What are Mutual Funds?
Updated on May 22 2019
A mutual fund or investment fund is a type of diversified investment program funded by shareholders for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.
What is the definition of a mutual fund?
A mutual fund is an investment vehicle made up of a pool of moneys collected from many investors for the purpose of investing. These funds are operated by professional money managers who allocate the fund’s investments and attempt to produce capital gains for the fund’s investors. A mutual fund’s portfolio is set up and managed to match certain investment objectives.
In layman’s terms, a mutual fund is a cooperative means for many people to pool their savings together and have their investment professionally managed in the type of investment they choose. This shared concept is one that allows many investors to put relatively small amounts of money into investment that are skillfully managed. The many small sums of money combine to create a large amount of available dollars that the fund manager can expertly diversity the investments represented into a specific fund. The investment fund offers professional money management as well as full administrating and accounting services for the investor.
Are mutual funds risky?
It’s difficult to compare mutual funds across the board. They differ in their monetary objectives and are quite varied securities investments since each investment has a different fund goal. Depending on the securities the fund is investing in, or the mix of securities chosen for a specific fund, the element of risk can vary significantly. Generally, the amount of risk involved is directly related to the fund’s objective. In other words, the higher the return, the higher the risk involved.
A built-in risk mitigation is that mutual funds are professionally managed by experienced fund managers who have many years of portfolio management expertise. So, the risk is minimized by expert management and marketplace knowledge. For example, in common stock funds, professional managers select the investments and monitor them carefully and constantly. Investors often also keep a close eye on investment activity to hold the managers accountable. Also, because of the combined investor concept inherent in the funds, the risk is shared between many stakeholders; making the funds less vulnerable to market fluctuations.
How do mutual fund companies work?
Mutual funds are virtual companies that buy pools of stocks and/or bonds as recommended by an investment advisor and fund manager. A board of directors hires the fund manager who 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 advisor or fund manager may employ the following:
- Financial analysts to help pick investments or perform market research
- A fund accountant is kept on staff to calculate the fund’s net asset value (NAV), or the daily value of the mutual fund that determines if share prices go up or down
- A compliance officer to keep up with government regulations
- Possibly an attorney.
Most mutual funds are part of a much larger investment company setup; the biggest have hundreds of separate mutual funds.
How do rates of return in mutual funds compare with savings accounts?
It’s important to keep in mind that while it may be considered ‘safe’ to keep one’s savings in cash, there is always the risk that inflation will, over time, chip away at the value of those savings. Savings accounts, after all, serve a completely different function from mutual funds:
- Savings accounts are the avenues by which banks and trust companies borrow money from the public and lend that money to companies and individuals at higher rates. The financial institution makes money on the difference or profit between the rate it pays on the account and the rate it charges borrowers.
- A money market mutual fund lends money directly to governments, corporations and financial institutions and the people who invest through the funds earn the higher rate. There is no middle man with the mutual fund.
Over time, the rates of return for common stock funds have been much superior to that of a savings account. Investors in the funds choose “share” ownership and expect profit for taking the risk. It’s important to keep in mind, though, that common stock funds are not necessarily consistent from year to year—which is why the investment always has a little risk.
What are the different kinds of mutual funds?
Mutual funds fall into many different categories, representing the kinds of securities the mutual fund manager invests in.
- Fixed income – Focuses on investments that pay a fixed rate of return, such as government bonds, corporate bonds or other debt instruments.
- Index funds – This type of fund is when the manager buys stocks that correspond with a major market index. This is a more conservative strategy that requires less research from analysts and advisors so there are fewer expenses. These funds are often designed with cost-sensitive investors in mind.
- Money market fund – Funds whose objective is to earn interest for shareholders while maintaining a net asset value of $1 per share. This is typically a short-term, less than one year, securities representing high-quality, liquid debt and monetary instruments.
- Balanced fund – This fund combines a stock component, a bond component and sometimes a money market component in a single portfolio. Generally, these hybrid funds stick to a relatively fixed mix of stocks and bonds that reflects either a moderate, or higher equity, component, or conservative, or higher fixed-income, component orientation.
- Sector funds – A stock mutual, exchange-traded or closed-end fund that invests solely in businesses that operate in a particular industry or sector of the economy. Because the holdings of this type of fund are in the same industry, there is an inherent lack of diversification.
- Stock or Equity funds – A type of fund that invests in stocks, also called equity securities. Fund assets are typically mainly in stock, with some amount of cash, which is generally quite small.
- Funds-of-funds – Mutual funds that buy shares of other mutual funds.
Are mutual funds suitable for people looking to retire soon or who are retired?
Funds are suitable for retired people provided there is careful selection of the fund’s investment objectives. A conservative approach to the preservation of capital may be desirable as one reaches more mature years. There may also be increased emphasis on the income needed for retirement. Funds can provide the means to reach both these objectives, but it is recommended to seek the help of an expert investment professional or financial advisor to determine if mutual fund investments are right for you.
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