What it means
A fund's unit price is its net asset value, calculated once a day by valuing every holding, deducting liabilities and dividing by the number of units in issue. Unlike shares, units are bought and sold at that end of day price rather than trading continuously through the session.
Funds fall broadly into active and passive camps. An active fund pays a manager to pick investments in the hope of beating a benchmark, while a passive or index fund simply tracks a market index at a far lower cost.
Fees deserve close attention because they are charged every year on the whole balance, not just on gains. The ongoing charge, often quoted as an expense ratio, is deducted from the fund's assets before performance is reported, so an advertised return is already net of it.
The diversification benefit is genuine and is the main reason funds exist for smaller investors. A single $500 purchase can buy exposure to hundreds of companies, which no individual could assemble directly without punishing dealing costs.
The trade offs are worth stating plainly. You give up control over individual holdings, you cannot trade intraday, and in many jurisdictions gains realised inside the fund can create a tax charge for you even in a year when you bought nothing and sold nothing.
In practice
Real-world examples
Example 1
A first time investor puts $200 a month into a global index fund inside a workplace scheme. The single monthly payment buys a slice of well over a thousand companies, something impossible to replicate by buying shares directly at that contribution level.
Example 2
A charity's trustees compare two bond funds with almost identical portfolios and near identical performance before costs. They switch to the cheaper one, cutting the annual charge from 0.85% to 0.35% and saving $10,000 a year on a $2 million holding.
Example 3
A company pension committee reviews a poorly performing active fund and finds it has quietly come to resemble its benchmark. The committee replaces it with an index tracker, on the basis that it was paying active fees for close to passive behaviour.
Think of it
Mutual fund pools money from investors to buy many securities-professional management.
Formula
Calculation
Net asset value per unit = (total assets - total liabilities) / units in issue
Annual fee paid = amount invested x expense ratio
An equity fund holds investments and cash worth $850 million and owes $10 million in accrued fees and unsettled trades, with 42 million units in issue. Net asset value per unit = ($850 million - $10 million) / 42 million = $840 million / 42 million = $20.00 per unit.
An investor placing $10,000 therefore buys $10,000 / $20.00 = 500 units. If the fund's expense ratio is 0.75%, the annual cost is $10,000 x 0.0075 = $75, taken from fund assets rather than billed separately. Against a passive alternative charging 0.10%, or $10 a year, the active fund must beat the index by at least 0.65 percentage points annually just to leave the investor level.Case study
Seen in the real world
This example is illustrative and entirely fictional. The trustees of the invented Elmwood Community Trust held $4 million across eleven mutual funds accumulated over two decades, each added by a different trustee with a different favourite manager. Nobody had ever added up the total annual cost.
A new treasurer in this fictional scenario worked it out: a weighted average charge of 1.12%, or roughly $45,000 a year, and an underlying portfolio so overlapping that three of the funds held largely the same twenty companies. The diversification the trustees believed they had was mostly duplication.
Elmwood consolidated into four funds with a blended charge of 0.28%, saving about $34,000 a year, money that went straight into grants. Performance over the following three years was unremarkable, which the treasurer regarded as the point rather than a disappointment.
Watch out
Common mistakes
- Choosing a fund on last year's performance, which is a weak guide to the next year and often means buying at the top of a hot sector.
- Treating fees as a rounding error, when a one percentage point difference compounds into a very large sum across twenty years.
- Believing that owning six funds means real diversification, when they may hold substantially the same underlying companies.
Questions
People also ask
How is a mutual fund different from an exchange traded fund?
The economics are similar, but an exchange traded fund trades continuously on an exchange at a market price, while a mutual fund is dealt once a day at net asset value.
What does the expense ratio actually cover?
Management, administration, custody and audit costs, all deducted from fund assets, though it usually excludes trading costs incurred when the manager buys and sells.
Can a mutual fund lose money?
Certainly, since the units are worth whatever the underlying assets are worth, and there is no guarantee of capital in an ordinary fund.