How do mutual funds work?
By Robin Applegarth CRPC®
This question is best answered by a visit to the store. Grab your silver purse and let’s go. We’ll pick up some smart personal finance tips for women.
Some funds are “Closed-end” and start with a packed suitcase of investments that stays packed and unchanged for the time the mutual fund is in existence.
More commonly though, mutual funds are “Open-end funds” and the holdings are bought and sold by fund managers, changing over time. We’ll look at managed, open-end funds.
Shopping at the superstore
Here’s how it works. All actively managed mutual funds have one or more managers. The fund manager is like someone who frequently visits a large superstore. He or she has a shopping cart and roams the aisles looking for bargains or desirable items to purchase. But not just any items will do. The fund has provided a shopping list that says what types of things it needs or wants.
This is where the fund’s goals and objectives come in. If this is a bond fund, the fund manager will shop only where the bonds are. This might be equivalent to the vegetable section. If this is a growth stock fund, the manager will be looking at faster growth products, like high-octane foods such as coffee and meats. A precious metals fund manager might be shopping in the equivalent of the jewelry department. If this is a balanced fund, all areas of the store are open for shopping.
Looking for bargains
The fund manager’s goal is to find items that can be resold for a higher price later. Mutual fund managers research products and services like smart consumers and may even travel around to talk to the company’s management. They collect a fee to be the “family” shopper. Mutual funds vary in size, so some managers push small maneuverable shopping carts, while others use fork-lift sized loads to spread their risks around.
Selling the surplus
Over the course of weeks, months or years, the manager may sell items previously bought, seeing the price is now higher and a profit can be realized. Perhaps those two dozen in-the-package-new organic sheets can now be sold for double the amount on Ebay.
As sales are made, it raises cash to buy new items. In the real world, the buying all happens at the same place–the stock exchanges of the world, which function as superstores of commercial enterprise.
As an investor in a mutual fund, you’re like a member of the family and share in the profits or losses of the fund holdings. Once or twice a year those profits or losses will be passed on to the family members (fund shareholders).
Filling the shopping list automatically
There are also funds with no active managers, called Index funds. These funds automatically buy stocks or bonds that match a pre-defined list, such as the S&P 500 which includes 500 stocks from Standard and Poors list.
There are Index funds for all kinds of investments, such as dividend-paying stocks, European stocks, short-term corporate bonds, etc. Since Index funds don’t have to hire an active manager or spend on research teams, their management fees are often lower. The Vanguard Company has one of the largest menus of no-load Index funds.
Daily price changes
How are mutual funds priced? The collective prices of the individual stocks, bonds or holdings inside the mutual fund will determine the daily price of the fund, also called the Net Asset Value (NAV). This is the price you pay to own one share. If a mutual fund’s NAV is $14.245 for example, you can buy 100 shares for $1,424.50. The NAV is always determined after the trading day has closed.
Reading the ingredients
You should always check out the fund’s goals and composition before you invest. Each mutual fund has a pamphlet called a “Prospectus” that tells you about its objectives, major holdings, fees, managers, historic performance, and more. It will often tell you very directly what its goals are so you can see whether it matches your own goals. This invaluable summary can be read online, or call the company for a paper copy.
Think of the Prospectus as a menu of the fund. You wouldn’t think of catering a large party feast without some shopping around, so do the same with your mutual fund. Pick ones that will feed you a balanced diet for good financial health. Happy shopping!
By Robin Applegarth CRPC®