Mutual funds are professionally managed investments that hold a variety of assets like stocks and government and corporate bonds. Investing in mutual funds lets you earn returns based on the dozens of stocks and other assets a mutual fund owns without actually buying dozens of individual assets yourself. Despite the benefits of diversification and professional management, investors should be aware of issues like fund expenses, taxation and limitations on trading.
Fees and Expenses
Mutual fund managers are, of course, paid for their work. So mutual funds charge an annual fee called an "expense ratio" to pay for the fund's annual operating costs, such as the cost of paying managers, marketing and selling fund shares and providing shareholder services. Expense ratios can range from hundredths of a percent to 1 or 2 percent, depending on the fund's expenses. Investors may also face transaction fees when buying or selling shares.
Mutual fund investors can earn income in three forms: capital gains, dividends and capital gain distributions. All three forms of compensation are subject to federal taxation unless you hold funds in a tax-deferred retirement account like a 401(k) or IRA. Capital gains are profits you realize when you sell an asset at a price that is higher than the amount you paid. Capital gains you make from selling shares of mutual funds and other assets are subject to a maximum long-term gains tax rate of 15 percent if you hold an investment longer than a year and a tax rate equal to your normal income tax rate if held a year or less. Dividends are taxed at your normal income tax rate unless you meet certain holding period requirements, in which case they are taxed at the long-term gains rate. When mutual fund managers sell assets a mutual fund owns, the sale of the assets may result in a capital gain for the fund itself. Mutual funds are required to distribute capital gains they make that are not offset by losses to shareholders as payments called capital gain distributions, which are subject to the long-term capital gains rate. Even if you reinvest this distribution in the fund, you still must pay tax on it.
Mutual funds are defined as either "open-end funds" or "closed-end funds." Open-end funds are the more popular of the two versions; the term "mutual fund" is usually synonymous with open-end fund. Open-end funds can have an unlimited number of shares, and the value of shares is determined directly by the value of underlying assets the fund holds. Fund shares can only be bought and sold at the end of the day after the stock market closes and the value of the fund’s assets can be determined. With open-end funds, the value of assets might not be calculated until hours after investors place buy or sell orders, so investors may not know the exact price they end up paying for shares ahead of time. In contrast, closed-end funds have a fixed number of shares and trade on exchanges similar to stocks.
Buying shares of stock in a corporation gives the shareholder certain privileges, such as the right to vote on certain corporate decisions and to elect board members. A stock shareholder with a large stake in a corporation may have a significant amount of influence over the company's decisions. Mutual fund shareholders can't influence management decisions, such as which assets the fund buys and sells.
- U.S. Securities and Exchange Commission: Invest Wisely -- An Introduction to Mutual Funds
- Internal Revenue Service: Investment Income
- Internal Revenue Service: Sales and Trades of Investment Property
- Financial Industry Regulatory Authority: Mutual Funds
- CNN Money: Mutual Fund Fundamentals
- MSN Money: Mutual Funds and Taxes
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.