Learning to Invest with Mutual Funds

If you have a small account or if you are just learning to invest, you should consider investing with mutual funds. A good mutual fund offers access to professional money managers and also allows you to diversify your holdings across multiple asset classes. Once you feel you understand how to evaluate businesses and stocks and have enough capital to diversify into asset classes that you want, than you may consider buying stocks on your own and build your own unique portfolio. Even seasoned investors with significant investments may still want to use mutual funds as part of their portfolio as it saves time by outsourcing the research and due diligence of stocks to a professional mutual fund manager. In practice, however, you still need to perform detailed due diligence on the mutual fund that you are considering buying to understand its investment philosophy, managers, fees, performance and its fit into your asset allocation and investment strategy. Besides, many investment accounts available today (such as 401Ks, 529 plans, etc), offer mutual funds as the only available investment options, and therefore, it is important to understand mutual funds and how to invest in them.

We will present the basics of investing in mutual funds in a set of articles that will cover all aspects of investing in a mutual fund. Please be sure to check back often for new articles in the series.

What is a mutual fund?

At its very basic, a mutual fund is a way of pooling investments from many different investors to invest according to a definite strategy. Typically the strategy of the mutual fund is outlined in its Prospectus. Every mutual fund investor should review the mutual fund prospectus of the fund they are looking to invest in. Wide array of strategies are available today. Investors can choose from bond mutual funds of different durations (short term, intermediate term, long term), stock mutual funds of all types and flavor (value, growth, small/medium/large cap, sector specific funds, income funds, long only funds, short only funds, global funds, international funds, country or region focused funds, etc), blend funds, commodity funds, real estate funds, index funds and so on. The concept of pooling investments from many investors allows a fund to leverage a large capital base to make investments in a diversified set of securities. Most funds available to retail investors have low minimum investments that allows an investor with small capital to invest. An investor in a mutual fund is issued shares of the mutual fund. Every share of a mutual fund is equivalent, meaning they all represent a portion of the total assets of the mutual funds equally.

Types of mutual funds

There are essentially two main types of mutual funds in US today (similar concepts exist in most other countries globally), Open Ended Mutual Fund and Closed-Ended Mutual Fund. Exchange Traded Funds (or ETFs) have recently emerged as a new kind of investment fund that essentially combines the features of an Open-Ended mutual fund and a Closed-Ended mutual fund.

An Open-Ended fund is a mutual fund where new shares are issued as new investments come in. Conversely, as investors redeem their shares, the redeemed shares are retired. This means that there is no secondary market for the shares of an open-ended mutual fund. All buy and sell transactions of these funds are ultimately conducted with the mutual fund itself (even though the funds may be sold through brokers and advisers). A new investment in these mutual funds mean that the mutual fund manager may use the new money to buy additional shares of the investments it carries. Similarly, a redemption often means that the mutual fund manager may need to sell some of the investments to meet the redemption request. An open ended mutual fund is always quoted and transacted at its Net Asset Value (NAV), which is the market value of all its investments on a per share basis. Typically mutual fund NAVs are revised once each trading day (although there may be cases where the NAVs may be revised less often, mostly if the underlying investments are illiquid).

A Closed-Ended fund has a fixed number of shares that it issues once when the fund launches. The launch of the fund creates the capital base for the fund that it can use for investments. The fund may choose to do additional issues or even buy back shares at a later date. Once the fund has launched, its shares can be bought and sold in the secondary market. The shares of a closed-ended funds are continually priced just like stocks and may be higher than the NAV (selling at a premium to NAV) or they may be lower than the NAV (selling at a discount to NAV). A good rule of thumb when buying a closed-ended mutual fund is to always buy it at a discount to its NAV (A quick tip: if you use Yahoo Finance to look up the quotes on a closed-ended fund with ticker ABC, you can in most cases find the NAV of this fund using the ticker XABCX, i.e, by adding Xs before and after the ticker symbol). Closed-ended funds are legally a closed-end companies in US and are similar to Investment Trusts in UK or Listed Investment Companies in Australia.

Exchange Traded Funds have recently emerged as an attractive alternative to traditional mutual funds. ETFs combine the best features of Open-Ended mutual funds and Closed-Ended mutual funds. ETFs trade on exchanges just like a stock at a price very close to its NAV. This is accomplished by letting retail investors trade ETFs in the secondary market and at the same time allowing authorized participants (mainly large institutional investors) the ability to buy or redeem shares of ETFs from the fund manager directly in exchange for a basket of underlying securities. This arbitrage opportunity for the institutional investors helps maintain the ETF price close to its NAV. ETFs were originally created to track indexes but can now also be actively managed. Exchange Traded Funds are an attractive alternative to traditional mutual funds as they typically have low cost, tax efficiency and high liquidity.

In future articles we will cover each of these fund types in greater detail, including some tips on how to select these funds for investment. In the meantime, here are some excellent resources on mutual funds available around the net. Feel free to explore these sites