What Are Mutual Funds? Key Facts To Know

Understanding mutual funds

When considering mutual fund investments, investors can choose between two primary types: actively managed funds and passively managed funds.

Actively managed funds aim to surpass the benchmark indices, leading to potentially higher returns for investors. However, this pursuit of increased returns comes with additional costs for research and maintaining an active fund management team to ensure investor satisfaction and alignment with the fund's goals.

On the other hand, passively managed funds solely aim to replicate the returns of the index benchmark without attempting to establish new benchmark records. It's important to note that all index funds fall under the category of passively managed funds. The value of a mutual fund is determined by its Net Asset Value (NAV), calculated for each unit. The total NAV of the fund considers the value of all investments made by the fund, minus the expenses incurred.

The classification of mutual funds into equity or debt is crucial due to the tax implications on returns. An equity mutual fund is characterized by a portfolio investment of more than 65% in equity and equity-related assets. In contrast, a debt mutual fund has less than 65% invested in such assets. Tax laws are applied based on this broad classification of funds, influencing the taxation of returns.

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Mutual fund fee structure

Annual fund operating expenses

Management fees
Management fees represent payments made from the fund's assets to the fund's investment adviser for overseeing the fund's investment portfolio and handling administrative costs not covered by the "Other Expenses" category.

Distribution [and/or Service] (12b-1) fees
This category outlines "12b-1 fees," funds' expenses paid from their assets to address distribution and sometimes shareholder service costs. The term "12b-1 fees" derives from the SEC rule permitting funds to pay these fees, requiring the adoption of a plan (12b-1 plan) for their authorization.

"Distribution fees" cover expenses related to marketing, selling fund shares, compensating brokers, advertising, and the printing and mailing of prospectuses and sales literature. Some 12b-1 plans also include "shareholder service fees" for responding to investor inquiries and providing investment information. A fund may pay these fees even without a 12b-1 plan. If included in the plan, shareholder service fees are part of this fee category; otherwise, they fall under "Other Expenses."

Other expenses
This category includes costs not classified under "Management fees" or "Distribution [and/or Service] (12b-1) fees." Examples include shareholder service expenses not covered by the 12b-1 fees, custodial expenses, legal fees, accounting expenses, transfer agent expenses, and various administrative costs.

Shareholder fees

Redemption fee
A redemption fee is an additional charge that some funds may apply when you sell your shares. Typically expressed as a percentage of the redemption price, it serves to cover the fund's costs related to a shareholder's sale. Unlike a sales load, which compensates brokers, a redemption fee is directed towards offsetting the fund's expenses linked to the shareholder's redemption, with the fee paid directly to the fund and not a broker. The SEC places a cap on redemption fees, limiting them to 2.00%.

Exchange fee
An exchange fee is a charge that certain funds may impose if you transfer your shares from one fund to another within the same fund group. This fee is incurred when you decide to switch your investments between different funds within a specific fund family.

Account fee
Some funds may institute an account fee, a separate charge associated with maintaining your accounts. For instance, an account maintenance fee may be applied to accounts valued below a certain dollar amount, such as those valued at less than $10,000.

Purchase fee
A purchase fee is a type of charge that some funds may levy when you buy their shares. Distinct from a front-end sales load, a purchase fee is paid directly to the fund and aims to cover specific costs associated with the purchase process.

Sales loads
Funds employing brokers to sell their shares compensate these brokers through a fee commonly known as a "sales load" or "sales charge (load)." This fee is akin to a commission paid when purchasing any security through a broker. While the SEC doesn't impose a strict limit on sales load percentages, FINRA restricts mutual fund sales loads to a maximum of 8.5%. This percentage may be lower if the fund imposes other charges.

There are two main types of sales loads: front-end sales loads, paid when purchasing fund shares, and back-end or deferred sales loads, incurred when redeeming shares. The decision of whether to pay a front-end or deferred sales load depends on the fund's structure.

How are returns calculated for mutual funds?

There are various return metrics used for mutual funds:

Absolute returns
Absolute returns measure the overall percentage change in a mutual fund's value over a specified period, excluding the influence of time and compounding effects. The calculation involves comparing the initial Net Asset Value (NAV) with the current NAV:

Absolute Return = (Present NAV – Initial NAV) / Initial NAV × 100

For instance, if the initial NAV was 30 and the present NAV is 40 over a one-year period, the absolute returns would be 33.33%.

