It is technically possible to trade mutual funds for a living, if you have a substantial amount to invest and are happy to employ a highly active trading strategy. However, mutual funds are not designed for short-term investing.
In fact, most mutual funds actively discourage short-term trading by implementing steep fees for early redemption or excessive trading.
However, you can generate a decent amount of annual income by investing in dividend- or interest-bearing funds. Of course, the amount of income you receive is a function of how much you invest, so those who have sizable bank accounts already are the most likely to be successful at making a living.
In truth, mutual funds are not the best choice when it comes to making a living through investing. Stocks and exchange-traded funds (ETFs) offer investment options that are much more suitable to active trading.
Key Takeaways
- Mutual funds offer convenience, instant diversification, and low fees.
- They are designed for long-term investing, not for short-term trading.
- Exchange-traded-funds and individual stocks are more suitable for active trading but making a living from trading is challenging.
- Dividend funds distribute income to shareholders.
- You’d have to invest a large amount in a dividend fund to make an annual living from dividend income.
Mutual Funds: The Basics
Mutual funds are a popular option for investors because of the wide variety of funds available and the automatic diversification they offer.
A mutual fund pools the money of many shareholders and invests in various securities, such as stocks, bonds, and short-term debt, according to the stated goals of fund.
Funds that are more heavily invested in stocks or low-rated debt instruments are best suited for investors who are willing to take on a considerable amount of risk in exchange for the possibility of big gains.
Alternatively, funds that only invest in highly rated corporate or government bonds are generally better for investors with low risk tolerance, and for whom income generation is an investment goal.
Mutual Fund Redemption
Unlike stocks or ETFs, mutual funds are not traded on the open market. Instead, investors must redeem shares directly through the fund, or through an authorized broker.
The value of a mutual fund share—called its net asset value (NAV)—is calculated at the end of each trading day using the total value of all the assets in the fund’s portfolio. The share price does not fluctuate throughout the day like that of exchange-traded securities.
Because mutual fund shares cannot simply be bought and sold between investors, a mutual fund itself must find the money to cover shareholder redemptions. Since mutual fund capital is typically wrapped up in the fund’s portfolio, share redemption often requires the liquidation of assets.
You can sell your shares in a mutual fund at any time after you’ve purchased them. However, as a consequence of selling them earlier than your fund allows (as detailed in the fund prospectus), you’ll probably have to pay an early redemption fee, as well as any back-end load.
How Short-Term Trading Affects Shareholders
Short-term trading can have two negative effects for shareholders:
- Distributions resulting from short-term trading and redemptions cause tax events for all shareholders
- More trading than necessary results in added costs
Liquidations Can Mean Taxable Distributions
When a mutual fund liquidates its holdings for any reason, it can generate a capital gains distribution for all shareholders.
Thus, liquidations can present a tax liability to all shareholders, not just for the shareholder redeeming shares. This makes short-term mutual fund trading particularly burdensome to other shareholders who most likely are long-term investors.
Trading Can Boost Fees
In addition, excessive trading causes a mutual fund’s expense ratio to increase because of the additional trading and administrative fees incurred.
Short-term mutual fund trading increases the costs for buy-and-hold investors, mutual funds’ key demographic, across the board.
Mutual Fund Early Redemption Fees
The dangers of short-term mutual fund trading became apparent in 2003 when it was found that many investors were rapidly buying and selling shares to make quick profits, negatively impacting the returns of other shareholders.
To discourage the practice of short-term mutual fund trading and to minimize its impact on long-term shareholders, many mutual funds prohibited the liquidation of shares within a certain period after purchasing them.
In addition, many institutions closely monitor the number of round-trip transactions a shareholder makes—that is, any transaction in which an investor buys shares and then sells them in rapid order.
At Fidelity, for example, an investor can be blocked from making any further trades within a set period if they are found to have executed multiple round-trip trades.
A Better Income Option: Dividend Funds
If you’re set on investing in mutual funds, you can generate annual income without trading by investing in dividend funds and employing a buy-and-hold strategy commensurate with the security’s intended purpose.
Dividend funds are mutual funds that invest in dividend-bearing stocks or interest-bearing debt instruments. Dividend equity funds only invest in stocks with proven track records of paying solid dividends every year.
Similarly, dividend debt funds generate annual income from the guaranteed coupon payments carried by the bonds, notes or bills in their portfolios. Some balanced funds include both types of assets.
Of course, the more money that you can invest in a dividend fund, the greater the income you may make. You’ll have to determine the return necessary to make a living.
All dividend funds make at least one dividend distribution each year, but they may make more depending on when the underlying assets pay dividends or interest.
$1.3 Million
The size of the investment needed in a dividend-paying portfolio yielding 3.8% to provide you with just over $50,000 annually.
The Active Option: Stocks and ETFs
As mentioned, if you have a substantial amount to invest, it may be possible to make a living investing in dividend mutual funds. If you have that much discretionary capital on hand, however, you may be better served by diversifying your portfolio with other securities.
Stocks and ETFs are a much better choice than mutual funds for investors looking to make short-term gains; both are designed to be bought and sold in any time frame, and they can be traded on the open market.
Index ETFs
If you like the security of passively managed index mutual funds, for example, ETFs offer just as many index options but with lower expenses and fewer trading regulations.
If you’re looking to employ an active trading strategy but want to minimize risk, index ETFs can be an excellent option.
The Risk-Reward of Stocks
If you are more tolerant of risk, trading stocks can generate substantial income, but with a considerable degree of risk.
Some ETFs, such as leveraged or inverse products, also offer the potential for increased profits in exchange for a higher risk level.
However, if you have enough capital to invest in mutual funds to the degree necessary to generate sufficient annual income, then you can probably afford to allocate a portion of those funds to an asset with more high-risk/high-reward potential.
Can You Live Off of Mutual Funds?
Since mutual funds are considered long-term investments and discourage taking profits through trading, living off them probably won’t work until you’re in retirement and have a large amount of money in them to withdraw over time. However, you might be able to live off income provided by one or more dividend funds, if you have enough money invested.
How Do Dividend Funds Provide Income?
Dividend funds seek to purchase stocks with higher-than-average and/or rising dividend yields and increasing dividend amounts. They distribute to shareholders dividends paid on the stocks in the fund. When interest rates are low, high-dividend equities can pay more than interest-bearing securities.
Why Are Mutual Funds Difficult To Trade?
They’re difficult to trade because they don’t trade actively on an exchange and can only be bought or sold after the close of a trading day at the fund’s net asset value. In addition, there are fees and taxes associated with buying and selling shares in funds that would affect return.
The Bottom Line
Using your investment portfolio to generate your yearly income is an enticing proposition. However, actively trading mutual funds is unlikely to be a good way to go.
But investing in a dividend fund could be an option for annual income, if you have a substantial amount of money to invest. Overall, though, a diversified portfolio is likely to serve you better in the long term.
Discuss your specific investment goals with your financial advisor to learn which products can provide short-term gains and which are best for long-term growth.
By diversifying properly, you can use long-term investments to provide income in the future while using actively managed short-term assets to pay the bills now.