more expensive it is to run a mutual fund the higher the expense ratio within the same mutual fund company. Thus, internationl funds typically have a higher expense ratio than domestic funds.
The investor usually does not see the expense ratio on a normal statement. Instead, the expense ratio is taken out of the fund's earnings. Thus, if a mutual fund had investments which returned 10% in the market, the investor would see on his statement that his fund had returned 9%. The expense ratio is just subtracted from the return.