Annualised return
To assess annual returns as if the investment remained for a full year, the Simple Annualized Return (SAR) is used. Derived from the absolute return, the formula is:

SAR = [(1 + Absolute Rate of Return) ^ (365/number of days)] – 1

Considering a 20% absolute return over 270 days, the simple annualized return would be approximately 29.63%.

Compounded Annual Growth Rate (CAGR)
CAGR offers a standardized measure to evaluate the average annual growth rate of your investment over multiple years:

CAGR = {[(Present NAV / Initial NAV) ^ (1 / Number of years)] - 1} × 100

For a lump-sum investment increasing from $20 to $70 over five years, the CAGR would be approximately 14.87%.

Extended Internal Rate of Return (XIRR)
XIRR, a more advanced method, considers the timing and amount of cash flows into and out of the mutual fund. It provides a more accurate picture, especially for investments involving systematic investment plans (SIPs). Calculating XIRR involves using the XIRR function in Excel and factoring in multiple cash flows.

Things to consider about mutual funds returns
When assessing mutual fund returns, consider crucial factors:

Timeframe
Evaluate returns over an appropriate timeframe to gain insights into the fund's performance.

Benchmark comparison
Compare returns to an appropriate benchmark index to determine relative performance.

Risk-adjusted returns
Assess the risk associated with returns to align with your investment goals and risk tolerance.

Expense ratio
Consider the expense ratio, which represents annual fees and expenses, as higher ratios can impact overall returns.

Mutual Funds vs ETFs

Consider an ETF, if:

• You prefer intraday trading and desire real-time pricing, ETFs offer flexibility unavailable in mutual funds.

• You want to incur lower management expenses (expense ratio).

• You are tax conscious.

Consider a mutual fund, if:

• You prefer a professional fund manager to make investment decisions and adjusting the portfolio actively.

• You prefer regular and automated investing through systematic investment plans (SIPs).

• You do not seek highly liquid investments.

Stock funds
Stock funds, also known as equity funds, specialize in investing in stocks or equities. These funds target various types of stocks, such as those from established companies or the technology sector, exposing investors to different risk levels due to the inherent volatility of stock prices.

Bond funds
Debt funds, commonly known as bond funds, focus on investing in bonds and other debt instruments to generate a steady monthly income. These funds can include a variety of bonds, including government, corporate, municipal, or convertible bonds. Classifications based on time to maturity, such as short-term, intermediate-term, and long-term, offer investors choices aligned with their income and risk preferences.

Index funds
Index funds adhere to the performance of specific market benchmarks, like the S&P 500, employing a passive investment strategy. This approach offers lower risk through extensive diversification, as the fund mirrors the composition of the chosen index. The simplicity and cost-effectiveness of index funds make them attractive to investors aiming for broad market exposure without the need for active management.

Balanced funds
Balanced funds, also referred to as hybrid funds, allocate investments across asset classes, providing a mix of low- to medium-risk stocks, bonds, and other securities. These funds aim to create a balanced portfolio that offers both income and capital appreciation. Investors in balanced funds benefit from the diversification of their holdings, as different asset classes respond differently to market conditions.

Money market funds
Money market funds are low-risk, low-return investments that focus on high-quality, short-term debt instruments. These funds are often used as a cash alternative, offering stability and liquidity for investors prioritizing the preservation of capital and easy access to their funds. Money market funds typically invest in instruments like Treasury bills, certificates of deposit, and commercial paper.

Income funds
Income funds aim to deliver a consistent income stream by investing in securities that pay interest or dividends. These may include bonds, dividend-paying stocks, and other income-generating assets. The choice of income-generating assets within the fund's portfolio influences the level of income generated. These funds offer an alternative for investors looking beyond traditional savings accounts or fixed-income securities for income generation.

International/Global funds
International or global funds provide investors with exposure to securities from companies located worldwide. These funds offer an opportunity to diversify an investment portfolio by venturing beyond domestic markets. Investing globally allows investors to access different economies, industries, and currencies, potentially reducing risk through broader diversification. However, such funds come with their own set of challenges, such as currency fluctuations and geopolitical risks.

