Buying shares in mutual funds can be intimidating for beginning investors. There is a huge amount of funds available, all with different investment strategies and asset groups. Trading shares in mutual funds is different from trading shares in stocks or exchange-traded funds (ETFs). The fees charged for mutual funds can be complicated. Understanding these fees is important since they have a large impact on the performance of investments in a fund. The following is a guide to help get a new investor up to speed on the basics of trading mutual funds.

What Are Mutual Funds?

A mutual fund is an investment company that takes money from many investors and pools it together in one large pot. The professional manager for the fund invests the money in different types of assets including stocks, bonds, commodities and even real estate. An investor buys shares in the mutual fund. These shares represent an ownership interest in a portion of the assets owned by the fund. Mutual funds are designed for longer-term investors and are not meant to be traded frequently due to their fee structures.

Mutual funds are often attractive to investors because they are widely diversified. Diversification helps to minimize risk to an investment. Rather than having to research and make an individual decision as to each type of asset to include in a portfolio, mutual funds offer a single comprehensive investment vehicle. Some mutual funds can have thousands of different holdings. Mutual funds are also very liquid. It is easy to buy and redeem shares in mutual funds.

There is a wide variety of mutual funds to consider. A few of the major fund types are bond funds, stock funds, balanced funds and index funds. Bond funds hold fixed-income securities as assets. These bonds pay regular interest to their holders. The mutual fund makes distributions to mutual fund holders of this interest.

Stock funds make investments in the shares of different companies. Stock funds seek to profit mainly by the appreciation of the shares over time, as well as dividend payments. Stock funds often have a strategy of investing in companies based on their market capitalization. Market capitalization is the total dollar value of a company’s outstanding shares. For example, large-cap stocks are defined as those with market caps over $10 billion. Stock funds may specialize in large-, mid-or small-cap stocks. Small-cap funds tend to have higher volatility than large-cap funds.

Balanced funds hold a mix of bonds and stocks. The distribution among stocks and bonds in these funds varies depending on the fund’s strategy. Index funds track the performance of an index such as the S&P 500. These funds are passively managed. They hold similar assets to the index being tracked. Fees for these types of funds are lower due to infrequent turnover in assets and passive management.

How Mutual Funds Trade

The mechanics of trading mutual funds are different from those of ETFs and stocks. Mutual funds require minimum investments of anywhere from $1,000 to $5,000, unlike stocks and ETFs where the minimum investment is one share. Mutual funds trade only once a day after the markets close. This is different from stocks and ETFs that can be traded at any point during the trading day.

The price for the shares in a mutual fund is determined by the net asset value (NAV) calculated after the market closes. The NAV is calculated by dividing the total value of all the assets in the portfolio, less any liabilities, by the number of outstanding shares. This is different from stocks and ETFs, wherein prices fluctuate during the trading day.

An investor is buying or redeeming mutual fund shares directly from the fund itself. This is different from stocks and ETFs, wherein the counterparty to the buying or selling of a share is another participant in the market. Mutual funds charge different fees for buying or redeeming shares.

Mutual Fund Charges and Fees

It is critical for investors to understand the type of fees and charges associated with buying and redeeming mutual fund shares. These fees vary widely and can have a dramatic impact on the performance of an investment in the fund.

Some mutual funds charge load fees when buying or redeeming shares in the fund. The load is similar to the commission paid when buying or selling a stock. The load fee compensates the sale intermediary for the time and expertise in selecting the fund for the investor. Load fees can be anywhere from 4% to 8% of the amount invested in the fund. A front-end load is charged when an investor first buys shares in the fund.

A back-end load, also called a deferred sales charge, is charged if the fund shares are sold within a certain time frame after first purchasing them. The back-end load is usually higher in the first year after buying the shares, but then goes down each year after that. For example, a fund may charge 6% if shares are redeemed in the first year of ownership, and then it may reduce that fee by 1% each year until the sixth year, when no fee is charged.

A level-load fee is an annual charge deducted from the assets in a fund to pay for distribution and marketing costs for the fund. These fees are also known as 12b-1 fees. They are a fixed percentage of the fund’s average net assets and capped at 1% by law. Notably, 12b-1 fees are considered part of the expense ratio for a fund.

The expense ratio includes ongoing fees and expenses for the fund. Expense ratios can vary widely but are generally 0.5 to 1.25%. Passively managed funds such as index funds usually have lower expense ratios than actively managed funds. Passive funds have lower turnover in their holdings. They are not attempting to outperform a benchmark index, and thus do not need to compensate the fund manager for his expertise in choosing investment assets.

