Month: January 2018

What Are Mutual Funds and How Do They Work?

The definition of a mutual fund

A mutual fund is a different type of a company where the money comes from various investors. In addition to that, they try to invest in securities that do not represent an incredible risk to the participants.

The most important part of a mutual fund is its portfolio. In contrast to regular investing, the portfolio consists of all kinds of investments. Hence, the mutual fund does not have to buy shares in one sector only. Moreover, it is better if they invest in a variety of mixed stocks and money market instruments. That way, there is less risk for all of the members and a higher chance of capital gains or income.Mutual funds

Who are the members?

Mutual funds are the best option for investors who do not have a lot of money or those who are new on the stock market. Furthermore, it is also a fantastic ground for participants who have never invested before and are scared for their income.

However, all shareholders join individually and they split the gains or losses proportionally.

How is it different from other companies?

A mutual fund is a way to become an investor and a company owner at the same time. Once you invest your money in it, you own shares of the fund. However, at the same time, you also have an income based on the assets. Moreover, your profit depends entirely on the performance of the portfolio – not individual stocks you own.

That is the essential difference between owning stocks on your own, and investing in a mutual fund. There is a higher chance of diversification. In addition to that, the risks are lower than usual. You would suffer significant losses in other situations. For example, if you owned stocks from a company that had a bad quarter. However, if they are just a fraction of the portfolio of your mutual fund, your losses would be lower.

How do mutual funds work?

Just like with any other company, it should have a financial advisor. While mutual funds are a virtual business, they have a board of directors that hire a manager. This person can be a shareholder himself, although it is not obligatory.

His job is to do everything he can to preserve the income and the portfolio of the mutual fund.

Apart from him, there are few employees in a mutual fund. Usually, there are also market analysts, an accountant, one or two compliance officers, and an attorney.

Types of mutual funds

  • Fixed income funds – their main aim is to invest in government or corporate bonds, or debt investments.
  • Index funds – they buy only the stocks that have a significant market index.
  • Money market funds
  • Balance funds
  • Sector funds
  • Equity funds
  • Funds-of-funds – some mutual funds actually buy the shares of other similar companies.Mutual Funds Type


There are two types of fees in a mutual fund. Those that cover the operating costs during the year, and shareholder fees.

Clean shares funds

There is a newer type of a mutual fund on the market that uses  “clean shares.” That way, there is a supreme level of transparency among the shareholders. Furthermore, there is a higher chance of bigger savings.

Pros and cons of mutual funds


  • Diversification – mutual funds smartly invest in all sorts of stocks and bonds.
  • Economies of scale – the transaction fees are lower.
  • The funds are accessible, and they provide individual investors to participate in the market of exotic commodities or foreign equities.
  • Professional guidance – financial advisors are there to help you gain an income.
  • Perfect for individuals who do not want to participate directly in the market.


  • Diworsification – they might make a mistake and buy funds that are closely related.
  • Expense ratio costs are high
  • Sometimes, there is no transparency. And the purpose of the fund might not be clear to everyone involved.
  • Some of the portfolios are cash-based.
  • There is no guaranteed return, and FDIC does not insure money market funds.
  • The shareholders cannot compare earnings per share and other variables, making it hard for them to determine which fund is the best one.

Evaluating the Performance of Your Mutual Funds

When choosing which mutual fund to invest your money in, you may go off the one-year return rates, and arrive at the conclusion that a particular fund was very successful. However, it is not enough to merely look at the return rates for one year. Instead, you should take a look at a couple of years back, and even perhaps the whole history of the fund.

For example, if a particular fund boasted stellar returns last year, but we look at the average returns over the last 3 or 5 years, and they turn out to be much lower than the one year return rate, it is possible that the fund actually lost money in one or more of the years in question, even though the average return percentage remained positive.

mutual fund analysis

Relative Performance

The way in which we judge the performance of a mutual fund is fundamentally relative, and there is no empirically correct way to do it. The best way to gauge a mutual fund’s performance is, therefore, not to rely on the return percentages, but to compare its performance with other relevant data, in particular, with the performance of the appropriate stock index and with other similar funds.

mutual fund performance

Firstly, in order to see whether the mutual fund performed well, we need to ask the question of whether it accomplished its mandate. The reason people invest in mutual funds is that they expect it to be able to secure better returns than an index fund, which passively tracks the stock market. This is called ‘beating the market’, and it is very tricky to do consistently.

Market Benchmark

In fact, according to the efficient market hypothesis, it is impossible to consistently beat the market, since all the information about the future price of any financial instrument, be it stocks, bonds, or derivatives, is already contained within the price of the instrument itself. There is a wealth of evidence to support this claim, but it has still not been accepted as an unquestionable rule.

Going off the efficient market hypothesis, it is a good idea to compare the performance of a mutual fund with the relevant stock index. Large equity funds are most often compared with the S&P 500, whereas small equity funds are compared to the Russell 2000. Comparing the performance of a mutual fund with the wrong index can yield incorrect results, so it is important to know which index to compare it to.

s&p performance

This benchmark is even more effective when another layer of scrutiny is added. When considering the performance of a mutual fund, it is also important to take a look at how other funds in a similar family performed in comparison to the index. If we find that the fund we are evaluating stuck with the herd in terms of the investments it made, and the returns are similar, this should be seen as an average performance.

If, however, the fund we are evaluating chose to invest in different stocks, there can only be two results. Either it fared better than its peers by virtue of being able to select better stocks, or it fared worse, because its investment strategy didn’t pay off. Naturally, the goal of any investor is to invest in a fund that can maximize the returns by selecting stocks well, thereby beating the market.

However, even when comparing the mutual fund in question with its peers, there are data points which can be misleading. Fund companies paint a rosier picture of their overall performance by shuttering those funds which have lost money. That way, the composite performance of the fund company is improved, because the losers are removed from the statistics.

Full Performance Analysis

Thus, a general conclusion can be reached when the method of evaluating the performance of mutual funds is concerned. The trick to evaluating performance accurately is not to look at discrete data points in isolation, but rather to correlate as many points of data as you can, in order to have a clear picture.

Even though technically the management of your mutual fund works for you, their goals and your goals are not always aligned, since they get paid whether or not they were able to deliver results. Furthermore, their aim is to keep you invested in the fund for as long as possible, so they have developed ways of papering over their mistakes in order to make it look as though things are fine, even when they’ve made mistakes. Therefore, you would do well to constantly question the performance of your fund, and not to take management at their word.