A mutual fund is a type of investment that pools money from many investors and invests it according to the fund’s objective.
Mutual fund shares are purchased directly from the fund company and are redeemed by the fund company when investors elect to sell their shares. Mutual fund shares are not traded on exchanges or over the counter.
The price of a mutual fund share is referred to as its net asset value (NAV). The NAV is calculated by taking the market value of the total assets in the fund and dividing it by the number of shares outstanding.
Types of Mutual Funds
There are mutual funds for almost all types of investment styles. The most common types of mutual funds invest in domestic common stocks and bonds. Investors can diversify their mutual fund holdings by investing in funds that hold foreign securities as well.
There are also mutual funds that invest in certain sectors such as real estate, commodities, precious metals, and real estate investment trusts.
Active vs. Passive Management
Most mutual funds can be categorized as either actively managed or passively managed.
Actively managed funds seek to meet their investment objectives by giving the fund manager the authority to buy and sell securities in the fund as he sees fit. The popularity of this type of management has declined in recent years, as the popularity of passive investment management has grown.
Because of the additional administrative burden of actively managing a fund’s portfolio, active funds tend to have a higher expense ratio than passive funds. They also tend to be less tax-efficient than passive funds.
Passively managed funds employ a “buy-and-hold” strategy to achieve their investment objectives. The most popular types of passively managed funds are index funds, which hold securities that compose a separately-established index. A popular example is the Dow Jones Industrial Average, which is comprised of 30 large U.S. stocks. A fund that seeks to replicate the performance of this index would hold these 30 stocks, only replacing them if the index constituents change.
Index funds have exploded in popularity in recent years, especially for retirement planning. They are inexpensive to manage, so their expense ratios tend to be low. Because there isn’t much buying and selling in these funds, they also tend to be tax-efficient.
Mutual Fund Share Classes
There are three main types of mutual fund share classes. Each share class has a different cost structure, so it is important to select the class that is most cost-efficient for you.
A-shares have an up-front sales charge that is deducted from the amount invested and retained by the fund company. There are sales charge “breakpoints”, which are discounts that apply when certain investment levels are reached. These shares tend to be best for investors with large amounts to invest and long investment time horizons.
B-shares have no up-front sales charge, but they have a contingent deferred sales charge which applies if the investment is redeemed within a certain period of years. After this period ends, B-shares usually convert to A-shares.
C-shares work similarly to B-shares, but their sales charge periods are shorter – usually one or two years. In exchange for this liquidity, C-shares usually have high operating expenses. They are for short-term investing and are usually not suitable for retirement planning.