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Introduction to Mutual Funds

In this article, Professor Aaron Gilbert discusses what are mutual funds including the different types of mutual funds that exist.

What are Mutual Funds?

  • Mutual funds, also known as managed funds, are a professional managed pooled investment option.
  • Mutual funds are run by mutual fund companies, also called fund families, that typically manage different mutual funds, ranging from a few funds to families that manage tens of funds.
  • Each fund is effectively one large portfolio that is managed by professional fund managers. Their job is to buy and sell securities in line with the fund’s investment strategy. Effectively they do all the hard stuff! They select what to buy and sell and undertake the trades on your behalf. All you have to do is invest money into the fund.
  • A mutual fund is a pooled investment as the manager collects money from many investors into a single pool that they then use to invest.
  • Most managed funds have millions, if not billions in assets under management. The largest single managed fund has over 400 billion in assets under management (Vanguard 500 Index Fund Admiral).
  • The mutual fund industry worldwide manages around USD 140 trillion dollars in assets under management. There are thousands of funds and hundreds of different fund managers operating around the world.
  • The largest fund family is an organisation called Blackrock. They currently manage more than USD9 trillion dollars in assets across 120 individual mutual funds.

Types of Mutual Funds

  • Open-ended Funds. Investor can enter or exist at any time. The price is determined by value of the funds investments (Net Asset Value (NAV)).
  • Close-end Funds. Investor can only enter when fund is set up, cannot exit until maturity. The price is driven by supply and demand, and can deviate from NAV.

Types of Funds

  • Single Asset Class Funds, such as Equity Funds, Money Market Funds, Fixed Income/Debt/Bond Funds, Commodity Funds, Property Funds, and Alternative Assets
  • Multiple Asset Class Funds such as Balanced Funds
  • Hedge Funds.
  • Equity Funds. These are wide variety of funds with different focuses such as Industry or Sector Funds, Country or Region Funds.
  • Bond Funds. There are different bond funds such as Government bonds, Corporate Bonds, and Different Time Horizons

How do Mutual Fund Fees Work?

  • One issue we do need to be aware of is the cost of managed funds. There are costs associated with employing professionals to apply their skill and expertise on your behalf.
  • Fees are particularly important as they reduce the amount you have to invest, resulting in a sort of reverse compounding effect where the full cost of fund fees is greater than a simple addition of the amount paid directly.
  • There are two types of fees- Annual Operating Fees and Shareholder Fees.
  • Annual Operating fees is often referred to as an expense ratio. Covers hiring managers (management fee), sales and marketing expenses, and other costs (legal). Expressed as a percentage, generally between .1% and 1.5% and this is the percentage of your investment that they charge per year!
  • Shareholder fees are load funds charged to either buy (front load) or sell (back load) and are typically between 2% and 5% of the investment. There are account fees and transaction fees. The latter is charged if you buy or sell through a broker.

Why do fees matter?

  • Unlike performance, fees are guaranteed!
  • Fees are charged in up or down markets. If market drops, the fees will make the fall worse.
  • The impact of compound interest. Fees reduce your investment amount. It reduces the amount you earn on your money in a year, which further reduces your interest in following years.

What impacts fees?

  • The type of fund, such as International Equity and Small Cap Funds have high fees, High Yield and International Bonds have high research costs.
  • Active versus Passive Management. Let’s discuss this further next!

OVER TO YOU

  • Select a local mutual fund to invest in.
  • Using available sources such as prospectuses/product disclosure statements investigate the funds fee structure.
  • How much would you be charged if you invested $10,000 into this fund.
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