Brief Explanation of Mutual Funds
SilGro home page for Alan Silverstein and Cathie
Last update: January 7, 2016 --
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This webpage is a brief, simple, point-by-point introduction to mutual
fund terms and concepts. It starts top-down and adds one small point at
a time. The numbering is arbitrary and doesn't mean anything, it's just
a way to refer to paragraphs for discussion.
I created this webpage to try explaining mutual funds to a relative.
If you have one extra dollar you don't need to spend today, so
you decide to save it for later, how many ways can you save or invest
First, you could just store or hide the money as currency or an
equivalent. But then you'd have to worry about it being lost or stolen,
plus it loses buying power over time to inflation. (Assuming inflation
is normal and deflation is rare enough to ignore.)
Often instead of just holding cash, you would store extra money in a
bank, credit union, or brokerage account of some kind --
checking, saving, money market fund, or certificate of deposit (CD) --
that pays you a little interest for letting them borrow your money.
The more money or longer time you promise to leave it in
the account, usually the higher the interest rate. With a CD there's
usually a six-month interest penalty for early withdrawal.
But interest rates themselves go up and down over time with
supply and demand. They are usually locked in when you invest in a CD
(or take out a mortgage or other loan).
These simple accounts might not earn enough interest to keep up with
inflation, meaning your nominal returns (dollars on account) over
time are positive, but your real returns (buying power) are negative.
Often but not always these simple accounts are insured up to some
level by the FDIC, NCUA, or SIPC against loss due to bankruptcy or
Beyond these simple accounts, you can invest your money in lots of ways
that all have the common property that in order to get your money back
out, you must sell something -- a stock, bond, mutual fund share,
rental house, artwork, gold or silver bars, whatever.
Any time you must sell an asset to recover its value (turn it back into
cash or equivalent), that means it has a "volatile" price that
can go up or down over time. Some types of assets are much more
volatile than others, and many cannot be insured against loss either.
Usually you can't predict the future price. So there's a risk
you won't be able to get out later as much as you put in earlier, if the
price is down (compared to what you paid to buy in) when you think it's
time to sell.
Of course most of the time people invest in assets they hope will
increase, not decrease, in value over time. Certainly shares of
successful companies tend to get more valuable as the companies grow.
On the other hand, cars (other than old collector models) lose a lot of
their value with time, so they're poor investments.
Bonds and mortgages each have a built-in interest rate that the borrower
is supposed to pay back. As a result, these "debt obligations"
have values that go down when interest rates rise, and
vice versa. Think about it, if interest rates rise, why would someone
pay you as much now as they would have previously for a bond or mortgage
you own (where you are the lender, and they assume the credit
side of the debt) when they can create a new bond or mortgage for a
higher interest rate?
Some assets have the risk of losing their entire value, such as
if a company declares bankruptcy, or a bond seller defaults on their
Most volatile assets pay various kinds of "dividends". Many
companies in which you buy stock send out periodic dividends (if they
are doing well) to their share owners. Bonds or mortgages return
periodic payments from the borrowers to the lenders (or current debt
owners). Rental houses produce rental income, although you must deduct
your overhead expenses (like principle, interest, taxes, insurance,
utilities, and maintenance). And so on.
Some types of assets, like just holding gold or silver bars in a vault,
pay no dividends at all.
The total return of an investment or asset includes both changes,
if any, in its base value (price) and its interest or dividend payments
to the owner. For example, you might buy an asset for $1000, receive
$400 in total dividends since you bought it, and still have only $1000
in total present value if the asset price has dropped to $600 in the
People tend to pay more for assets with higher interest,
dividends, or other rates of return (current or expected).
In general, the more volatile the price of an asset, the higher
the long-term average price increases for that asset. In other words,
you are usually rewarded for taking more risk, but sometimes you must
wait years to see returns on your investment, and there's always a risk
of losing it completely.
When you buy or sell most volatile assets there are transaction
costs involved. These include commissions on stock trades, real
estate buyer/seller costs, etc.
