What is a Mutual Fund?
A mutual fund is an investment vehicle used to invest in financial assets such as stocks or bonds. Unlike private funds such as hedge funds, private equity funds, or venture capital funds, mutual funds are available for anyone to buy on a stock exchange.
While closed-end mutual funds can be traded throughout the day like a stock, open-end mutual funds only price their shares at the end of the day and thus cannot be traded throughout the day.
Mutual funds typically invest with a diverse portfolio of 50 or more investments and are professionally managed by an asset management company. A mutual fund can invest in a variety of strategies ranging from a conservative bond fund to an aggressive equity growth fund.
Open-End vs. Closed-End Mutual Funds
There are two types of mutual fund structures: open-end and
Open-End Mutual Funds
Open-end mutual funds are the most common structure.
Just like exchange traded funds, open-end funds allow the manager to issue an unlimited number of shares in the fund. When an investor buys shares in an open-end mutual fund, their money goes to the fund company who uses it to buy stock on behalf of the investor in the open market. When an investor buys or sells a mutual fund they purchase or receive the net asset value ("NAV") of the fund's current assets.
To calculate the NAV, by take the total value of a mutual fund's portfolio (minus the fees and any other liabilities) and divide it by the total number of outstanding shares in the fund.
Consider the example in the graphic below.
The example above shows a sample mutual fund where the assets are comprised of only four stocks worth $13.2 billion.
The fund has $15 million in liabilities due to fee obligations and other fund expenses, and it has 300 million shares outstanding. To calculate the fund's NAV, we take the $13.2 billion in asset value, subtract the $15 million of liabilities, then divide by 300 million shares, to arrive at a NAV of ~$44 per share.
If this were an open-end mutual fund, the buyer or seller would always buy or sell at the $44 price.
Closed-End Mutual Funds
On the other hand, closed-end mutual funds have a fixed size.
When a new investor buys shares, they are buying shares from another investor, not the mutual fund manager. Closed-end mutual funds also trade on the stock market, but can trade above or below the net asset value of the fund.
There are several reasons why a closed-end mutual fund can trade at a price different from its NAV.
If a mutual fund is managed by an exceptional portfolio manager, investors may be willing to pay a premium to get access to the fund manager. Conversely, if a mutual fund has had very poor performance, investors may be willing to sell their shares out a discount just to get out in anticipation of more poor performance.
Alluding back to the earlier example where the fund had a NAV of $44 per share.
If that fund were an open-end fund, it would only trade for $44 per share and transactions would occur only at the end of the day once a definitive NAV could be calculated.
If that fund were a closed-end fund, it would trade throughout the day and could swing above or below the $44 NAV.
What to Know Before Buying a Mutual Fund
As always, investors should read a mutual fund's prospectus before investing to learn key information about the fund.
Focusing on the strategy, risks, and expenses, can save you from making an investing mistake!
Ask yourself key questions about the fund's strategy:
• What types of assets does the fund invest in? (stocks, bonds, commodities, etc.)
• Does the fund actively pick investments or does it passively follow an index?
• Does the fund invest domestically or internationally?
• Is a fund diversified in many holdings or concentrated in just a few?
Keep Investment Goals in Mind
Align yourself with the goals of the mutual fund.
If you are looking for something conservative, don't invest in an aggressive fund. Review a mutual fund's historical performance statistics to get a sense for what to expect. Pay attention to how volatile the performance is, not just the final numbers.
Mutual funds will usually provide a style box categorizing a fund. Funds focused on small companies tend to be more risky than funds focused on large blue-chip companies.
Don't Forget Fees
Finally, read the fee disclosures very carefully.
• What is the annual management fee being charged?
• Is there a load fee charged to buy or sell a mutual fund?
• Does the mutual fund charge any other fees such as marketing expenses?
Sometimes a mutual fund will sneak in fee language in the fine print—buyer beware!