If you’re thinking about entering the world of stocks and shares for the very first time, you might be concerned about which companies to invest in.
The good news is that mutual funds remove the need to choose individual shares – as the provider in question will buy and sell stocks on your behalf. In return, you will need to pay a small fee – which is usually less than 1% per year.
In this guide, we explore the ins and outs of how mutual funds work – and why they are highly sought after by newbie investors.
- 1 What are Mutual Funds?
- 2 How do Mutual Funds Work in the UK?
- 3 How do I Make Money From a Mutual Fund?
- 4 How Much Does it Cost to Invest in Mutual Funds?
- 5 What is the ‘Redemption’ When Investing in Mutual Funds?
- 6 How to Choose a UK Mutual Fund?
- 7 Lump-Sum, Regular Payments, or Both?
- 8 How to Invest in a Mutual Fund?
- 9 Conclusion
- 10 FAQs
What are Mutual Funds?
Mutual funds are offered by large financial institutions. They allow both retail and professional clients to invest money into the mutual fund, who in turn, will buy and sell shares on your behalf. Your money will be pooled together alongside thousands of other investors of all shapes and sizes – subsequently giving the mutual fund a multi-billion pound war chest.
This then allows the fund to access stock markets that would otherwise be difficult to reach. The main attraction of mutual funds for newbie investors is that the entire process is passive. That is to say, once you inject money into a mutual fund, nothing else needs to be done.
As we cover in more detail later, this ensures that you get to access to the UK and international stock markets without needing to have a single inch of trading knowledge. More specifically, you will be entrusting your investment funds with a proven trading house that will have vast resources under its belt. As such, mutual funds will typically strive to outpace the wider stock markets.
This will, however, come at a fee – which is often less than 1% per year. In terms of making money, this can come in two forms. If the mutual fund holds dividend stocks, then you will be entitled to your share of payments. The mutual fund will also look to increase the value of your investment through capital gains. Put simply, this means that it will look to buy shares that it can then sell at a higher price in the future.
How do Mutual Funds Work in the UK?
Investing in a mutual fund couldn’t be easier. You simply need to find a UK broker that gives you access to the mutual fund, decide how much you wish to invest, and that’s it – the rest is taken care of. In fact, you don’t need to do anything until you decide to cash your investment out.
As straight forward as the investment process is, we would still suggest that you brush up on your knowledge of how mutual funds work. After all, you are going to be investing your hard-earned money.
- Let’s suppose that you invest in a mutual fund that buys and sells UK shares
- As such, its portfolio might contain shares in Royal Mail, Tesco, BP, HSBC, Barclays, and many others
- You decide to invest £10,000 into the mutual fund
- The mutual fund will then actively manage its portfolio by buying and selling shares
- The value of your investment will go up and down depending on how the portfolio performs
It is important to note that the above process of buying and selling shares on your behalf is super-transparent. In fact, mutual funds are typically listed on public markets like the London Stock Exchange – which in itself ensures that the fund is required to release information on what shares it holds.
How do I Make Money From a Mutual Fund?
Much like an ETF, you can make money in two key forms when investing in a mutual fund – capital gains and dividends. As it is important for you to understand how each revenue stream works, we first need to explain how the NAV will determine how much money you are making or losing when you invest in a mutual fund.
Net Asset Value (NAV) of a Mutual Fund
When you invest in shares in the traditional sense, it’s simple to figure out how much you are making or losing.
- For example, if you buy 100 shares in Facebook at $200 per stock – you have invested $20,000
- If the shares increase to $250, your investment is then worth $25,000
- As such, you’ve made a profit of $5,000
However, in the case of mutual funds, things are a bit more complex. At the forefront of this is the Net Asset Value (NAV) of the fund. In its most basic form, the NAV is the total value of the assets the mutual fund is holding on behalf of its investors. This figure is taken by adding all of the shares that the fund has in its portfolio, at the current market price.
