A mutual fund is a financial vehicle that pools the assets of its shareholders for investment in securities such as stocks, bonds, money market instruments, and other assets. A mutual fund is managed by a professional money manager who allocates the fund’s assets and seeks to generate capital gains or income for the fund’s investors. The Investment Fund’s portfolio is constructed and managed to meet the investment objectives set forth in the prospectus.
Most mutual funds are part of large investment firms such as Fidelity Investments, Vanguard, T. Rowe Price and Oppenheimer. Mutual funds have fund managers, sometimes called investment advisors, who are legally obligated to work in the best interest of the mutual fund’s shareholders.
How Are Returns Calculated for Mutual Funds?
When an investor buys Apple stock, they are buying partial ownership or a share of the company. Similarly, a mutual fund investor is buying partial ownership of the mutual fund and its assets.
Investors typically earn a return from a mutual fund in three ways, usually on a quarterly or annual basis:
- Income is earned from dividends on stocks and interest on bonds held in the fund’s portfolio and pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. Funds often give investors a choice either to receive a check for distributions or to reinvest the earnings to purchase additional shares of the mutual fund.
- If the fund sells securities that have increased in price, the fund realizes a capital gain, which most funds also pass on to investors in a distribution.
- When the fund’s shares increase in price, you can then sell your mutual fund shares for a profit in the market.3
When researching the returns of a mutual fund, an investor will see “total return,” or the change in value, either up or down, of an investment over a specific period. This includes any interest, dividends, or capital gains the fund generated as well as the change in its market value over some time. In most cases, total returns are calculated for one, five, and 10-year periods as well as since the day the fund opened, or the inception date.4
Types of Mutual Funds
There are several types of mutual funds available for investment, though most mutual funds fall into one of four main categories which include stock funds, money market funds, bond funds, and target-date funds.
Stock Funds
As the name implies, this fund invests principally in equity or stocks. Within this group are various subcategories. Some equity funds are named for the size of the companies they invest in: small-, mid-, or large-cap. Others are named by their investment approach: aggressive growth, income-oriented, value, and others. Equity funds are also categorized by whether they invest in domestic (U.S.) stocks or foreign equities. To understand the universe of equity funds is to use a style box, an example of which is below.5
Funds can be classified based on both the size of the companies, their market caps, and the growth prospects of the invested stocks. The term value fund refers to a style of investing that looks for high-quality, low-growth companies that are out of favor with the market. These companies are characterized by low price-to-earnings (P/E) ratios, low price-to-book (P/B) ratios, and high dividend yields.
Conversely, growth funds, look to companies that have had strong growth in earnings, sales, and cash flows. These companies typically have high P/E ratios and do not pay dividends. A compromise between strict value and growth investment is a “blend,” which simply refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle.
How Are Mutual Funds Priced?
The value of the mutual fund depends on the performance of the securities in which it invests. When buying a unit or share of a mutual fund, an investor is buying the performance of its portfolio or, more precisely, a part of the portfolio’s value. Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give their holders any voting rights. A share of a mutual fund represents investments in many different stocks or other securities.
The price of a mutual fund share is referred to as the net asset value (NAV) per share, sometimes expressed as NAVPS. A fund’s NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Outstanding shares are those held by all shareholders, institutional investors, and company officers or insiders.
Mutual fund shares can typically be purchased or redeemed at the fund’s current NAV, which doesn’t fluctuate during market hours, but is settled at the end of each trading day. The price of a mutual fund is also updated when the NAVPS is settled.2
The average mutual fund holds different securities, which means mutual fund shareholders gain diversification. Consider an investor who buys only Google stock and relies on the success of the company’s earnings. Because all of their dollars are tied to one company, gains and losses are dependent on the company’s success. However, a mutual fund may hold Google in its portfolio where the gains and losses of just one stock are offset by gains and losses of other companies within the fund.