Often when you set out to make savings, mutual funds often come across as one of the most dependable sources of investments. You can consider them as options with minimum risk exposure and relatively stable returns. Often mutual funds are seen as those magic instruments that will help you beat market trends. While one can consider them as an instrument to make money, have you ever wondered how do mutual funds make money? Well, that is a complex mechanism. Most importantly, you would need to understand how mutual funds work. It is often important to understand their structure to get a clear idea of the revenue flow.
What Are Mutual Funds?
In this context, one of the first questions that would come to mind is what exactly are mutual funds? Only then, can you get anywhere closer to how do mutual funds make money. In very simple terms, mutual funds are a collection or a portfolio of stocks, Index funds or bond or a combination. One of the simplest examples could be that of a big corporate. Just like them, a mutual fund brings together several individuals and groups of people. It helps them make money by investing in a select number of stocks or Index funds.
Often the share of the portfolio that a mutual fund investor holds is, in reality, a part of the holding that the main fund creator has conceptualized. Every bit of the mutual fund holding is an extension of this. So one aspect is very clear:
Mutual funds make money is closely linked to how investors in mutual funds realize their returns. Often the two elements are very closely interlinked, and you could say that one is an extension of the other.
How Do Mutual Funds Make Money?
You can normally follow the overall methodology in which investors make money in mutual funds. If you do so, you will notice that there are broadly three most important aspects of the overall procedure. The revenue inflow is dependent on:
Whatever stocks or bonds that you might have in the mutual fund portfolio, you earn the dividend or interest that comes with them. In fact, this is often a key indicator on how you make money and how the mutual funds you are dealing with earn from them. Often as part of a standard operational procedure, a fund owner receives all the income due to a fund for distribution. Normally as an investor, you get an option to either get this distribution as a check or this amount could be reinvested into the same fund. Finally, you could end up investing in more shares using the same amount. The investor’s choice with respect to this distribution can significantly alter the scope of your and the fund’s income prospects.
2. Utilizing Capital Gains:
This is another symbiotic channel of income for both the mutual fund and its investors. When prices of the securities that a fund is selling increase, the fund sees the capital gain. This is generally passed on to investors in the distribution channel. Alternatively, mutual funds see capital gains even if fund holding increases. Even if a particular mutual fund manager does not sell this, the fund’s share will anyway see an increased price structure. As an investor, you could then sell these mutual funds for a profit in the open market. Therefore, the link between how do mutual funds make money and the way mutual fund investors earn money can be easily established in a sustainable fashion. The point that comes to the forefront now is that how exactly mutual funds function to generate this type of earnings.
How Do Mutual Funds Work?
One of the most important factors that contributed to the popularity of mutual funds is their flexibility and low-risk profile undoubtedly. The chances of higher returns and the comparatively lower cost of transaction almost make you overlook the expenses involved in investing in mutual funds. You have to understand that this isn’t about going to the bank and depositing some money in the savings account. It involves series of complicated measures. After all, you must remember investing in mutual funds is also about owning shares of a firm. The assets that you own are then used to generate further wealth.
You can choose to relocate this wealth for buying more assets. But how do they make this business profitable for themselves is that crucial question that could even put the most astute investor on the backfoot. The question is why are most people unsure about how mutual funds operate and make money for themselves?
This is particularly disconcerting because all these mutual fund investors who blindly believe in the power of this investment tool would benefit largely if they had a clear idea of how these funds operate. In fact, better grasp of how mutual funds make money could actually help the average investor in saving a considerable amount of money that they lose in the form of charges or load factors and the like. In fact, they could invest with lot more clarity and considerable depth of understanding. Perhaps investors armed with better knowledge of this investment instrument would help themselves make money faster with the amount that they invest in mutual funds.