Load fees and expense ratios can be a significant drag on investment performance. Funds that charge loads must outperform their benchmark index or similar funds to justify the fees. Many studies show that load funds often do not perform better than their no-load counterparts. Thus, it makes little sense for most investors to buy shares in a fund with loads. Similarly, funds with higher expense ratios also tend to perform worse than low expense funds. Luckily, there are many high-quality no-load funds with low expense ratios for investors to consider.

Popular Investment Strategies

Individual investors can look for mutual funds that follow a certain investment strategy that the investor prefers, or apply an investment strategy themselves by purchasing shares in funds that fit the criteria of a chosen strategy.

Value Investing

Value investing, popularized by Ben Graham in the 1930s, is one of the most well-established, widely used and respected stock market investing strategies. Buying stocks during the Great Depression, Graham was focused on identifying companies with genuine value and whose stock prices were either undervalued, or at the very least not overinflated and therefore not easily prone to a dramatic fall.

The classic value investing metric used to identify undervalued stocks is the price-to-book (P/B) ratio. Value investors prefer to see P/B ratios at least below 3, and ideally below 1. However, since the average P/B ratio can vary significantly among sectors and industries, analysts commonly evaluate a company's P/B value in relation to that of similar companies engaged in the same business.

While mutual funds themselves do not technically have P/B ratios, the average weighted P/B ratio for the stocks that a mutual fund holds in its portfolio can be found at various mutual fund information sites, such as Morningstar.com. There are hundreds, if not thousands, of mutual funds that identify themselves as value funds, or that clearly state in their descriptions that value investing principles guide the fund manager's stock selections.

Value investing goes beyond only considering a company's P/B value. A company's value may exist in the form of having strong cash flows and relatively little debt. Another source of value is in the specific products and services that a company offers, and how they are projected to perform in the marketplace.

Brand name recognition, while not precisely measurable in dollars and cents, represents a potential value for a company, and a point of reference for concluding that the market price of a company's stock is currently undervalued as compared to the true value of the company and its operations. Virtually any advantage a company has over its competitors or within the economy as a whole provides a source of value. Value investors are likely to scrutinize the relative values of the individual stocks that make up a mutual fund's portfolio.

Contrarian Investing

Contrarian investors go against the prevailing market sentiment or trend. A classic example of contrarian investing is selling short, or at least avoiding buying, the stocks of an industry when investment analysts across the board are virtually all projecting above-average gains for companies operating in the specified industry. In short, contrarians often buy what the majority of investors are selling and sell what the majority of investors are buying.

Because contrarian investors typically buy stocks that are out of favor or whose prices have declined, contrarian investing can be seen as similar to value investing. However, contrarian trading strategies tend to be driven more by market sentiment factors than are value investing strategies, and to rely less on specific fundamental analysis metrics such as the P/B ratio.

Contrarian investing is often misunderstood as consisting of simply selling stocks or funds that are going up and buying stocks or funds that are going down, but that is a misleading oversimplification. Contrarians are often more likely to go against prevailing opinions than to go against prevailing price trends. A contrarian move is to buy into a stock or fund whose price is rising despite continuous and widespread market opinion that the price should be falling.

There are plenty of mutual funds that can be identified as contrarian funds. Investors can seek out contrarian-style funds to invest in, or they can employ a contrarian mutual fund trading strategy by selecting mutual funds to invest in using contrarian investment principles. Contrarian mutual fund investors seek out mutual funds to invest in that hold the stocks of companies in sectors or industries that are currently out of favor with market analysts, or they look for funds invested in sectors or industries that have underperformed compared to the overall market.

A contrarian's attitude toward a sector that has been underperforming for several years may well be that the protracted period of time over which the sector's stocks have been performing poorly (in relation to the overall market average) only makes it more probable that the sector will soon begin to experience a reversal of fortune to the upside.

Momentum Investing

Momentum investing aims to profit from following strong existing trends. Momentum investing is closely related to a growth investing approach. Metrics considered in evaluating the strength of a mutual fund's price momentum include the weighted average price-earnings to growth (PEG) ratio of the fund's portfolio holdings, or the percentage year-over-year increase in the fund's net asset value (NAV).

Appropriate mutual funds for investors seeking to employ a momentum investing strategy can be identified by fund descriptions where the fund manager clearly states that momentum is a primary factor in his selection of stocks for the fund's portfolio. Investors wishing to follow market momentum through mutual fund investments can analyze the momentum performance of various funds and make fund selections accordingly. A momentum trader may look for funds with accelerating profits over a span of time; for example, funds with NAVs that rose by 3% three years ago, by 5% the following year and by 7% in the most recent year.

Momentum investors may also seek to identify specific sectors or industries that are demonstrating clear evidence of a strong momentum. After identifying the strongest industries, they invest in funds that offer the most advantageous exposure to companies engaged in those industries.

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