A Simple Explanation of How Mutual Funds Work

Updated: February 28, 2023

What are mutual funds and how do they work? Let me explain through a simple story.

Imagine there are five friends: Allan the doctor, Bong the engineer, Charlie the commercial model, Dante the restaurant chef, and Eric the investment banker.

Allan, Bong, Charlie, and Dante all want to invest in the stock market, but they’re too busy with their careers. So they decided to pool their money together and give it to Eric, who agrees to invest it on their behalf.

Allan gave P10,000, Bong gave P20,000, Charlie gave P30,000 and Dante gave P40,000. The P100,000 total money that Eric now has is called the mutual fund.

The four friends are confident that Eric can make it grow because he is an investment banker by profession; and thus becomes the mutual fund manager.

Eric is a good friend, but he’s not doing the investing for free. He tells his friends that he will ask for a management fee of 1% per year. This means Allan will pay him P100, Bong will pay him P200, and so on. Eric is now P1,000 richer.

Eric decides to buy shares of Company Z at P10 each; so he ends up with 10,000 shares. These shares don’t belong to Eric, they belong to his four friends.

So to make everything clear, Eric gives Allan a certificate that he owns 1,000 shares of Company Z. He does the same for Bong (2,000 shares), Charlie (3,000 shares), and Dante (4,000 shares).

After a year, shares of Company Z become valued at P15 each; and all the investors decide to redeem their shares.

The 1,000 shares of Allan now have a value of P15,000. The same goes for Bong (2,000 shares at P30,000), Charlie (3,000 shares at P45,000), and Dante (4,000 shares at P60,000).

But Eric, being the smart investment banker that he is. Tells them that they have to pay a redemption fee of 5%. This means Allan will pay Eric P750. It’s the same for Bong (P1,500), Charlie (P2,250), and Dante (P3,000).

Thus, Allan will receive P14,250, Bong will get P28,500, Charlie will have P42,750 left, and Dante, P57,000. And in the end, everybody is happy.

What you just read is a simple analogy of how mutual funds work.

In reality, the investors of mutual funds are thousands of people and not just four people. The entity that collects the pool of money is called the mutual fund company, and the one who invests the money is called the mutual fund manager.

The mutual fund manager is a professional investor, that’s why you can trust him or her that your money will grow. But of course, the mutual fund manager and the company will not do the investing for free.

Mutual fund investors will typically have to pay:

1. Periodic fees such as management fees and account fees.
2. Transaction fees such as purchase fees and redemption fees.
3. Sales load fees such as front-end loads and back-end loads.

Not all funds ask for these fees. Be sure to read carefully the fund prospectus to know what kinds of fees you actually have to pay when you invest.

Moreover, front-end load rates depend on how much you will invest. The higher the investment, the lower the rate. Meanwhile, back-end load rates depend on how long you will invest. The longer you redeem, the lower the rate.

The good news is that some funds will waive the back-end load or redemption fee if you invest for more than 5 years. Furthermore, you should know that not all funds have front-end and back-end loads, those are called no-load mutual funds.

Lastly, index funds typically have lower management fees.

Quick Questions and Answers About Mutual Funds

How do I know the value of my shares?

Just ask your mutual fund company for the NAVPS or Net Asset Value Per Share of the mutual fund and multiply that by the number of shares you own. To know if your investment is doing good, the product should be greater than the amount you originally invested.

Do I have to pay taxes from the income?

In essence, yes – but don’t worry! The withholding taxes are already incorporated into the NAVPS and you don’t have to report your income to the BIR because that’s already being done for you by the mutual fund company.

What happens if the mutual fund company closes?

You will be compensated according to the provisions of the securities where the mutual fund company invested. This is a complicated legal matter, and you should cross the bridge when you get there.

Suffice to say, it’s much simpler to think that if the mutual fund company closes, then you should just say goodbye to your money because mutual fund investments are not insured with the PDIC.

That’s why you must invest only in reputable mutual fund companies.

How do I choose the best mutual fund company where I will earn the most?

That’s a hard question to answer. My advice is to just choose the one whose office is convenient for you to go to.

Of course, you can also base it on the historical performance of the fund; but even that is not a guarantee that your fund will do well in the future.

Mutual fund managers are people too, who can make mistakes; and like employees, they too can resign and transfer to another mutual fund company.

How long should I invest in a mutual fund?

For money market funds, at least one year. For bond funds, at least three years. And for balanced and equity funds, at least five years. This is just my opinion by the way.

A List of Mutual Fund Resources:

Here are the past articles I’ve already written about mutual funds:

• Mutual Fund Companies in the Philippines
• Advantages and Disadvantages of Mutual Funds
• Mutual Funds vs Unit Investment Trust Funds
• The Benefits of Investing in Mutual Funds

I hope you all learned something today. For those who haven’t yet, I’d appreciate it if you can subscribe to Ready To Be Rich below. Thanks!

What to do next: Click here to subscribe to our FREE newsletter.
———
Photo credits: choctruffle, guin and the-tml