What is a mutual fund? Definition and meaning
A mutual fund is a company that brings together the money from several investors and invests the pooled funds. It invests those funds in securities such as bonds, stocks and short-term debt. Some mutual funds, in fact, pool money from hundreds of thousands of investors. We call the total holdings of the mutual fund its portfolio.
In the United Kingdom and Ireland, people refer to mutual funds as ‘unit trusts.’ Several words in the English language have slightly different meanings in various parts of the world. For example, ‘holidays’ simply means ‘vacations’ in the UK while in the USA it means the Thanksgiving to Christmas and New Year period.
If you want to invest in a mutual fund you have to buy its shares. Each share represents your part ownership in the fund as well as the income that it generates. So, you effectively become a shareholder in the fund.
A mutual fund pools people’s money (top image). Its fund managers study the market and invest the money, which generates more money (hopefully). The company subsequently passes back extra money to the investors.
If you are a mutual fund investor, you do not actually own the securities that the company has bought. You only own shares in the fund company itself.
Mutual funds generally charge various administration fees. In many cases, there is a charge if you want to cash in your shares, i.e., redeem your money.
Mutual funds that take a cut of any new money that comes into the fund – impose a sales charge – are load funds. No-load funds, on the other hand, do not have a sales charge.
If you want to know what the structure of a mutual fund’s portfolio is, you can read about it in its investment objectives within its prospectus.
These are the twenty-five largest Mutual Funds according to MarketWatch.
Fidelity Investments explains what mutual funds are:
“Mutual funds are investment strategies that allow you to pool your money together with other investors to purchase a collection of stocks, bonds, or other securities that might be difficult to recreate on your own.”
“This is often referred to as a portfolio. The price of the mutual fund, also known as its net asset value (NAV), is determined by the total value of the securities in the portfolio, divided by the number of the fund’s outstanding shares.”
Why are mutual funds popular?
People like mutual funds because they generally offer professional management, diversification, affordability, and liquidity. They are relatively liquid because you can easily redeem mutual fund shares.
In other words, the mutual fund has fund managers who do all the research, select the securities and monitor their performance. They invest in a range of companies and sectors, which reduces the risk if one company fails or an industry does badly.
Most mutual funds have a low initial investment amount – subsequent purchases typically are not expensive.
Mutual funds offer many advantages, especially for small investors who have no market expertise.
Many types of mutual funds
According to Investor.gov, part of the US Securities and Exchange Commission, the majority of mutual funds fall into one of four main categories: stock funds, bond funds, money market funds, and target date funds. They all have different levels of risk, rewards and other features:
- Bond Funds: while producing higher returns than money market funds, bond funds have higher risks. Risks and rewards of bond funds can vary considerably, given that there are several types.
- Money Market Funds: these are relatively safe, low risk investments. In the United States, by law money market funds can only invest in specific high-quality, short-term investments issued by the federal, state and local governments or US corporations.
- Target Date Funds: sometimes called Lifecycle Funds, these include a mix of bonds, stocks and other investments. The mix gradually tilts in one direction over time, depending on the fund’s strategy. This type of investment is aimed at people with particular retirement date objectives.
- Stock funds: these invest in company shares (stocks). There are several types, including growth funds, income funds, index funds and sector funds.
- Focused Fund – a fund that does not invest in many different companies or sectors. In fact, it invests in fewer than thirty companies and no more than three sectors. Focused funds contrast with diversified funds.
Investing in mutual funds does have some disadvantages which you should consider carefully before making a decision.
Open-end vs. closed-end funds
Open-end funds sell shares to anybody who is interested in purchasing. Their share price is determined by the underlying investments’ value and is calculated every evening after the US markets close.
An open-end fund’s share price is determined by the NAV (net asset value), i.e. the total value of all the securities the fund possesses divided by the number of fund shares outstanding. The NAV is the price at which people can buy-sell shares.
Closed-end funds issue a limited number of shares that trade like stocks in the open market – in the stock exchange. Closed-end fund share prices can fluctuate.
Key Points to Remember
– No Guarantee: the Federal Deposit Insurance Corporation (FDIC) does not guarantee mutual funds. In fact, no government agency guarantees them.
No matter where you buy from, even if it is a bank with the bank’s name on it, there is no minimum guarantee. There is a risk of losing money, including your whole investment if things turn really ugly.
– Past Performance: this is not a reliable indicator of what performance is likely to be like in the future. Do not let the hype regarding last year’s high returns dazzle you.
However, the Securities and Exchange Commission (SEC) says that past performance may help investors assess a fund’s volatility over time.
– Costs: all mutual funds have costs that eat into your investment returns. You should shop around. The Finance Industry Regulatory Authority has a Fund Analyzer which offers information and analysis on over 18,000 mutual funds.
A global mutual fund is one that invests all over the world, as well as in the investor’s home country.
Video – What is a Mutual Fund?
This Wall Street Survivor video explains what a Mutual Fund is. It gives an example of a fictitious individual who gets $1,000 each from ten different people, invests the pooled money in equities, bonds etc., and then watches that money grow.