What Is A Mutual Fund?

A mutual fund is a type of investment that hold stocks, bonds, or other securities and is often professionally managed. When owning a mutual fund, the investor essentially owns a portion of all the securities within the mutual fund. The focus of the mutual fund is defined in the fund prospectus which outlines the purpose of the fund, the rules by which the fund is managed, how fees are managed, and other information.

Things to Know

There are a few things to know when researching mutual funds.

The Symbol - This is a series of five letters, always ending in X. The symbol is used much the way a stock symbol is used for quick reference. The X at the end of the symbol indicates that the mutual fund is and open ended fund, meaning anyone can buy into or sell out of the fund at any time.

The NAV - Net Asset Value is the cost to purchase a single share of a mutual fund. For an individual stock, the stock price is what is paid to own the stock. In a mutual fund, the NAV is what is paid.

Market Sector, Market Capitalization, and Allocation - The market sector indicates what kind of securities are included in the fund. A fund that focuses on technology stocks would buy a stock like Apple because it is a technology stock, but would not buy a company like Toyota because Toyota is a consumer cyclical stock. 

Market Capitalization refers to the dollar size of a stock. Mutual funds that purchase mid-Capitalization stocks might buy a stock like Delta Airlines which fall into the mid-cap category, but would not buy a stock like Microsoft because Microsoft is considered a large capitalization stock.

Other mutual funds do not focus on market sector or market capitalization but rather focus on owning a particular percentage of stocks and bonds. The popular allocation percentage for such mutual funds is to own 60% stocks and 40% bonds.  

Expense Ratio and Load - There is a cost for active fund management. The buyer of a mutual fund is entrusting the buying and selling of stocks within that mutual fund to the fund manager. The fee that the fund manager receives to cover his costs of managing the fund is called an expense ratio. The average expense ratio is 1%. This cost is deducted from the balance of the mutual fund at the end of each year regardless of whether the mutual fund makes a profit or not.

A Load is the cost of the mutual fund. Often this is a cost paid upfront and is deducted from the total investment. For instance, if a mutual fund has a load of 5% and the investment amount was $1,000, then the fund automatically takes $50, leaving a principal of $950. Choosing a mutual fund with a load is almost never a good idea and should be avoided if at all possible.

Standard Deviation - Standard deviation is one method by which risk is measured. The larger the number, the more that price tends to move up and down. It is a measure of volatility. As a reference, the S&P 500 standard deviation is about 15. If a mutual fund has a standard deviation greater than 15, then it experiences greater highs and lows than the general market. If the standard deviation is less than 15, then it is more stable than the general market. 

Performance Return - The performance return is a record of the total returns of the mutual fund over a given period of time. Most mutual funds will show recent performance over the last 3, 5, and 10 years. 

Top Holdings - The top holdings of a mutual fund are the stocks, bonds, or securities that represent the largest amount of market value. The top holdings of a mutual fund should align to their prospectus strategy and market sector/cap.

Benchmark - A benchmark is a group of unmanaged securities that are used for comparison. For example, if an investor was considering a mutual fund that specialized in utility stocks, the investor wold compare the returns of that mutual fund with a utility benchmark index to verify if the mutual fund was doing better or worse than the average of all utility stocks. Or, if an investor was simply looking to find a mutual fund that performs better than the overall market, then the investor would compare the returns of the mutual fund against the returns of the S&P 500 as a benchmark. Benchmarks allow an investor to determine if a mutual fund is performing above or below average based on its particular strategy focus. 

Examples

Name: Berkshire Focus Fund 

Symbol: BFOCX

NAV: $36.84

Market Sector/Capitalization/Allocation: Large Cap Technology 

Expense Ratio: 1.95%

Load: None

Standard Deviation: 25.37

Performance Return: 22.53% (10 Year)

Top Holdings: Microsoft Corp, Amazon.com Inc, NVIDIA Corp, Advanced Micro Devices Inc, Lam Research Corp, Tesla Inc, Apple Inc, Netflix Inc

Benchmark Return: 16% (10 Year - technology stocks)

The Berkshire Focus Fund focuses on large capitalization technology stocks which is verified by the top holdings such as Microsoft Corp and Amazon.com Inc. The NAV or cost of a single share of this fund is $36.84. The expense ratio or cost of active management is 1.95% or $1.95 for every $100 invested. There is no load for this mutual fund.

The standard deviation is 25.37 which is higher than the average standard deviation for the S&P 500. The ten-year price performance of the Berkshire Focus Fund is 22.53%. Compare this the ten-year return of 12% for S&P 500. The greater return may justify the increased volatility and risk. This mutual fund's total returns (22.53%) significantly exceeds the technology benchmark (16%) indicating above average returns. Even after the expense ratio (1.95%) is accounted excess returns are still significant (20.58%).

Name: Fidelity Capital and Income Fund

Symbol: FAGIX

NAV: $9.49

Market Sector/Capitalization/Allocation: High Yield Bond

Expense Ratio: 0.67%

Load: None

Standard Deviation: 12.08

Performance Return: 7.06% (10 Year)

Top Holdings: Ally Financial Inc 8%, Numericable 7.375%, Bank of America 5.86%, CSC Hldgs 5.75%, CCO Hldgs/Cap 5%, T-Mobile US Inc, Sprint Cap Corp 8.75%, Sprint Cap Crp 6.875%

Benchmark Return: 6.46% (10 Year - High yield bond market)

The Fidelity Capital and Income Fund focuses on high yield bonds and companies in troubled or uncertain financial situations. This is apparent in the funds top holdings which include mostly high yield bonds. The NAV or cost for a single share of this fund is $9.49. The Expense ratio is 0.67% or sixty seven cents for every $100 invested. There is no load for this mutual fund. 

The standard deviation for this fund is 12.08 which is lower than the standard deviation for the S&P 500. The ten-year price performance of the Fidelity Capital and Income Fund is 7.06%. This return is lower than the 12% return of the S&P 500 but may be justified by the lower risk of this fund. This mutual fund's total returns (7.06%) slightly exceeds the high yield bond benchmark (6.46%) indicating only average returns. After subtracting the expense ratio (0.67%), this mutual fund slightly under-performs the benchmark. 

Are Mutual Funds a Good Investment?

There are literally thousands of different mutual funds which have thousands of different strategies and purposes. Some mutual funds are simply trying to attain the highest returns possible in the market regardless of risk. Other mutual funds attempt to create a stable source of income with low risk. To make sure that a chosen mutual fund is a good investment determine the following:

1. What is the investment strategy? 

2. How much risk is acceptable?

3. How does the mutual fund compare to it associated benchmark?

Mutual funds that align with the investor's strategy, stay within acceptable risk limits, and beat their benchmarks are good personal investments.

*Past performance is not indicative of future returns.