– Getting Information About Mutual Funds Is Not Difficult
As per the provisions of the US Exchange body, the Securities and Exchange Commission, every mutual fund needs to disclose complete details fees that shareholders have to pay. The prospectus also lists out other expenses incurred by the fund. For investors to understand how do mutual funds make money, they have to simply read the fees table a lot more minutely and pay attention to all the details provided therein. You have to understand that the fees table is most times the biggest indicator and can most times provide the most distinctive set of information. For any mutual fund worth its salt, the fees often constitute the largest chunk of revenue inflow for them. While it is possible that some mutual fund managers might take a company specific call about making additional investments, the role of fees cannot be undermined at all.
They invariably contribute the largest chunk of fund inflow. A close study of the fees table would indicate the long list of fees that you need to pay. These include:
- Sales charges or popularly known as mutual fund load
- Deferred sales charges
- Purchase fees
- Account fees
- Redemption fees
- Exchange fees
– The Fee Structure Relates to How Mutual Funds Make Money
The fee structure, therefore, brings us to the moot point of discussion in this entire article, how do mutual funds make money?
Well you have understood the role played by the various fees levied on your mutual fund investment but that is not all. That cannot suffice to generate the kind of profitability that makes this investment instrument a popular alternative for not just investors, but also all those who make a business of investing your money. In fact, all these various line-ups of different fees gain importance from the way they are levied and from where they are being charged. Not only does it make a telling impact on the revenue structure of the mutual funds but often makes all the difference in their overall profitability.
For example, when you consider the most basic fee, ‘sales charge fee,’ it is most commonly known as the load factor in the world of MF investment. This fee is essentially triggered when an investor buys a mutual fund unit or takes ownership in a share through mutual funds. So apart from the market-determined cost of the share that you are buying as a mutual fund, you have to pay an additional amount for buying it. On an average, this could be as much as 5% of the share value. Now the mutual fund company which created the fund do not keep the entire amount that they levied as sales fees. In fact, a major chunk is distributed amidst the brokers and fund managers who helped sell the fund and convert it into a popular investment tool. So, in short, they make money as they guide you about how to make money.
The Revenue Sharing Model of Mutual Funds
There are many aspects of the overall revenue sharing model of mutual funds. Only when you grasp them in totality, you would be able to understand how mutual funds make money. Let us first start with mutual fund loads. You might think we already discussed sales charges, but that’s only a part of the entire narrative. To start off with, there are diverse types of loads that are levied by the fund operator. It could be:
1. Front-End Load:
This amount is deducted from your final investment amount, the moment you buy these mutual funds. According to the FINRA or Financial Industry Regulatory Authority, the front-end load needs to be about 8.5% or lower than that. Under no circumstance can you look at increasing this amount. In very simple terms, this means that when you buy $1000 worth of mutual funds, the company actually buys for $950 worth of MFs actually. The rest of the $50 is deducted as front-end load charges.
2. Back-End Sales Fees:
As the name indicates, this type of fees is levied when the mutual fund is sold. This fee is therefore often seen as deferred payment as well. While in the initial years of owning a mutual fund, this fee can be very large, by the time investors reach the end of the tenure it reduces to even in some cases. The back-end fees on account of sales charges is often known as redemption fees. Quite unlike the front-end fees, this is more or less, claimed by the fund in entirety. Hardly any amount is paid to the broker in this case.
3. Management Fees:
The next in the list of crucial fees that is important in understanding how do mutual funds make money, is undoubtedly management fees. This is particularly relevant for successful and liquid mutual funds. The basic logic is that the more successful a mutual fund is, the more trading interest will it generate. This means that the relative liquidity of the fund will determine the inflow. The more actively traded a mutual fund is, the greater would be. Therefore, more trading equal more fee inflow in this case.
