Stock Market 101: What is a Mutual Fund?
- Sai Vikram Kolasani
- May 1, 2020
- 4 min read
Overview:
1. What is a Mutual Fund?
2. How Mutual Funds Work
3. Major Types of Mutual Funds
4. Mutual Fund Fees
5. Pros vs Cons
What is a Mutual Fund?
A mutual fund is a type of financial vehicle made up of a pool of money collected from many different investors to invest in other securities like stocks, bonds, and other assets. Mutual funds are operated by professional money managers, who allocate the fund's assets and attempt to produce capital gains or income for the fund's investors. Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund.
How Mutual Funds Work
Mutual funds pool money from the investing public and use that money to buy other securities, usually stocks and bonds. The value of the mutual fund company depends on the performance of the securities it decides to buy. So, when you buy a unit or share of a mutual fund, you are buying the performance of its portfolio or, more precisely, a part of the portfolio's value. The price of a mutual fund share is referred to as the net asset value per share(NaVS). Unlike traditional stocks, mutual fund prices don't fluctuate during market hours, but rather are settled at the end of each trading day.
A mutual fund is both an investment and an actual company. This dual nature may seem strange, but it is no different from how a share of AAPL is a representation of Apple Inc. When an investor buys Apple stock, he is buying partial ownership of the company and its assets. Similarly, a mutual fund investor is buying partial ownership of the mutual fund company and its assets. The difference is that Apple is in the business of making innovative devices and tablets, while a mutual fund company is in the business of making investments.
If a mutual fund is construed as a virtual company, its CEO is the fund manager, sometimes called its investment adviser. The fund manager is hired by a board of directors and is legally obligated to work in the best interest of mutual fund shareholders. Most fund managers are also owners of the fund. There are very few other employees in a mutual fund company. The investment adviser or fund manager may employ some analysts to help pick investments or perform market research. A fund accountant is kept on staff to calculate the fund's NAV, the daily value of the portfolio that determines if share prices go up or down. Mutual funds need to have a compliance officer or two, and probably an attorney, to keep up with government regulations.
Major Types of Mutual Funds
I will not be going in-depth with every type of mutual fund. But there will be a slight overview of each.
The largest category is that of equity or stock funds. As the name implies, this sort of fund invests principally in stocks. Within this group are various subcategories. Some equity funds are named for the size of the companies they invest in: small-, mid-, or large-cap. Others are named by their investment approach: aggressive growth, income-oriented, value, and others. Equity funds are also categorized by whether they invest in domestic (U.S.) stocks or foreign equities.
Another big group is the fixed income category. A fixed-income mutual fund focuses on investments that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments. The idea is that the fund portfolio generates interest income, which it then passes on to the shareholders.
Balanced funds invest in a hybrid of asset classes, whether stocks, bonds, money market instruments, or alternative investments. The objective is to reduce the risk of exposure across asset classes.
Exchange-Traded Funds (ETFs) A twist on the mutual fund is the exchange-traded fund (ETF). These ever more popular investment vehicles pool investments and employ strategies consistent with mutual funds, but they are structured as investment trusts that are traded on stock exchanges and have the added benefits of the features of stocks. There will be a more in-depth post about ETFs later.
Mutual Fund Fees
A mutual fund will classify expenses into either annual operating fees or shareholder fees. Annual fund operating fees are an annual percentage of the funds under management, usually ranging from 1–3%. Shareholder fees, which come in the form of sales charges, commissions, and redemption fees, are paid directly by investors when purchasing or selling the funds.
Pros:
Liquidity
Diversification
Minimal investment requirements
Professional management
Variety of offerings
Cons:
High fees, commissions, and other expenses
Large cash presence in portfolios
No FDIC coverage
Difficulty in comparing funds
Lack of transparency in holdings
KEY TAKEAWAYS
1) A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities. 2) Mutual funds give small or individual investors access to diversified, professionally managed portfolios at a low price. 3) Mutual funds are divided into several kinds of categories, representing the kinds of securities they invest in, their investment objectives, and the type of returns they seek. 4) Mutual funds charge annual fees (called expense ratios) and, in some cases, commissions, which can affect their overall returns. 5) The overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds.
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