Mutual funds have been around for a very long time. They were created to allow investors easy access to pool money together to gain access to experienced portfolio managers’ investment strategies. For a small dollar amount ($500 for example), an investor could get a diversified portfolio of (for example), 200 U.S. and international stocks, 300 Treasury and corporate bonds, oil and gold commodity futures and active tactical trading and rebalancing all in one mutual fund for a fee. If an investor wanted the same portfolio to execute on their own, they would need a lot more investment dollars and a lot more experience and time to execute the portfolio. A mutual fund packages the entire portfolio into one fund and allows hundreds/thousands of investors invest in the fund. The individual investor is better off due to the ease of execution of a diversified portfolio, and the fund manager is better off by managing one fund with shares efficiently spread out amongst thousands of investors.
Mutual funds are offered by large, medium and small investment firms. Some of the large ones you may have heard of are BlackRock, Capital Group/American Funds, Vanguard, PIMCO, etc. More often than not, an investor in an employer’s retirement plan probably has a mutual fund from one of these well-known managers. There are many more than just these managers out there.
Mutual funds tend to be actively managed, with portfolio managers making active decisions to try to outperform some particular benchmark for a fee. In comparison to another packaged product type, called exchange traded funds (ETFs), ETFs are often passive in nature, attempting to track a particular index for a low fee.
There are thousands of mutual funds available across various asset classes and investment styles. Most U.S. based mutual funds with sufficient asset sizes and track record have been assigned categories by the largest research firms, most notably Morningstar and Lipper. These firms offer technology and investment research on mutual funds to try to help investors categorize the fund strategies for better comparison purposes. I have used Morningstar technology since 2007 and believe they do a great job providing information on trying to identify mutual fund investment strategies for investment purposes. I’ve always used the institutional Morningstar Direct platform (approx. $10,000/yr subscription) for investment research on mutual funds. There are so many different categories that Morningstar has assigned to mutual funds and other packaged products, and those categories seem to change over time as Morningstar gets more granular in their categorizations. We’ll get into the specifics a bit more in the manager due diligence lesson, but be aware that there are so many mutual fund options to chose from.
Access to mutual funds depends on the investment platform you are interacting with, whether it is a brokerage firm or through a financial advisor. Mutual fund companies need to have a selling agreement with the brokerages, etc. in order to offer their funds to that brokerage firm’s investors. Mutual funds generally need to pay revenue sharing to the brokerage firm to be on their platform. This is all done behind the scenes, but drives which mutual funds are available on which platform. You may get into a situation that you have done research on a particular mutual fund and want to allocate to it, but the fund is only available on Fidelity, but not Schwab, for example. That’s generally a selling agreement issue with the fund company and the brokerage. Yes, it can be annoying, especially if you really want access to that fund/manager.
Mutual Fund Fees
As stated earlier, mutual funds have fees that the mutual fund firm charges clients, which are all embedded in the fund’s expense ratio. These fees do not show up in the client’s accounts as a deduction of money in the account, rather the fees are pulled directly from the mutual fund itself. For example, if the fund’s investments increased 10% in one year, but the fund’s expense ratio was 1% which was pulled from the mutual fun directly, the total return for the client’s investment in the mutual fund is 10% minus the 1% fee, which equals 9% for the year.
Mutual Fund Share Classes
Mutual funds offered by brokerage firms also often have sales charges, which are different than the expense ratios of the funds. Sales charges can be directly taken out of the client’s account in one form or another and/or can be an embedded sales charge that gets added to in the expense ratio, often called a 12b-1 fee. Sales charges are generally defined by the mutual fund’s share class. The brokerage firm or representative of the brokerage firm can determine which share class(es) they offer to clients and are essentially commissions to the selling firm and/or representative. More often than not, there is an A share, C share and institutional share class. Each one of these different share classes have a specific mutual fund symbol/ticker. Oh, FYI – all mutual funds have a 5 letter symbol/ticker that ends in “X”. In a brokerage account, the sales charge and 12b-1 fees often go to the financial advisor/broker that sold you the mutual fund as a commission.
