Investment Basics: What is a mutual fund
A mutual fund is a collective investment vehicle that pulls together the money of a large number of investors to purchase a variety of securities or bonds. When you purchase a share in a mutual fund you have a small stake of all investments included in that fund. You can think of a mutual fund like a basket of investments, so when purchase a share in a mutual fund you are buying one share of this basket and therefore have a stake in a small fraction of all the investments in that fund. Mutual funds can benefit investors in several ways, they are a simple way to make diversified investments, they are mostly managed by financial professionals and because of the wide variety of mutual funds, they allow investors to participate in a wide variety of investments.
Let’s walkthrough an example of how a mutual fund works. Suppose there is an investor who wants to invest some of his retirement money in the stock market but he does not have the time to analyse individual stocks and create a diversified stock portfolio. Instead he decides that he would rather purchase a part in a mutual fund, this way the investor can purchase a single investment which will in effect be similar to purchasing an entire portfolio of stocks.
After researching and reading multiple prospectuses, our investor decides that one fund suits his needs and so he pays the minimum investment amount and purchases one share of the mutual fund. By owing this share, the investor now participates in the gains and losses of all the companies held in the fund. The benefit of this is diversification, this is when an investment or portfolio is spread across several different investments, doing this helps lower risks. For example, if one company that the fund invests in has a rough year, the impact on the funds total assets can be small because that struggling company is only one fraction of the funds total assets.
Like most mutual funds, the fund our investor chose is actively managed, it is run by a fund manager or managers who buy and sell the funds assets. Asset managers work to provide the biggest return they can for investors using financial analysis and professional expertise and while a talented manager could earn good returns for the investors, there is no guarantee of success. If the manager makes choices that don’t pay off our investor will not earn the returns he was hoping for. However even if the fund does not perform well, the manager still collects a fee, which is paid from fund assets, meaning even lower returns. Management fees are not the only cost our investor has to pay, you can add transaction fees and sales loads.
After the investor has bought into a fund, he can make money in two ways from it. The first way is through appreciation, which is when the funds shares go up in value. When the funds assets rise in value the funds shares do the same, but unlike a stock, the value of a fund share does not change throughout the trading day, instead the funds value is calculated and updated when the market closes. The second way to make money through a mutual fund is through a dividend payment which is when a mutual fund pays out a portion of its earnings to shareholders. However when the fund’s assets fall in value the fund shares do the same, which is a risk of owning a mutual fund.
One benefit to mutual funds is the variety of mutual funds available. Our investor can chose a mutual fund that invests in stocks, however there is a mutual fund for almost every type of investment. For example, equity funds buy stocks, fixed income stocks buy bonds and balanced funds buy both. Some equity mutual funds invest in a whole index while some others focus on stock of a certain country or market sector. Certain funds have different objectives as well, some may look for riskier stocks and growing industries while others will invest in more stable companies.