A mutual fund is a form of financial vehicle that is made up of a pool of money that has been collected from a number of investors to invest in securities such as stocks, bonds, money market instruments and other assets and commodities.
Operated by professional money managers, mutual funds are used to fund assets in an attempt to grow capital gains or create income for the investors in the fund. Mutual funds charge annual fees, known as expense ratios and in some cases, they also charge commissions.
Mutual funds’ portfolios are structured and maintained to match the objectives set out in its prospectus and give small or individual investors access to more diversified managed portfolios at a lower cost.
How a mutual fund works
The dual nature of mutual funds mean they are both an investment and a company, a mutual fund investor buys partial ownership of the mutual fund company and its assets. Typically, there are three ways for investors to earn a return from mutual funds, they are:
Earn income in the form of dividends on stocks and interest on bonds held in the mutual fund’s portfolio. A mutual fund distributes almost all of the income it receives annually to fund owners, who can take it as income or can reinvest to buy more shares.
If the mutual fund sells securities at an increased price, it will have a capital gain. Most funds pass any capital gains onto investors in a distribution.
If the holdings the mutual fund holds increase in price but are not sold, this leads to an increase in the fund’s share price. These can then be sold in the market for a profit.
Mutual funds are usually structured in the following ways, the CEO or fund manager is hired by a board of directors to legally work in the best interest of the fund and its shareholders. The fund manager may then employ analysts to help them research investment opportunities and manage the portfolio.
Typically, mutual funds will also include a fund accountant, at least one compliance officer and possibly an attorney to keep up with regulations and ensure compliance.
Types of mutual funds
Mutual funds can be categorized into several different types based on the securities they hold or the type of return they seek. The different types of mutual funds include:
by far the largest category, equity or stock funds invest largely in stocks. Further categorization of equity funds can be the size of the companies they invest in, the investment approach they use and whether they focus on domestic stocks or foreign equities.
These types of funds focus on investments that pay a set rate of return. They generate interest income which is then distributed to shareholders. Examples of fixed-income funds include government bonds, corporate bonds and other debt instruments.
Index funds use a strategy that is based on the belief that it is difficult and costly to try to consistently beat the market. So instead they focus on stocks that correspond with one of the major market indexes such as the S&P 500 or the Dow Jones Industrial Average (DJIA).
Balanced funds invest in a hybrid of asset classes to reduce the risk of exposure across asset classes. Some balanced funds have a fixed allocation strategy while others may use dynamic allocation to respond to market conditions or business cycle changes.
Money market funds
Money market funds consist of safe, low risk and short-term debt instruments, mostly made up of government treasury bills. Investors will not make substantial returns, but they have the peace of mind that they will not lose their principal investment.
This type of fund has the primary objective of providing a steady income. They focus on government and high-quality corporate debt to provide interest streams that are in turn distributed to shareholders.
Advantages of Mutual Funds
There are a variety of advantages for investors when it comes to mutual funds, including:
Ease of access
Traded on the major stock exchanges, mutual funds are easy to buy and sell. They are often considered to be highly liquid investments. Mutual funds can also open up opportunities that would not be available for individual investors.
Fewer commission charges
For investors to create a diversified portfolio without a mutual fund, they would be subject to many commission charges which can soon chip away at profits. But with a mutual fund, the transaction costs are lower providing economies of scale.
Disadvantages of Mutual Funds
The disadvantages of mutual funds include:
As with all investments that do not offer a guaranteed return, there is the risk that the value of the mutual fund you have invested in will decrease. As the Federal Deposit Insurance Corporation does not back mutual funds, investors are not insured by the FDIC.
When a fund manager sells a security that leads to a capital gain, a capital gains tax is triggered. Investors will then be liable for capital gains tax, investors concerned about the impact of taxes on their return should consider this factor before investing in a mutual fund.