A mutual fund (yes we are finally at this point!) is a
product created by a company that buys many different assets, sometimes
all in the same class (like small company stocks or junk bonds), or
sometimes across many different classes. Then the fund sells shares of
the fund to buyers.
So owning a share of a mutual fund is like owning a share of one
company's stock, except that the risks and returns are averaged
across many underlying assets, and shared by all of the fund owners in
proportion to how many shares they own of the fund.
Why bother with this extra complexity? What a mutual fund does is make
it easy to get wide diversification. This means the collection
of underlying assets is less volatile than its worst members, and you
are less likely to lose everything -- or to see huge increases in value
either. One mutual fund could hold thousands of different underlying
assets, where you own a tiny share of each one without having to buy or
sell them yourself.
At the end of every business day, a mutual fund tallies up the
numbers of shares, and closing prices for each, of everything it
owns, plus adds all of the money it has in its own "bank accounts" that
really belongs to its fund owners. (Real estate investment trust funds,
or REITs, probably don't do it nearly this often because it's
impractical, but computers make it easy to do for stock, bond, and many
other mutual fund types.) This way the fund knows its own total asset
value on a regular (like daily) basis.
Next, the mutual fund divides its total asset value by the number of
fund shares outstanding, which are owned by the investors in the fund,
to calculate the fund's share price or NAV (net asset value) for
that day. This NAV is widely publicized after every business day.
When you own shares of a mutual fund, you can look up the daily
NAV and multiply it by your own number of shares to figure out how much
money your ownership of the fund is worth that day. For example, Google
"fund VSCGX". (Google, but not all search engines, directly offers
quotes and plots on assets it recognizes when you search for them.)
As the mutual fund's underlying assets rise or fall in value, so
will your asset value in the fund, although not exactly in step.
In the meantime, most mutual funds pass through their interest,
dividends, and capital gains to their fund share owners, usually by
paying monthly, quarterly, or annual fund dividends. Stocks (companies)
also pay dividends directly to their shareholders. When a stock or
other asset is owned by a mutual fund, it collects their dividends, bond
payments, etc, and redistributes them periodically to the fund owners.
Some stock or mutual fund owners like to get a check in the mail
or by direct deposit every time the fund pays a dividend. In this case
their number of shares owned doesn't change over time, but their asset
value in the fund still goes up and down with the fund's NAV. (Same for
owning an individual stock that pays dividends.)
Some stock or mutual fund owners prefer not to be bothered with periodic
dividends and the associated bookkeeping. Instead they set up a
DRIP or dividend reinvestment program. Every time the stock or
fund issues them a dividend, they automatically buy more (fractional)
shares of the stock or fund. In this case an owner's asset value in a
mutual fund can increase over time even if the NAV stays flat.
Either way (direct payments or DRIPs), income taxes are due every
year on the money paid to you by a stock (company), bond, or mutual
fund, even if you never see it in your own hands.
This can get very messy when you sell an asset (stock or a mutual
fund) because you are supposed to deduct the cost basis (what you paid)
for each group of shares from your total proceeds to figure out your
capital gains, that is, the net income you haven't yet been taxed upon.
Often a mutual fund company can help you by telling you the average
cost basis for all of the shares you sold, whether it was part or
all of your ownership in the fund.
Now it costs money to operate a mutual fund. This is reflected in an
expense ratio that is charged to share owners. Some of the money
flowing into a mutual fund never goes to the owners, but is used instead
to pay salaries, office expenses, etc.
Mutual fund expense ratios can be as low as 0.10%/year, while others are
much higher, like 1.5%/year. The higher the expense ratio, the
better the fund must perform over time for its share owners to come out
ahead of inflation.
Passive or index mutual funds usually have lower costs (expense
ratios) because they follow simple rules to track large parts of the
marketplace without a lot of decision making or daily trading.
Active funds usually have higher costs because their fund
managers continously try to predict the future and beat the market
average, "outperforming" their baseline index by making timely buys and
sells. But roughly 80% of active funds fail to keep up with their
reference points each year.
Finally, some mutual funds have loads or commissions that must be
paid, on top of annual expense ratios, when you buy or sell their
shares. Ugh! Avoid these, they are seldom worthwhile.