Mutual funds offer a way to invest in a bucket of stocks or bonds or other asset classes. If you are new to investing, mutual funds may be a better option to achieve diversification without investing in multiple individual stocks or bonds. Mutual funds also allow investors to own an entire slice of the market or a particular strategy at an affordable price. Buying all individual stocks in the same proportion as that in the index is cost prohibitive for most investors. However, a mutual fund can offer a proportional investment in the market at a much reduced price.
Investment companies pool together money from multiple investors and invest the pooled funds into various assets as described in the fund prospectus. In return for the money invested, investors get rights to a proportional share of the investment. Because of economies of scale, you pay lower management fees compared with hiring an investment manager.
Unit Investment Trust (UIT)
Investment companies are classified as managed and unmanaged. Unit investment trusts (UIT) in the United States are unmanaged investment companies that buy and hold a fixed portfolio of assets. These assets are held by a trust that divides this pool of assets into smaller chunks and sells them to investors. These chunks are called units. Hence the name unit investment trust. These units are redeemable back to the trust at net asset value. Assets in the UIT don’t change over the life of the UIT and a UIT has a definite termination date at which all assets in the trust are liquidated and funds are redistributed to its investors. No new units are created over the life of the UIT, however, redemptions can and do occur at the net asset value or NAV.
NAV = (Market value of the fund – liabilities of the fund)/(total units in fund).
Open-end mutual fund
In a managed investment company, assets are actively managed and they do change over time. A managed investment company is divided into two types – an open-end mutual fund, and a closed-end fund. Let’s look at an open-end fund. If a new investor wishes to purchase shares in the fund, the mutual fund creates new shares by buying more of the same assets in its portfolio. When an investor wants to sell his share of the mutual fund, he/she simply sells it back to the mutual fund. The fund then sells a proportion of assets from the portfolio and returns capital minus any fees to its investor.
Most open-end mutual funds trade once a day at the end-of-day price of the fund. To receive pricing for the same day, a trade order needs to be sent before the 4 PM market close in the United States.
A closed-end fund issue shares only once. It also does not allow investors to redeem their shares unless the fund is liquidated. The only way for new investors to buy shares in a closed-end fund or for an existing investors to sell shares in the closed-end fund is by trading in the secondary market. Closed-end funds trade like regular stocks on the exchange. These funds trade throughout the day. Often times, share prices of closed-end funds diverge from their NAVs. This divergence can be quite high. For example, historically, the Morgan Stanley China A share fund (Ticker: CAF) has traded at discounts higher than 10% to its NAV. These discounts can sometimes offer an interesting investment opportunity. I want to talk about closed-end funds in a future article.
Fund premium = (Share price – NAV)/NAV expressed as a percentage.
If the above value is negative, the fund is trading at a discount, else it is at a premium.
Learn more about closed-end funds at https://www.cefconnect.com/.
Managed investment companies are regulated by the U.S. Securities & Exchange Commission (SEC) and as such have to follow very strict guidelines. For example, open end funds have to price their shares every business day. If a mutual fund calls itself diversified, it cannot hold more than a certain percentage of assets in a single security. Mutual funds are also required to issue a prospectus that details the objectives, strategies, operations and risks of the fund. It is important to review the prospectus from time to time and give it a detailed read before investing. Reading the prospectus is very important. Relying only on fund performance numbers can be very damaging. For example, a fund that utilizes a small cap stock strategy can have great return numbers in bull markets, however a value strategy fund may show poor returns overall but also be less volatile.
Fund Management Fees of Mutual Funds
This is a very important section. So please use this portion to compare different funds across similar strategies. Funds often charge individual investors sales fees (also known as loads). Some funds charge a sales fee upfront. This is known as the front-end load. Some funds may charge a deferred sales fee at the time of redemption. This is the back-end load. The back-end load is usually reduced by a certain amount each year. This incentivizes investors to leave the money in the fund instead of redeeming early. Funds usually waive these fees for institutional investors. A fund may charge different loads to different types of investors. Usually they do so by offering different classes of funds that have different minimum investments. Look for no-load funds because loads reduce your return on investment.
In addition to the loads, there are annual fees that comprise management fees, distribution fees (12b-1 fees), and other administrative expenses. Management fees are the highest percentage of the annual fees funds can charge. Distribution fees include marketing costs that allow the fund to be sold to new investors.
Let me walk you through an example so you can better understand how these fees will affect your investment. Let’s look at Madison Diversified Income fund. I got the below information from the fund’s prospectus on Madison Funds’ website in July of 2019. You can play around with the numbers for other funds to compare across different share classes. Look at the below just as an example. Some information may not be in the table. For example, class B of the fund is not open to new investors.
Do note that each share class may have its own constraints and minimum investment requirements. Also, the expected rate of return may not realize. The below calculator is just for you to try different scenarios for each class of a fund.
|Shareholder fees||Class A||Class B||Class C|
|Annual Fund operating expenses||Class A||Class B||Class C|
Finally, mutual funds are required by law to publish their return numbers going back to 10 years or inception, whichever is longer. One should look at how those numbers compare to the benchmark stated in the prospectus. Some funds don’t have a specific benchmark. In such cases, look at how the returns vary over time. You definitely don’t want to invest in an unpredictable fund that is highly volatile year over year. Do note that future performance cannot be predicted from historical performance but it gives you an idea of what the investment manager is going after – whether it is steady returns, risky growth, etc.
Pay attention to turnover rates specified in the prospectus. Turnover rates tells you the percentage of the portfolio that gets traded each year. This measure is important because the higher the turnover rate, the higher the likelihood of paying capital gains tax each year.
In sum, you want to invest in a fund that invests in strategies that is in line with your investment policy statement. If you are close to retirement, you may have immediate liquidity needs and a 100% investment in a small cap growth fund may not be the best choice for you. On the other hand, having 100% of your portfolio invested in a Treasury bond fund may not be the best idea for a 20 year old.
Secondly, look at the fund’s performance. See who the management is. A reputed firm has better chances of attracting better fund managers. The board may be more responsive to take action against bad managers. Also check the fund’s returns over its benchmark.
Finally, expenses will eat into your portfolio so look for no-load funds that have lower expenses. Index funds are more cost effective compared to actively managed funds.
These were some of the main things you should look for in a prospectus. However, you should still read the prospectus carefully. There are items such as leverage that I haven’t discussed above. I will discuss ETFs in my next article.