Mutual Fund Calculator
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Mutual Fund Cost Breakdown
A mutual fund is a company that pools together money from many different investors and invests in different types of assets such as stocks, and bonds, and other asset types. If you are new to investing, a mutual fund may be a great option to achieve diversification without investing in multiple individual stocks or bonds. Moreover, mutual funds may 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.
How to Invest in a Mutual Fund
Here is how it works. You, as an investor, give your money to a mutual fund company by agreeing to the terms of the mutual fund. In exchange for the money, the mutual fund company issues you some units in the fund known as shares. The mutual fund company then invests your money in assets as defined in the prospectus of the mutual fund.
Once you have decided on a specific mutual fund to invest in, you have a few options –
- You may be able to invest through your brokerage OR
- You may invest directly with the mutual fund company OR
- If you have any types of tax-advantaged accounts such as 401(k), HSA, 403(b), etc. you may already be invested in mutual funds through those.
If you choose to buy through your brokerage firm, you may have to pay a brokerage fee in addition to the expenses charged by the mutual fund company. A mutual fund always trades at its NAV.
What is NAV in Mutual Fund
NAV, also known as the NET ASSET VALUE of the mutual fund is the total market value or equity value of the fund. It is calculated by subtracting all the liabilities of the fund from the assets of the funds. When you divide the NAV by the number of shares outstanding, you get the Net Asset Value Per Share.
NAV = (Market value of the fund – liabilities of the fund)/(total units in fund)
In the United States, the NAV is calculated once per day at market close. Unlike stocks that have prices that fluctuate throughout the day, the NAV is one single number updated only once a day. The market value of the fund is determined using fair market value at close for all securities and cash. The liabilities of the fund could include any trading costs or fees that may be due.
Types of Mutual Funds
There are many ways to classify mutual funds. Let’s discuss some ways it can be done.
Types of Mutual Funds Based on How the Fund is Managed
- Passively managed mutual fund or Passive Fund or Indexed Fund
- Actively managed mutual fund or Active Fund
Passively Managed Mutual Fund Or Passive Fund or Indexed Fund
An indexed fund does not take active bets on any specific security, industry or sector. Instead, the fund tracks an index. That index can be a broad market index, such as the S&P 500 Index that tracks a broad set of 500 stocks or a sector index, such as the S&P 500 Information Technology Sector Index that tracks the technology sector or an industry index such as the S&P Semiconductor Select Industry Index that tracks the semiconductor industry index.
If you invest in an indexed fund, your fund performance will mimic the underlying index minus any expenses the fund incurs. The expenses are generally lower because managing a passive fund is less work compared to managing an active fund. Pay special attention to fees here. A passive fund most likely cannot justify high fees. There are some exceptions to this rule but if you don’t invest in illiquid markets or niche indexes, you shouldn’t have to pay high fees. PERIOD.
A passive fund will try to hold mostly all securities that are part of the underlying index in the same proportion as they are in the index. For example, if an index has 100 stocks with 1% in each stock, the indexed fund that tracks this index will have the same 100 stocks with 1% weight in each stock.
Actively Managed Fund or Active Fund
An actively managed fund or active fund can and will take active bets on stocks, industries, sectors or markets. An active fund will often (but not always) use an index as a benchmark against which will be evaluated. The expectation is for an active fund to outperform its benchmark – give an investor returns that are higher than what an index can return. However, reality is far from it, especially in efficient markets. More on that later!
But because an active fund takes active bets and holds securities that are different from its benchmark or same securities but in different proportions than the benchmark, the fund manager has to constantly monitor and alter the portfolio. The fund manager thus justifies charging higher fees to its investors on the promise of better returns, a promise that often goes unfulfilled.
Active funds can be further divided into
- Open-end funds and
- Closed-end funds
Open-end Active Mutual Fund
If you own an actively managed mutual fund, it is most likely going to be an open-end fund. The investment process is exactly as described above in how to invest in a mutual fund. If a new investor wants to invest in this fund, the investor can buy directly from the fund or through her brokerage account, as long as the fund is accepting new money. When you purchase shares in an open-end mutual fund, the fund may use your money to purchase securities and create new shares in the fund that are then issued to you.
When the fund reaches capacity, it can decide to stop taking money from new investors. The fund is then said to be CLOSED TO NEW INVESTORS. One reason this can happen if the fund is deciding to close the fund and return money to all investors because it is not profitable. Another reason is the fund is so profitable that it is seeing a huge influx from investors and it is not able to invest efficiently without sacrificing returns. In this case, the fund may continue accepting investment from existing investors but will not accept investment from new investors.
When you buy or sell an open-end mutual fund, you trade at NAV. That means all buyers purchasing shares in the mutual fund pay NAV per share for the transaction and all sellers redeeming shares in the fund get the same NAV per share for the transaction. The trade occurs during market hours i.e. before 4 PM EST in most cases for U.S. trades. However, the price is not determined until after 4 PM. So you trade before knowing what price the trade will settle at. This is usually not a big risk if you are investing for the long term.
Closed-end Mutual Fund (CEF)
While an open-end fund can keep issuing new shares and accepting new investment, a closed-end fund issues shares 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 existing investors to sell shares in the closed-end fund is by trading on the secondary market – like the stock exchange.
Closed-end funds trade like regular stocks on the exchange. These funds trade throughout market trading hours. The price is dictated by the demand for and supply of shares in the fund. Oftentimes, share prices of closed-end funds diverge from their NAVs. This divergence can be quite high. If the demand is high, the price can be higher than the NAV making the fund trade at a premium to its NAV and if the demand is low, the fund can trade at a discount from its NAV. 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.
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. Unlike an open-end fund, which trades only at NAV, a closed-end fund seldom trades at its NAV.
