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What Is a Mutual Fund?

Key Takeaways

  • Mutual funds are investment vehicles that pool money from multiple investors to purchase a collection of securities, which are managed by a portfolio manager(s).
  • You can buy shares of mutual funds at the net asset value (NAV) of the fund, which is determined at the close of each day.
  • Mutual funds have two types of fees: shareholder fees and operating expenses.

A mutual fund is an investment vehicle that pools money from many investors to purchase a collection of securities (stocks, bonds, or other investment vehicles). When you purchase one or multiple “shares” of the fund, they represent part ownership of the fund along with the other investors.

The collection of securities is referred to as the fund’s portfolio, which is operated by one or more portfolio managers. The portfolio manager is responsible for seeking out future investment opportunities that can help the fund outperform the standard, also known as a benchmark. Mutual funds tend to invest in a range of companies and industries to diversify their portfolio.

How do mutual funds work?

To purchase a share of a mutual fund, you can buy it straight from the fund itself or through a broker. The share is purchased at the net asset value (NAV), which is determined by dividing the total value of the securities in the portfolio by the total number of shares. This is updated daily.

Shares can be purchased or traded once a day. If purchased before the close of the market at 4 p.m. ET, the purchase price is that day’s closing NAV; if purchased after 4 p.m., they’re purchased at the next day’s closing NAV. Stocks and exchange-traded funds (ETFs) differ in trading styles since those can be traded throughout the course of the day.

Mutual funds tend to have minimum initial investments, typically in the $250 to $3,000 range. However, there are situations when the minimum can be waived or reduced.

So, how do you earn a return on your investment? It’s simple: When the market value of the fund’s portfolio increases, the value of the fund and its shares increases as well. This raises the value of your investment. Then you can sell your shares at the higher NAV and realize your gain. (Note: There are taxes you must pay on gains, which we’ll get to later.)

Why investors choose mutual funds

Mutual funds provide investors the opportunity to purchase professionally-managed, diversified securities that can be sector-specific. They are also easily accessible through brokerage firms or mutual fund companies, and accounts can be opened quickly. Mutual funds also are affordable investment opportunities with relatively low account minimums and management costs.

Mutual fund fees

Investing in a mutual fund is not free. There are costs that shareholders must pay, which are broken into two categories: shareholder fees and annual fund operating expenses.

Let’s start with shareholder fees. There are five to be aware of:

  1. Sales loads: This is the commission you pay to the brokerage firm (if you used one) from whom you purchased shares of the mutual fund. However, even if you don’t purchase shares through a broker, you might still be charged sales loads. Sales loads can either be charged on the front end (when investors purchase fund shares) or on the back end (when investors redeem their shares).
  2. Redemption fee: Some funds charge these fees when shareholders redeem their shares. This is different from a back-end sales load — redemption fees are used to defray fund costs associated with the redemption, while back-end sales loads are paid as a commission to the broker.
  3. Exchange fee: Mutual funds could charge this fee if investors transfer their shares to a different fund within the same fund group. 
  4. Account fee: This is essentially a maintenance fee that some funds charge, typically if your account falls below a certain dollar amount.
  5. Purchase fee: This fee could be charged at the point of sale. Similar to the redemption fee, this is different from a front-end sales load because the fee is paid to the fund and not a broker, and goes toward the cost of running the fund.  

There are also annual fund operating expenses. These charges are recurring payments that count as the operating expenses for the fund. They come directly out of fund assets so you’re paying these expenses indirectly rather than seeing a charge and paying it.

They include:

  1. Management fees: These fees go to the portfolio manager(s) as payment for running the mutual fund’s investments.
  2. 12b-1 fees: This comes from a Securities and Exchange Commission (SEC) rule outlining mutual funds that classify as “12b-1” plans to pay distribution expenses. These expenses include marketing, advertising, selling shares, and others.

Taxes on mutual funds

As a shareholder, you are required to report any of the mutual fund’s distributions on your personal tax return, as well as any shares you buy or sell. In addition, since you’re a part owner of the mutual fund, you also pay taxes on any transactions made by the fund itself as part of the management of the portfolio.

Distributions can be taxed in one of two ways: your ordinary income tax rate or the capital gains rate. If the mutual fund has held the security for less than a year, gains are taxed at the ordinary income tax rate; those held for a year or more are taxed at the capital gains rate. This is an important distinction because the capital gains tax rate tends to be lower than your ordinary income tax rate.

More information

Investing can be a helpful method of planning for the future, whether it’s your retirement or any other financial goal.  To learn how we can help you invest for the future, visit us online or schedule a Citizens Retirement Checkup® at your nearest Citizens Bank branch.

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