Specialty funds
Specialty funds focus on specific sectors, industries, or investment strategies, catering to the unique preferences or interests of investors. Examples include technology, healthcare, real estate, and socially responsible investing. These funds are designed to meet the specialized investment objectives of those with specific preferences or ethical considerations.

How to invest in mutual funds?

Understanding Fees
Mutual fund investors need a clear understanding of various fees associated with their investments:

• Expense ratios – Typically ranging from 0.25% to 1% per year, expense ratios represent the annual cost of managing the fund. Actively managed funds tend to incur higher expenses.

• Management fees – Paid from fund assets to the investment adviser, management fees compensate for overseeing the fund's investment portfolio.

• Transaction costs – Brokers may charge flat fees per trade, varying from $10 to $75. Some brokers offer no-load and no-transaction-fee mutual funds, providing cost-saving options for investors.

• Impact of fees – Even seemingly minor variations in fees can lead to significant differences in returns over time. Investors should carefully evaluate and compare fees when selecting funds.

Avoiding Fraud
Investors must be vigilant against potential fraud when entering the mutual fund market, mainly by keeping the following aspects in mind:

• Thoroughly research and verify the credentials of both the fund and the investment adviser to ensure reliability.

• Be cautious of promises offering high returns with low risk, as they may signal potential investment fraud.

• Investors should evaluate their risk tolerance before venturing into mutual funds.

• Assess your comfort level with risk. Near retirement, opting for lower-risk funds may be prudent, while younger investors might consider higher-risk options.

Investing strategies
Balanced advantage funds, incorporating a mix of stocks, debt, and potentially gold, provide a diversified investment approach. The fund's equity proportion adjusts based on market conditions, offering stability during market downturns. Systematic Investment Plans (SIPs) enable investors to buy more units in market downturns and fewer units in upswings, leveraging rupee cost averaging. SIPs offer a strategic approach during unpredictable market phases.

Knowing the right time to close a mutual fund
Deciding when to withdraw from a mutual fund is critical. Abandoning funds during market downturns is discouraged, as skilled fund managers can navigate negative phases for optimal recovery and long-term benefits. Investors should exercise patience and strategic thinking when considering fund closures.

Pros and Cons of mutual fund investing

How are mutual funds taxed?

Understanding the tax implications of mutual fund investments is crucial for investors. Here's a breakdown of how mutual funds are taxed in the US:

Capital gains tax
For capital gains, there are two rates: short-term (for assets held less than one year) and long-term (for assets held longer than one year). Long-term capital gains, typically capped at 20%, are often taxed at 15%, with some individuals paying 0%. On the other hand, short-term gains are taxed as ordinary income, subject to regular income tax rates, which can go up to 37%.

Stock funds
Stock funds may distribute dividends or gains from stock sales. Dividends, categorized as "qualified" or "ordinary," are taxed differently. "Qualified" dividends are taxed at the long-term capital gains rate, while "ordinary" dividends are taxed at regular income tax rates, reaching up to 37%. Fund distributions, irrespective of reinvestment, incur taxes.

Bond funds
Bond funds earn interest taxed as ordinary income. Tax implications vary based on the type of bond fund. Municipal bond funds are often tax-free at the federal level, while federal debt funds, like Treasury Bill funds, remain taxable at the federal level but exempt from state income tax.

International funds
International funds may benefit from the foreign tax credit, avoiding double taxation. However, careful consideration of covered countries is essential, as those without a tax treaty with the U.S. may lead to dual taxation.

Tax efficiency strategies
Tax efficiency can be maximized by minimizing trading activities. Placing bond funds in tax-advantaged accounts, such as a 401(k) or IRA, can mitigate annual tax hits. Considering the lower capital gains rate, it may be advantageous to hold stock funds in taxable accounts, paying smaller rates consistently. Exchange traded funds (ETFs) can offer higher tax efficiency during rebalancing, potentially resulting in lower capital gains taxes compared to mutual funds. Investors should weigh these factors and strategize to optimize tax outcomes in their mutual fund investments.