The Operating Expense of Mutual Funds
Apart from the gamut on fees levied by mutual funds, they also make money in terms of charging for the operational expenses that these firms incur in general. There are many expenses that are borne by most mutual fund companies. Apart from the large cross-section administrative employees that they have to recruit, they also have to bear the expenses of
- Paying various advisors including research analysts
- Employing tools of publicity
- Distribution fees to brokers
- Handling cost of running regular operations
The mutual fund fee structure levied to customers is aimed directly at recouping this entire gamut of expenses that they bear. The only exception to this rule is perhaps the management fees that mutual funds levy on their more liquid offerings. These are never charged as fees directly to the customer. As the US Securities and Exchange Commission specifies, the mutual funds can make money from management fees but only when they are paid out of the fund’s asset base. This is exactly why the fees table lists this as a standalone entity, and it is never bunched up together as other expenses. This will enable any average investor to clearly understand how much money the mutual fund made and from what fund and the time frame. The specific listing of the different fees not only helps the investor get a fair idea of the various revenue channels but also adds a decidedly strong layer of transparency in these dealings.
1. The Distribution Fees in Mutual Funds
When you ask a mutual fund investor about the potential fees that they know of, the distribution fees wins hands down in terms of awareness amongst the investors. However, for most, the common term of reference, in this case, is “12b-1 fees.”
This fees is generally levied to the buyer to recover the expenses that were incurred in the creation and marketing of the same fund. You must understand that creation of a new fund involves a lot of cost like printing as well as distribution of prospectus to investors. Even distribution and awareness about the mutual fund becomes a necessary expense for the fund manager. As competition in the mutual fund space increased, investors have increasingly become aware of this 12b-1 fees. It is needless to mention that has also led to rationalization and even narrowing of the fees.
Lower Fees to Attract More Customers
In an effort to woo more and more customers, it became necessary for them to keep these charges minimum. The general reaction was to buy these as invariably investors wanted to make money by spending as minimum as possible. The type of mutual fund also impacted the overall cost to a significantly large extent. If you considered buying a Class A shares, it invariably tends to carry front-end loads. As a result, the distribution charges or the 12b costs are also on the lower side.
Often mutual funds also brought down this cost on the basis of the exact investment that you might have made in the fund. This is a popular technique used by fund managers to make money. They give up a certain amount of expense on a per share basis in the hope to attract more buyers and greater volume sale. However, for Class B and Class C shares, the expenses tend to be significantly higher and the resultant fees as well.
2. The No Load Mutual Funds
We all understand the dynamics of competition, and that plays a crucial role in how mutual funds make money. While it is true that the fees comprise of the most sustainable source of revenue for these mutual funds, it is also a unique that they have in terms of safeguarding or stirring up a better response for their products. As a result of the stiff competition and the need to score better over the other players in this field, many mutual funds have given up on this key fees and introduced zero load or ‘no-load’ mutual funds. But most times, it is more of a marketing initiative and funds have introduced, and they levy the distribution charges indirectly to recover the losses.
According to the 12b-1 provisions, if the distribution charges do not exceed 0.25% of the total cost of the funds, it is referred to as a no-load fund. The Vanguard Fund is one of the best examples of a no-load mutual fund. But that in no way means that they are giving up on any amount of the fees or income source. Normally, these no-load mutual funds also significantly cut down expenses to rationalize the lower fees that they charge from customers. The investment strategy as well is more passive for these type of mutual funds. They do not have an active day to day fund management in an effort to cut down cost and help them make money.
3. Active vs Passive Mutual Funds
That brings us to take to the next point of concern in terms of deciding on how mutual funds make money. An actively managed fund is charged differently while passive mutual funds have a different kind of expense sheet. You must understand that when a fund is actively managed, it needs a lot more staff and administrative expenses to ensure smooth day to day functioning. A relatively more number of staff members also has to be employed to make sure that the fund’s growth is maintained. On the contrary, a passive mutual fund is, as the name suggests, needs a lot less follow-up on a day to day basis. They function on the basis of a pre-decided strategy.
