The idea behind a mutual fund is simple: Many people pool their money in a fund, which invests in various securities. Each investor shares proportionately in the fund’s investment returns — the income (dividends or interest) paid on the securities and any capital gains or losses caused by sales of securities the fund holds.
Every mutual fund has a manager, also called an investment adviser, who directs the fund’s investments according to the fund’s objective, such as long-term growth, high current income, or stability of principal. Depending on its objective, a fund may invest in stocks, bonds, cash investments, or a combination of these financial assets.
Advantages of Mutual Funds
Mutual funds have become popular because they offer 5 advantages:
A single mutual fund can hold securities from hundreds or even thousands of issuers, far more than most investors could afford on their own. This diversification sharply reduces the risk of a serious loss due to problems in a particular company or industry.
- Professional management.
Few investors have the time or expertise to manage their personal investments every day, to efficiently reinvest interest or dividend income, or to investigate the thousands of securities available in the financial markets. They prefer to rely on a mutual fund’s investment adviser. With access to extensive research, market information, and skilled securities traders, the adviser decides which securities to buy and sell for the fund.
Shares in a mutual fund can be bought and sold any business day, so investors have easy access to their money. While many individual securities can also be bought and sold readily, others aren’t widely traded. In those situations, it could take several days or even longer to build or sell a position.
Mutual funds offer services that make investing easier. Fund shares can be bought or sold by mail, telephone, or the Internet, so you can easily move your money from one fund to another as your financial needs change. You can even schedule automatic investments into a fund from your bank account, or you can arrange automatic transfers from a fund to your bank account to meet expenses. Most major fund companies offer extensive recordkeeping services to help you track your transactions, complete your tax returns, and follow your funds’ performance.
Mutual funds offer a very simple way for the average investor to invest. This appeals to the buy it and forget it type of investor who still wants to be involved in the market.
Explanation of How Mutual Funds Work
In simplistic terms, investors buy shares of the mutual fund, and the money is in turn used by the fund manager to invest in some type of assets (for example, stocks). Therefore, investors are in effect buying a share of the underlying asset that the fund purchases when they buy a share of the mutual fund.
At times, the mutual fund will issue more shares to sell to investors to cope with demand. However, some funds may become closed to new investors when its portfolio simply becomes too large to manage. While it can’t be proven, it is interesting to note that many believe that as the size of the fund grows, it eventually comes to a point where returns suffer.
Prices of a Mutual Fund
Much like a stock, the share price of a mutual fund fluctuates. However, unlike the former two where the securities are traded constantly during market hours, the share price of a mutual fund is typically calculated on the end of every business day.
Since orders for mutual funds can only be entered during market hours, it implies most investors won’t know the exact price of the fund until the transactions go through. However, since the share price is highly correlated with the assets that it owns and the volatility is lower than a typical stock, investors generally are not as sensitive about market timing a mutual fund.
Disadvantages of Mutual Funds
There are many reasons not to like mutual funds as well. Let’s explore a few here:
Cost:Theoretically, Mutual fund managers help increase your returns and reduces your risk. However, many believe that those managers are no better at finding the right investment than you or I. The worst part is that whether they make or lose money, they still take a cut (known as management fees). Other possible fees include: sales charges, administrative fees, marketing expenses. These funds definitely are more expensive than a do-it-yourself approach.
Tax Implications:Because you do not control the buy and sell of each security, you might be stuck with a tax bill when the fund made money on the sale of some stocks when the whole portfolio has negative return!
Size of the Fund: Mutual funds control so much money that whenever they decide to buy an asset, they increase the demand so much that they end up having to pay more for the asset. This obviously hurts your return as an investor. Additionally, the fund managers are sometimes forced to buy assets at terrible prices because they have so much money to invest.