- Let’s suppose that the mutual fund is holding 100 shares in IBM, Apple, and Amazon
- For the purpose of simplicity, we’ll say that each share is worth $50 at the start of 2020
- As such, the fund has $5,000 invested in IBM, $5,000 in Apple, and $5,000 in Amazon
- This means that the NAV of the mutual fund is $15,000
- If at the end of 2020 each of three shares were collectively worth $7,000 each – this would mean that the NAV would have increased to $21,000
Of course, this is a super basic example, as mutual funds typically hold billions of pounds worth of shares in their portfolio. But, the key point here is that the NAV is the most effective way of assessing how much your investment is worth.
The good news for you is that – as we noted earlier, mutual funds are usually listed on a public stock exchange. Not only does this make it easy to invest, but it also means that you can assess the value of your investment at the click of a button. Crucially, the mutual fund is required to report its NAV each and every day – which is subsequently reflected in its share price.
So now that you know how the NAV works, we can then explain how this translates into capital gains.
In simple terms:
- If the NAV of your chosen mutual fund increases, as will the value of your investment
- If the NAV of your chosen fund decreases, as will the value of your investment
For example, let’s supposed that you invest £10,000 into a mutual fund when its NAV is £2 billion. A few years year, the NAV is now worth £3 billion – representing a gain of 50%. On an initial investment of £10,000, your money is now worth £15,000. But, you will not be able to realize this 50% increase unless you exit your position. That is to say – and much like a traditional stocks and shares investment, you would need to sell your stake in the mutual fund before you can get your hands on the money.
When you do, your profits will be liable for capital gains tax. You can read our UK Tax on Shares Guide here.
On top of capital gains, mutual funds are also great for earning regular income in the form of dividends. Once again, the process is slightly different in comparison to buying dividend shares in the traditional sense, as everything goes through the mutual fund. Crucially, if the mutual fund that you invest in does hold shares in companies that distribute dividends – you will be entitled to your share.
- Let’s suppose that your chosen mutual fund holds shares in Tesco, and it receives four quarterly dividends at an annualized yield of 4%
- Tesco makes up 10% of the mutual fund’s portfolio
- You have £20,000 invested at the mutual fund
- In effect, you have a £2,000 stake in Tesco shares via the mutual fund, as it makes up 10% of the portfolio (10% of £20,000)
- This means that 4% in dividends on a £2,000 stake amounts to an annual return of £80
Once again, the example above is somewhat arbitrary, as there are many variables that will dictate how much you can earn in dividends.
For example, while the mutual fund might buy and hold Barclays shares for many years, in other cases, it might hold on to GlaxoSmithKline shares for a few months before selling them on.
Either way, we should also note that you will not get the dividends on the same date that they are distributed by the company. Instead, you will likely receive a lump sum payment from the mutual fund once every three months.
This is because the fund itself will potentially receive dividends throughout the week, so it would be inefficient for it to constantly be forwarding on payments to all of its investors.
How Much Does it Cost to Invest in Mutual Funds?
If you’ve read our guide up to this point, then you will know that mutual funds are 100% passive. That is to say, once you make an initial investment, there is nothing else for you to do – as the fund manager will determine which shares to buy and sell, and when. As you might have guessed, this will come at a cost. However, the fees associated with mutual funds are usually very competitive.
Nevertheless, let’s break down the main fees that you need to be aware of when using a mutual fund in the UK.
Annual Maintenance Fee
Irrespective of which mutual fund you decide to invest in, you will always pay an annual maintenance fee. This will be a percentage of the amount you have invested with the fund.
For example, if you have £15,000 invested at the fund and the annual maintenance fee amounts to 0.5%, then you will pay £75 per year.
Most mutual funds give you a more favourable rate if you invest larger amounts – but this often requires at least £100,000. Nevertheless, you will rarely find that the annual fee amounts to more than 1%.
