Believe it or not, modern mutual funds as we know them have been around since 1924. The first one in the United States was created by the Massachusetts Investors’ Trust in Boston, Massachusetts. Yet today, certain aspects of mutual funds still seem mysterious to many people. Of course, most people know that a mutual fund can invest in hundreds of stocks, bonds, or money market instruments. It’s a vehicle for making investments without the risk of losing your shirt over night.
But apparently one of the still mysterious questions is, “How do mutual funds make money?” I’ll do my best to put this mystery to rest.
There are actually two answers to the question. The first answer is that’s mutual funds can make money for themselves by charging their investors’ (you) fees. This requires a fairly involved explanation, and you can learn all about mutual fund fees and what you should do to avoid them by reading our article called The Truth About Mutual Fund Fees and Expenses.
The second answer is that there are 3 ways mutual funds make money for you and other investors. They include appreciation, dividends, and capital gains. Let’s examine each one, with the following fact in mind.
A stock fund manager is constantly buying and selling securities in an attempt to get the highest return possible on the money he or she is investing. It is through all of this activity that produces the following three profit and income components.
Here’s how to understand appreciation. Put yourself in the shoes of a mutual fund manager. Let’s say that you start out with 5 investors who provide money for you to buy 10 shares of stock associated with 10 companies. So that’s one share per company.
If each share of stock cost $1, that means the total value of your mutual fund portfolio is $10. Remember, you’re still the mutual fund manager in this example. So if you then divide $10 between the 5 fund shareholders, that means each of them owns the equivalent of 2 shares at a total value of $2.
Next, let’s say that a few weeks later, you notice that the price of 3 of the stocks has gone up to $1.25. That means the mutual fund has now appreciated in value by 75 cents. Its new total value has risen to $10.75.
The good news for the 5 mutual fund investors is that a small piece of the appreciation will be reflected in their their personal accounts. Now, the value of their shares is ($10.75/5 = $2.15).
So a fund’s appreciation is something that is reflected on paper. But of course, the investor could make money if he or she decided to sell their mutual fund shares right away at the new appreciated value. On the other hand, it’s just as possible for the prices of stocks in the mutual fund to fall and have the opposite depreciation affect.
The point is that mutual funds constantly appreciate and depreciate in value just like the stock market. But over time the trend should be one of consistent appreciation.
The stocks inside mutual funds are no different than those that are purchased by individual investors. With that said, there are some companies on the stock exchanges that pay out cash dividends to their shareholders on a quarterly or annual basis.
A dividend can occur when a company decides to distribute some of it’s profits to shareholders rather then reinvest it within the company.
As a mutual fund investor, you own a piece of all the companies in the fund. So if a company pays a dividend, the fund manager will pass along a share if it to you. It will be your choice to take the dividend as a cash payout or have it reinvested in the fund.
In many instances, a mutual fund manager may decide to sell off certain stocks even though they are now worth more than the original purchase price. For example, the fund manager might have purchased 100 share of a stock for $10, but now the going price in the stock market is $15. That’s a profit of $5 per share.
There are a variety of reasons why fund managers sell stocks. It could be that their research now shows that the stock is overvalued and about to take a nose-dive. So the smart thing to do is to lock in profits now.
When that happens, it creates a capital gain. The definition of a capital gain is the profits earned on the sale of an investment or asset.
So on an annual basis the mutual fund manager will offset the capital gains (profits) within the fund against any losses. Whatever capital gains or profits that are left over will be distributed to investors (you). Each investor can decide to accept the cash payout or request that the money be reinvested in the fund.
Okay, that’s it. Now you know the 3 ways mutual funds make money for their investors. And when you read or hear about a fund having a rate of return of 12%, 20%, or whatever percentage, all they’re doing is adding the three components together and expressing them as a percentage. So keep this in mind as you go forth and evaluate the performance of mutual funds.
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