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 than 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 is 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 where 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 where 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 have a dramatic impact on the performance of an investment in the fund. They also vary widely by the specific 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 reduce that fee by 1% each year until year six 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. 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 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.

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