No Share Dealing Charges
In all but a few cases, mutual funds will not charge you any share dealing fees. Ordinarily, when you buy and sell shares on a DIY basis, you are charged a flat fee. For example, whether you buy £50, £100, or £1,000 worth of shares at Hargreaves Lansdown – you will still pay a flat fee of £11.95. However, when you invest with a mutual fund, you rarely need to pay any fees when the provider buys and sells shares.
All in all, many would argue that for the service you get – i.e. an experienced fund manager that buys and sells shares on your behalf – at sub-1% this is an incredibly good deal. Sure, you can avoid this fee by picking and choosing shares on a DIY basis, but you need to ask yourself whether you are going to be able to do this as effectively as a mutual fund that has vast resources under its belt.
What is the ‘Redemption’ When Investing in Mutual Funds?
In a nutshell, ‘redemption’ in the context of mutual funds simply refers to the process of making a withdrawal. That is to say, you redeem the money you initially invested. There is no hard and fast rule when it comes to the redemption of mutual funds, so this is something that you must check before parting with your money.
- A minimum ‘redemption period’ is the number of months or years that you are unable to withdraw your money out of the mutual fund. For example, if the redemption period is 12 months, this means that your money is locked away until one-year passes.
- A ‘redemption fee’ is the amount of money that you will be charged to take your money out. This is typically a percentage fee of the amount you decide to withdraw.
Now, the good news is that heaps of mutual fund providers – whether you go direct or through a third-party broker, have no minimum redemption period or redemption fee – which is great. As such, it’s mainly just the annual maintenance fee that you need to factor in.
How to Choose a UK Mutual Fund?
On the one hand, investing money with a mutual fund as opposed to learning how to pick stocks will make your life significantly easier. After all, once you part with your money you do not need to do anything else until you make a withdrawal.
On the other hand, you still need to spend some time thinking about which mutual fund you want to invest in! Crucially, there are hundreds of mutual funds active in the market – each of which will target a specific niche within the stocks and shares space.
- FTSE 100: Some mutual funds will simply look to track the FTSE 100. In other words, they will buy shares in the 100 companies that make up the FTSE 100.
- FTSE All-Shares: To obtain even more exposure to the UK economy, the mutual fund might choose to invest in the 600-ish companies that make up the FTSE All-Shares Index.
- International: Some UK mutual funds will target stocks and shares listed on international markets. Many will focus on the New York Stock Exchange and NASDAQ – so its portfolio will contain the likes of Disney, Apple, Facebook, IBM, and Amazon.
- Emerging Markets: Mutual funds might invest some, or all, of its capital into the emerging markets. This means that they will be buying and selling shares that are listed in South Africa, Brazil, Vietnam, and India – to name a few.
- Dividends: Some mutual funds will focus exclusively on shares that pay dividends. This is ideal if you want to earn passive income on a regular basis.
- Sector-Specific: Some mutual funds will target specific sectors. For example, a tech-oriented mutual fund might buy shares in Apple, Microsoft, Netflix, IBM, and Uber.,
Crucially, you need to understand the type of marketplace, sector, and risk that your chosen mutual fund is targeting. As a side tip, it might be worth diversifying even further by backing several mutual funds – all of which targets a different niche of the stocks and shares space!
Lump-Sum, Regular Payments, or Both?
Once you have assessed the type of mutual fund that you wish to invest in, not only do you need to assess how much to invest, but also the frequency. For example, some UK investors simply choose to invest a one-off lump-sum and then allow the mutual fund to do its thing for a number of years.
Others will instead choose to invest a bit at the end of each month, while some might opt for a combination of the two.
There isn’t a one-size-fits-all investment strategy when it comes to mutual funds, as it all depends on personal preference. With that being said, it is worth considering a re-investment strategy if and when you receive your dividends.
This is because in most cases, your chosen mutual fund will distribute your share of dividends on a quarterly basis. If you were to re-invest these dividends back into the fund (or any other asset class for that matter), your money can grow substantially faster.
A couple of quick points to note about payments:
- Most mutual funds (whether that’s direct with the provider or through a third-party broker) will have a minimum investment amount. This can be as low as £25 per month or £100 upfront.