Typical Share Class Sales Charges
- A Shares:
- A shares often have an upfront charge (called a “front-end load”) from 1-5%, includes a 12b-1 fee in the expense ratio. If you put $1,000 in, and there is a 5% front-end load, instead of $1,000 being invested in the fund, the brokerage firm will take the 5% off the original investment and you only put in $950 in the investment. Generally, the more you invest or have already invested in the fund, the lower the front-end load. Mutual funds will have a “breakpoint schedule” that defines what level of assets determines the amount of the sales charge. For example, if you invest $1,000 in the fund for the first time, you might be charged a 5% load. If you invest $1,000,000 in the fund, you might only have a 1% front-end load or they might waive the load altogether.
- A shares front-end load can be lowered by Rights of Accumulation, which a fund company can have rules to determine how much you or members of your family have in the fund already. If you already have a good amount of assets in the fund already, you may have a lower front-end load (or eliminated altogether) for any subsequent purchases.
- A shares front-end loads can also be lowered by sending the fund company a Letter of Intent. This essentially allows you to tell the fund company that you will have a certain amount of assets in the fund in a certain period of time (generally 1 year) and that because of that, you should get a discount on the A share front-end load based on that “promised” amount, using the lower corresponding breakpoint level.
- A shares also generally have a 12b-1 fee, typically 0.25% that is added onto the fund’s expense ratio. Clients do not see this charge in their account, it is just automatically deducted from the fund and the fund’s performance.
- Oftentimes in an advisory account (fee based, not brokerage), advisory firms and their representatives will offer A shares without any sales charge/front-end load, regardless of initial investment. Since the financial advisor is already charging their advisory fee, they (and regulators) do not want the advisor to charge a front-end load as well. That’s double-dipping. The 12b-1 fee that is embedded in the expense ratio generally doesn’t change, and the firm that allows the mutual fund on their trading platform may keep the 12b-1 fee or rebate the fees to clients in one way or another. A share mutual funds without a front-end load are often called “A shares at NAV” where NAV (net asset value) is the share price of the mutual fund.
- C shares
- C shares are a bit different than A shares. C shares generally do not have any front-end sales charge, but have a higher 12b-1 embedded fund fee instead. The C share 12b-1 fee can often be 1% added to the expense ratio. So if the mutual fund has a 1.5% expense ratio plus a 1% 12b-1 fee, that is a 2.5% fee that is embedded in the mutual fund and performance is essentially reduced by 2.5% each year. If the fund was up 10% before fees, the fund would be up only 7.5% after fees.
- Oftentimes, C shares have a back-end sales charge if the fund is sold within 1 year of purchase. This back-end sales charge is typically 1%. This back-end sales charge is called a Contingent Deferred Sales Charge, or CDSC.
- Driven by regulatory pressures, sometimes investors in C shares that hold C shares longer than 5 years may automatically be converted to A shares. This is due to the 5 years of 1% 12b-1 fees in the C shares approaches the 5% front-end load of C shares. If brokerage firms do automatically convert the A shares to C shares, the investors 12b1 fees will often fall from 1% on the C shares, to 0.25% in A shares, saving investors 0.75% each year. If you own a C share, check with the brokerage firm or your brokerage firm representative if they automatically convert C shares to A shares after a certain period of time.
- Institutional Shares
- Institutional shares are share classes that do not generally have a front- or back-end load or a 12b-1 fee. These share classes often have a high investment minimum of $1,000,000 more or less, depending on the fund company.
- In some brokerage firms, the brokerage firm may offer an institutional share class to investors while waiving the high minimum, but may charge a transaction fee instead. Remember, the fund company and the firm offering the mutual fund on their platform are looking to make money one way or another. For example, a brokerage firm may offer an institutional share class with no investment minimum, but may charge $50 to buy and sell the mutual fund. So an investor that invests $100 a month in an institutional share class will pay $50 to do so, or 50% of the investment amount.
- Other Share Classes
- As previously stated, share classes are generally used to generate additional revenue for the investment firm/brokerage offering the mutual fund on their platform. It’s a way to generate additional revenue. With that said, mutual fund companies may have more share classes available outside of the typical A, C, and Institutional share classes.
- There are some firms that have so many share classes, that adjust the level of the front-end load and 12b-1 fees that the number of share classes is a bit ridiculous. I have seen share classes including F-1, F-2, F-3, Institutional – 2, Z, R-1, R-2, P, Investor, etc. This includes mutual fund companies making up their own letter or name for the share class.