These funds normally take reference and try to match up to the performance of a specific market index and are far less dynamic in its overall approach. They require almost no management of funds, and you pretty much invest in these on the auto-pilot basis. Normally the active funds also carry a significantly larger potential for returns and can yield better value than the benchmark index at certain points of time. But the passive mutual funds are relatively less expensive given the significantly lesser expense involved in managing them.
The Basic Demand-Supply Matrix as Well as the Cost-Return Potential
Therefore, when you are trying to understand how mutual funds make money, you must also analyze the basic demand-supply matrix as well as the cost-return potential. The money you make and the money that mutual funds make is in many ways linked to the cost and the demand that is seen by different funds. You must also understand that the cost of a mutual fund also impacts the overall risk profile. When you have an actively managed fund, it is needless to mention that the relative risk in it is also higher. They have a higher chance of outperforming the benchmark index.
Similarly, they also take a lot more risk in achieving that. As a result of it, these funds carry a higher expense tag along with them. In comparison, the passive mutual funds have a pretty predictable strategy and are not as risky as the active ones. For those who do not mind a little less return, a little less risky but a stable rate of returns, these could be the best option. While both you and the mutual fund make money, the extent is significantly moderated.
4. The Low Load Funds
When you are analyzing the details about how mutual funds make money and the correlation between load and expenses involved, another type of mutual fund that you might want to explore is the ones with low load factor. As you can understand from the name, it levies lower fees or is a low load fund. They charge close to 3.5% as sales charges opposed to the standard 8.5% that you associate with a regular mutual fund. While they might not be as actively managed, as the active mutual funds, they still offer reasonably good prospects to investors. The low load funds invariably pack in lesser features that your regular active mutual funds but at the same time they are a lot more stable with a reasonable return prospect. As you would have noticed in the case of a no-load mutual fund, the investment strategy is significantly pre-decided. In order to cut cost and make it a more value proposition for investors, mutual fund managers cut down many avoidable expenses involved in their operational and execution strategy. Often you can liken the cost and returns link in mutual funds to pretty much how no frill accounts in banks operate.
The Money Dynamics of Mutual Funds
Therefore when you set out to analyze how do mutual funds make money, you have to pay attention to some basic factors. Not only do they contribute to the way a mutual fund cost but in many ways, they become the key factors that determine the expenses incurred by the mutual fund creator. It is needless to mention that your prospects to make money are also directly dependent on the appropriate balance of these factors.
1. Risk Profile:
The higher the prospects of making money, the better the chances of returns from the mutual fund also means the higher the expenses involved in buying that fund. You must understand that the fund creator is employing that additional energy and effort in creating the fund and monitoring the returns that actively. In many ways, this is what ensures the significantly higher returns. But that also means that the mutual fund company is also spending more to achieve that level of excellence and brilliance that enables the fund to outsmart the market index and the benchmark.
2. Degree of Management:
Whether you are opting for an active or a passive mutual fund does not simply dictate the kind of returns that you can expect from it. In many ways, this is also a crucial factor that determines the cost that is involved in buying the fund. When you opt for a more active mutual fund, the creators and managers of the fund have to utilize lot more energy and resources into managing it. This means they are also incurring higher expense in maintaining the standards of the fund. The passive mutual funds have a lot more pre-decided strategy at work, and constant monitoring is not in place. Hence the mutual fund company charges far less from you for these.
3. Regulatory Requirement:
Different types of mutual funds have different requirements in terms of regulatory expenses. It is needless to mention that the mutual fund creator will not pay these expenses on their own. They will adjust in the various fees that they levy on the customer. They also make money from the buyers who invest in these funds. For example, the active mutual funds can levy about 8.5% as distribution fees. But the low load mutual funds levy about 3.5% as distribution charges. Therefore, do you want to analyze how do mutual funds make money?
If so, it is important to understand that they operate like any other business. The cost and expenses they incurred are recovered from the buyers, and the difference is how they make money from the entire operation. Overall the mutual fund bases its load factors in a way that balances the cost involved in creating it and the kind of profit that they hope to earn from this entire transaction.