- Most providers allow you to invest with a UK debit card or bank account, and even set up a direct debit
- You do not normally need to pay any fees to deposit funds
How to Invest in a Mutual Fund?
So now that you know the ins and outs of how mutual funds work, we are now going to explain how the investment process works.
Step 1: Choose a Mutual Fund
While the first step of the stocks and shares process typically centres on finding a suitable UK stock broker, in this instance, it’s best to start with the asset itself. In other words, spend some time researching a mutual fund that meets your long-term investment goals.
Some of the questions that you need to ask of the mutual fund are:
- What niche does the mutual fund target (dividend stocks, international shares, emerging markets, etc.)?
- How has the mutual fund performed over the past 10 years?
- What annual maintenance fee does the mutual fund charge?
- What is the minimum investment amount?
- Is there a minimum redemption period or redemption fee?
If you need some inspiration, Yahoo Finance has a highly comprehensive research facility on mutual funds.
Step 2: Find a UK Broker That Offers Your Mutual Fund
Once you have found a mutual fund that meets your long-term investing goals, you then need to find a UK broker that allows you to invest in it. Although some mutual funds allow you to invest directly, we actually find that going through a third-party broker is often cheaper.
Brokers also ask for a much lower minimum investment amount, and typically support more payment methods. Just make sure that your chosen broker is regulated by the Financial Conduct Authority (FCA).
Step 3: Open an Account and Upload ID
Once you have chosen a broker, you will then need to open an account. This will require you to enter some personal information – such as your full name, home address, date of birth, and national insurance number.
If the broker is unable to verify your identity electronically, you’ll likely be asked to upload a copy of your passport or driver’s license, as well as a proof of address.
Step 4: Deposit Funds
If you’re using a third-party broker, you will first need to deposit some funds into your newly created account. Most platforms accept debit/credit cards and bank accounts, and some will also support e-wallets.
Step 5: Invest in a Mutual Fund
Once your brokerage account has been funded, you can then proceed to invest in a mutual fund. All you need to do is specify the amount that you wish to invest in pounds and pence, and confirm the order. The funds will then be taken from your cash balance, and allocated into the fund.
From then on, any dividend payments that the fund distributes will likely be reflected in your brokerage account every three months. When it comes to withdrawing your funds back out – you can do this at the click of a button. But, don’t forget that a redemption period/fee might apply.
In summary, mutual funds are ideal if you want to invest in stocks and shares – but you have no idea where to start. They are also ideal if you want to diversify across hundreds of different companies – and invest in a 100% passive manner. The most challenging part is knowing which mutual fund to invest in, as hundreds exist. Whether that’s a fund targeting dividends, emerging markets, growth, or sector-specific companies – there’s plenty to choose from.
What is the difference between a mutual fund and an ETF?
Both are actually very similar, as they both allow you to invest in a basket of shares through a single trade - and they are 100% passive. The key difference is that ETFs are usually tasked with 'tracking' a specific market, while mutual funds will actively buy and sell assets. As such, mutual funds have much more flexibility in choosing what to invest in.
How much do mutual funds make?
There really is no one-size-fits-all answer to this question. Crucially, there are hundreds of mutual funds that each perform differently. For example, a fund investing in high-grade blue-chip stocks would likely have a lower profit target than those investing in higher-risk companies based in the emerging markets! As such, the best indicator is to look at the historical returns of your chosen mutual fund.
How are mutual funds traded?
Mutual funds are usually listed on a public exchange like the London Stock Exchange. This ensures that investors can easily enter and exit the market. The value of the mutual fund will go up and down in-line with its NAV.
Do mutual funds pay dividends?
If the mutual fund invests in companies that pay dividends, then you will be entitled to your share.
What is the minimum amount I can invest in a mutual fund?
This will vary from fund-to-fund. Furthermore, although a specific mutual fund might have a minimum investment amount, this might be lower if you go through a third-party broker!