Short-Term Trading Fees
Since mutual funds pool investments across many investors, and are structured as long-term investment products, mutual fund portfolio managers do not want individual investors to trade in and out of the mutual funds as it can be detrimental to the other investors. To try to reduce the bad offenders trying to frequently trade the fund, mutual fund companies and/or brokerage companies may have short-term trading rules and will assess fees if the rules are broken. Oftentimes these rules are called Excessive Trading Rules. For example, if a client buys then sells the fund within 90 days, then the client is charged a $50 short-term trading fee. In addition, mutual fund companies may define in their prospectus that if an investor is frequently trading the mutual fund over short periods of time, the mutual fund company may impose limits on that investor going forward.
Investors need to be very careful in understanding the differences across share classes and the impacts of investment amount and holding period of the mutual fund. FINRA, the regulator overseeing brokerage firms, has a Mutual Fund Fund Analyzer that you can use to compare the different share classes of a particular mutual fund. This is a great tool to use to get a better sense of the total fees you might pay based on the amount you invest and the length of time you anticipate to hold the fund. Transaction fees are also something to be aware of and can be different based on the investment/brokerage firm you are working with.
Trading
Unlike individual stocks, ETFs or closed end funds, mutual funds are only traded at the end of the trading day. If you put in a buy or sell order at the beginning of the trading day, it will not be executed until after the market closes, based on the day’s closing NAV (share price). For those investors that want to buy/sell investments intra-day, mutual funds are not the investment product for you. if you are a longer-term investor, needing intra-day execution of mutual fund trades may not mean much.
When buying or selling mutual funds, investors can make the trade in dollars or in whole or partial shares. Due to the ability to purchase mutual funds in partial shares, it is easy for investors to make small buys/sells in mutual funds, regardless of the NAV/share price of the mutual fund. If the share price of the mutual fund is $60 and you are only purchasing $50 worth of the fund, you are purchasing 0.833 shares. This is different from stocks, ETFs, closed end funds, etc. that trade on exchanges that generally require investors to purchase in whole share amounts. If an ETF has a share price of $60 and you only have $50, you can’t buy any of the ETF because you are $10 short for that ETF share price. If a stock price is $500, and you only add $50 per month to your account, it will take you 10 months to get enough to buy 1 share of that stock.
Taxes
Mutual funds generate taxable events from the income generated from the investments in the fund and in the buying and selling of investments in the fund, hopefully for a profit. All income and capital gains are passed through to the shareholders to be paid by the shareholders of the fund. You are also taxed on any profits you have from the difference in the share price of the mutual fund you purchased it at relative to what you sold it at.
Capital Gains Distributions
Mutual funds are well-known to have capital gains distributions each year, typically in the latter part of the year. One issue that investors in mutual funds have is the potential negative impact of capital gains distributions. This generally only pertains to your mutual fund investments in a taxable account, not in a tax-deferred account like your 401k plan or an IRA account.
Unlike an investment that you buy and sell for a profit and that is the capital gains you pay yourself, in a mutual fund, you are responsible for any net capital gains that the investment manager generates in the fund. This can be a negative for new investors in a fund. Let’s say the fund manager bought a stock 5 years ago and has a 200% gain on the position. Then let’s say you found the fund through your research and you wanted to invest in it. Two days later after you purchased the fund, the investment manager sold his stock with the 200% gain for a profit, generating a capital gain. Although you just bought the fund 2 days ago, you as a shareholder, along with every other shareholder, are responsible for paying capital gains tax on that 200% investment gain, even though you did not participate in the profit generated for the 5 years prior to you investing in the fund.
When looking at mutual funds, there are some data points available (from more sophisticated tools from Morningstar) that can provide a guess at the potential capital gains exposure in a fund. If you see a fund that has tremendous gains in their portfolio and have not had a signficant captial gains distribution in the past, there is a higher probability that the fund manager may take profits in their investments and generate capital gains in the future.
If a fund has had a strong run up in performance, then it is followed by a significant selloff, the ivnestment manager may need to sell positions to meet fund redemptions. This may result in forced selling of profitable positions (that the fund manager would rather not sell) that would generate capital gains and resulting capital gains taxes. So don’t be surprised in a deeper market selloff for capital gains distriutions to be higher in that year. A double negative for investors (negative fund performance and higher capital gains taxes). Just something to be aware of.
Summary
In summary, mutual funds offer great opportunities to get access to various investment strategies in an efficient manner, but keep an eye on all sales charges, wither they are front-/back-end loads or ongoing 12b-1 fees, if applicable