What are mutual funds and how do they work? A mutual fund is an investment vehicle created from a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are managed by professionals who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is built and maintained to match the investment objectives stated in its prospectus. A prospectus is a document that is used to define the objectives and parameters of any investment vehicle.
Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder or unit holder, therefore, takes part proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is measured by the change in the total value of the fund.
There are thousands of different mutual funds available from many companies. They each have their own individual characteristics and objectives. A mutual fund will often mimic parts of the larger stock market like energy, mining, technology or financial sectors. Some will concentrate their assets on creating growth, while others will attempt to maximize the income/yield for its holders. Some will attempt to do both.
It is important to understand that a mutual fund holds stock or bonds in dozens or possibly hundreds of different companies, so the holder of its shares or units has a very diversified portfolio, thus reducing the risk factors of having one company’s value drop. If this happens, the overall effect on the mutual fund is minimal. Most investors could not duplicate the holdings of a mutual fund because of the sheer amount of money required to do so. A mutual fund will have invested the combined holdings of its unit holders that total millions upon millions of dollars, allowing for diversification that the individual investor may not attain.
A mutual fund will appeal to investors who are reluctant to research and decide about investing themselves and prefer to trust the professional managers to make those decisions. This comes at a cost for the investor. Someone has to pay for the professional managers, sales commissions and administration costs and that someone is the investor. Before it splits any income among the unitholders, the company managing the fund assesses a fee that they charge against the overall value of the fund. The fees vary and are decided by the management company, but run in the 3 to 3.5% range. What this means is that the value of the mutual fund is reduced by 3% each year and any growth or income beyond that belongs to the unit holders. Hopefully, the money managers can create enough added value to the mutual fund to cover their fees and provide added value to the holders. It will depend on how the stocks or bonds held in the fund do on the market. In reality, the value follows the ups and downs of the stock or bond market itself.
Most investment advisors or mutual fund salespeople will assist their clients to create additional diversity by recommending a variety of funds. They will seek to build a portfolio that matches the investor’s goals for a combination of growth and income. Many large investment pools like pension funds hold large quantities of mutual funds to protect and grow their client’s capital. Mutual fund organizations will help their clients set up a regular investment program, which also helps the investor to increase their portion of savings.
This is a very general and brief rundown of mutual funds. If you are interested in more information, you can find it at Investopedia and also from your mutual fund company representative. Be sure to ask lots of questions about management fees and the purpose and goals of the funds you are interested in. They will show you historical changes in value and have an opinion about its future prospects. Keep in mind that the ultimate decision about how to manage your own money should reside with you.
In the next section, we will look at another investment vehicle that pools large amounts of money from its many holders and seeks to duplicate the movements in the overall market. They call these Exchange Traded Funds or ETF’s and there are many similarities with mutual funds but also some very interesting differences.
Just a heads up – I am working on something that will be available to my subscribers that will add value to this website by helping you save some money to invest in the market or just create more spending money. I should offer it in the next week or two, so stay tuned and add your name to the subscription list in the top right-hand corner if you haven’t done so.