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How mutual funds make money

By David Luhman on Sat, 05/09/2009 - 23:54

How mutual funds make money

A mutual fund is an investment company

I hope you see that in comparison with banks and insurance companies, mutual funds offer the best combination of flexibility, low cost and the chance for higher returns.

But you should remember that when you invest in a mutual fund, you're not simply making a deposit like you do at a bank. With a mutual fund you're buying shares of stock in a company.

The company you're buying is an investment company. Mutual funds are in the business of investing in securities, much like Coca Cola is in the business of making soda. Their assets are different, but they both are out to enrich their shareholders.

How to make money in mutual funds

When you invest in a mutual fund, you become a shareholder, and you can make money in one of three ways.

First, you can make money off the interest and dividend payments made by the fund's underlying holdings.

Second, you can make money via the fund's trading activity. If a fund buys a stock and then sells it at a profit later, the fund must pass that profit on to you as an internally realized capital gain distribution.

Third, you can make money as the fund's assets appreciate. If the mutual fund buys and holds onto a stock, and that stock appreciates, the value of the mutual fund's shares will increase as well.

Money market funds offer interest & stability of principal

Various types of mutual funds allow you to make money in one or more of these three ways. For example, money market mutual funds will only distribute interest income to you. Their share price normally won't fluctuate, and they won't distribute internally realized gains or losses.

Each share in a money market mutual fund is almost always set to one dollar. This value of one dollar is not guaranteed, but to date no mutual fund geared to individual investors has returned less than the initial one dollar invested.

Money market mutual funds usually distribute their interest monthly. Remember, however, that this income isn't called interest because we're talking about an investment company. The interest distributions are actually called dividends.

Bond funds offer interest and gains or losses

Bond mutual funds invest in debt instruments like government and corporate bonds or mortgage securities that have longer maturities than money market securities. Over time, most of the money you make from bond funds will come from the interest payments paid by the underlying bonds.

However, as market interest rates move up and down, the value of bond fund prices will move down and up. Note that is in the opposite direction. If you buy a bond fund and market interest rates move up, the share price of your mutual fund will move down.

I discuss this phenomenon in my tape on bond investing, but just remember that bond prices move opposite to the change in interest rates.

Notice that as interest rates change, the value of the bond fund's share price will also change. This is quite different from money market funds. In money market funds the share price almost always remains one dollar, no matter what happens to interest rates.

In a money market fund, if interest rates change, you may get more or less interest income, but the value of a single share should remain one dollar. In bond funds, the value of a share may increase or decrease depending on market interest rates.

How to make money in bond funds

With bond funds, you can make money in all three ways. First, you'll make most of your money from the interest payments which are distributed monthly.

Second, the bond fund may make capital gains distributions once a year from gains and losses arising from the fund's internal trades during the year.

Finally, you may have capital gains or losses due to price changes in the fund's underlying assets. If you bought into a bond fund when interest rates were low, and you sell the fund when interest rates are high, you've probably sold your shares at a loss.

Note that you can lose money like this with any kind of bond fund, including a fund that invests entirely in US government securities.

How to make money in stock funds

Finally, like bond funds, you can make money in stock funds using any of the three methods. However, with stock funds, most of your return comes from capital gains distributions made annually by the fund, or through increases in the fund's assets.

You also should get some income from dividends that the underlying stocks pay to the fund, but most of the return will be in some form of capital gains.

Stock funds normally distribute their dividend and internal capital gain income once a year, usually in December. As with all types of funds, you can tell the fund to either send you a check for the dividend and internal gain income, or you can have the fund reinvest your money by buying new shares.

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