A mutual fund is an investment product made up of a pool of money collected from several individuals. The money is invested in fixed income, money market instruments, stocks, and other assets. Notably, diversification helps investors lower the risk of one particular sector or stock.
How mutual funds work
A mutual fund is managed by professional money managers who buy and sell securities. The fund managers allocate the fund’s assets and try to generate capital gains or income for the investors. Managers invest the funds to match the specified investment objectives, risk profile, and time horizon mentioned in the prospectus. The minimum investment in mutual funds ranges from $1,000–$5,000.
Mutual funds give small investors access to diversified and professional money management services at a low price. Each investor gets a proportionate share of the fund’s return. Mutual funds are classified into several categories based on their investment objectives. They are classified by the kind of securities they invest in and the type of returns they expect. Mutual funds charge investors an annual fee, called the “expense ratio,” to finance the expenses. A high expense ratio impacts the fund’s returns and vice versa.
The price of a mutual fund unit is the NAV (net asset value). The NAV is the price at which investors purchase and redeem fund shares. The price is determined by dividing the overall value of the securities in the portfolio by the overall outstanding shares.
Do mutual funds pay dividends?
There are four broad categories of mutual funds—equity, fixed income, money market funds, and balanced funds. Mutual funds pay dividends, interest, or both based on the securities held in the portfolio. Equity mutual funds only invest in the stock market. Also, equity funds are subcategorized based on their investment approach (income-oriented, value, or aggressive growth) and the market capitalization of the companies they invest in (large-cap, mid-cap, or small-cap).
Equity funds can also be categorized by whether they invest in foreign or domestic stocks. If a stock within the fund’s portfolio pays a dividend, then the mutual fund also distributes a dividend to the fund’s shareholders. A mutual fund distributes all of the dividend income to avoid paying taxes on the investment income. The same happens when a mutual fund generates a profit by selling an asset called a “capital gain.”
Similarly, bond mutual funds only invest in corporate and government bonds. Bonds pay a fixed amount of interest called “coupon payments.” Since bonds pay interest, the bond fund also pays interest.
Balanced funds invest in equities and bonds. Balanced funds are guaranteed to pay interest. These funds may also pay dividends if a stock within the fund’s portfolio pays a dividend.
Money market funds only invest in short-term debt instruments like municipal bonds. Also, money market funds pay interest to the fund’s shareholders.
When do mutual funds trade?
Investors can buy and sell mutual funds daily. However, mutual funds can only trade once a day after the markets close. The NAV is determined by the mutual fund at the end of the day at 4:00 p.m. ET. A trade will likely be executed within one to three business days. In comparison, stocks and other types of securities can be traded throughout each trading day on the secondary market. Usually, bond and equity funds clear within one day of the trade.