Learn more about closed-end funds at https://www.cefconnect.com/.
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. In other words, 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. In addition, no new units are created over the life of the UIT. However, redemptions can and do occur at the net asset value or NAV.
Type of Mutual Funds Based on Assets
Another way to classify mutual funds is based on the types of assets in which the fund invests. Here are some of the main types of mutual funds
- Equity mutual funds or stock mutual funds
- Bond mutual funds or fixed income mutual funds
- Money market mutual funds
- Balanced funds
- Fund of Funds
Stock (Equity) Mutual Funds
Stock mutual funds are exactly what they sound like. These funds invest in stocks or equities of publicly traded companies. These funds can be classified further based on other attributes such as –
- Market capitalization – Large Cap, Mid Cap, Small Cap or Micro Cap mutual funds.
- Style – Value, Growth, Blend
- Sectors and Industries – Healthcare mutual fund, Technology fund, Pharmaceutical fund, etc.
- Geography – U.S. Domestic funds, International funds, Developed Markets, Emerging Markets, Country-Specific fund example China fund, etc.
Bond (Fixed Income) Mutual Funds
Bond mutual funds invest in bonds. These funds can be classified further based on other attributes such as –
- Type of bond issuer – Treasury, Government Agency, Municipalities, Corporations, etc.
- Quality of Investments – Investment grade, High Yield Bond fund, etc.
- Geography – Domestic, International Bond Fund, etc.
- Duration – Short duration, Intermediate, Long Duration, etc.
Money-Market Mutual Funds
Money market funds invest in short-term securities such as Treasury Bills (or T-bills) and short term corporate debt, also known as commercial paper or certificates of deposit. The yield on money market funds is typically lower than bond and stock funds
Balanced funds may contain a fixed proportion of stocks, bonds and money market securities.
Fund of Funds
A Fund of Funds will hold other mutual funds in fixed or varying proportions. A target-date fund is a great example of a fund of funds. A simple target-date fund may contain one stock fund and one bond fund. The fund starts with a greater proportion in the stock fund and a smaller proportion in the bond fund, for example 100% stock, 0% bond. As time progresses, the percentage in the stock fund goes down and the percentage in the bond fund goes up. Ultimately, closer to the target date, the fund may contain a larger proportion in the bond fund and a smaller proportion in the stock fund.
Mutual Fund Regulation
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. Returns cannot be relied upon without understanding risks.
What are Loads or Fund Management Fees of Mutual Funds
This is a very important section. 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. The fee is known as the front-end load. This fee reduces the amount that gets invested in the fund. For example, a front-end load of 2% will reduce your investable amount of $1000 by $20. Effectively only $980 get invested in the fund and $20 is pocketed by the management of the fund.
However, some funds may charge a deferred sales fee at the time of redemption. This fee is called the back-end load. With a back-end load of say 1%, and a current investment of $1000 NAV, you will lose $10 upon redemption.
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. This is the reason you should always read the prospectus before investing.
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. So basically you are paying for the fund to market to other investors. There are also costs associated with trading and custodial fees.
If you purchase your mutual funds through a broker, there may be additional fees and expenses associated with the brokerage.
These are implicit costs. This is the money you would have made if you had invested the sales charge, the deferred sales charge, the operating expense and other fees into the fund. For example, if you invested $1000 in a fund with a front load of 5%, only $950 went into the fund. Had you invested that $50, and the fund had made 10%, you could have made an additional $55 in a year. As you will realize, increased fees and loads will increase your opportunity costs.
Use my calculator below to calculate all your estimated mutual fund expenses. This will give you a good idea of how expenses eat into your investment return. It will also help you compare different mutual funds and even indexed funds. Just adjust the expense numbers and reduce the loads to zero.
Mutual funds in the United States are required by law to publish their return numbers for the previous 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. Don’t be fooled. Investment is a CHOICE. When you invest in a mutual fund, you are choosing to not invest in another investment vehicle. So you should be comparing the performance of the fund against a benchmark.
Returns are one aspect of performance. But you have to know what risk you are taking for those returns. And if you are adequately compensated for the risk you are undertaking. 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 turnovers specified in the prospectus. Percentage of the portfolio that gets traded each year is called the turnover. This measure is important because the higher the turnover rate, the higher the likelihood of paying capital gains tax each year. Some funds may have high turnover. For example, a fund with a 90% turnover may sell 90% of it’s holdings for new names each year.
How can you make money using mutual funds
You must be thinking all this is great but how do I actually make money using mutual funds. There are a few ways.
- Dividends – A mutual fund invests in a bunch of securities. When these securities pay out dividends or interest, the fund may choose to pass those along to investors as dividends. Unless you own the mutual fund in a tax-advantaged account, you will have to pay ordinary income tax on those dividends.
- Capital gains – The securities a mutual fund owns will go up and down in value over time. If the fund sells securities that have appreciated, this will result in capital gains. A mutual fund will often pass net capital gains to its investors. Again, if investors own this mutual fund in a regular account (not tax-advantaged) they will have to pay capital gains tax on these distributions.
- Capital appreciation – Just as securities owned by mutual funds, the funds themselves may go up and down in value. This is reflected in the NAV of the fund. When you sell shares of the fund at a higher NAV than the purchase price, you make a profit.
In sum, you want to invest in a fund that invests in strategies that are 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.
The fund’s performance is very important. Evaluate returns on a risk-adjusted basis. 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. If the fund doesn’t specify a benchmark, evaluate performance against similar investments managed passively.
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. They will also help you get better diversification.
These were some of the things you should look for in a prospectus. However, you should still read the prospectus very very carefully. I will discuss ETFs in my next article.