Mutual Funds

Mutual funds are tools that small-scale investors can use to maximize the potential of their investment funds.

 

In a mutual fund, an investment company brings together money from many different investors. Professional fund managers then purchase a variety of investments, such as stocks and bonds, using those funds. Over time, the fund managers adjust the diversity, balance and composition of the fund’s holdings to ensure the best long-term return on investment.

Mutual funds come in a variety of types and offer many distinct benefits. They are often a particularly good choice for investors who are new, investing on a small scale or seeking to maximize their returns without doing intensive, hands-on and day-to-day investment management themselves.

Mutual funds are not entirely without risk, however. Before choosing mutual funds as an investment tool, investors should familiarize themselves with this option’s pros and cons to determine whether it is the right choice for their needs.

How Mutual Funds Work

Mutual funds work through a somewhat unusual mechanism. Individual investors buy shares of the investment company, much the same way they would buy stocks or shares of any publicly traded company. Those shares entitle them to a measure of the profit the mutual fund makes on the investments that it holds.

Mutual fund shares are priced at what is called net asset value (NAV). The net asset value of one share is equal to the value of all the fund’s overall investment portfolio divided by the number of existing shares investors hold against that total. For example, if a mutual fund holds $400,000 in investments and investors hold a combined 40,000 shares of the fund’s stock, the NAV of each share would be $10.

Investors may or may not pay fees when participating in mutual funds. Common fee structures for mutual funds include:

  • No-load mutual funds: This type of mutual fund does not charge investors commissions or sales fees.
  • Operating fees: Also known as a fund’s “expense ratio,” operating fees are often collected annually and include advisory fees, management fees and administrative expenses.
  • Shareholder fees: Standard shareholder fees include commissions or redemption fees. They are usually assessed as a percentage of the funds invested. On average, they range between one and three percent.
  • Sales charges: Sales charges may be applied when investors buy or sell shares. Front-end charges are applied when investors buy shares. Back-end sales charges are applied when investors sell mutual fund shares.
  • Penalty fees: In some funds, investors may be subject to penalty fees if they sell shares or withdraw funds prior to an agreed upon time limit.

Types of Mutual Funds

Any type of mutual fund may apply any of the above fee structures. There are four types of mutual funds. In a Unit Investment Trust (UITs) fund, the investment company purchases a set portfolio, often mostly bonds, and then holds onto those same assets until they have fully matured. Face-Amount Certificate funds are structured the same way as bonds. Investors receive predictable interest-style payments for a set period of time and then the full amount of their initial principle at the end of the designated term.

Closed-End Management Companies are mutual funds that are run like private stock markets. The company issues a predetermined number of shares, which it sells at NAV in an IPO-style sale. After that, investors may purchase shares of the fund from other investors who already hold them. The cost of those shares will vary and be driven by supply and demand.

The majority of mutual funds operate as Open-End Management Companies. In this format, any investor may purchase or sell fund shares at their established NAV. New shares are created whenever a new investor buys in. When investors sell their shares back to the company, often called cashing out, the total number of shares falls.

 

Mutual Fund Pros and Cons

Mutual funds provide new or small investors immediate access to a number of desirable things that they might otherwise not be able to afford, or which might take a long time to accomplish. Prime examples include:

  • A diversified investment portfolio.
  • Professional investment advice and financial management service.
  • Liquidity and access.

Traditionally, investors have found it necessary to dedicate significant amounts of time and effort to create diversified portfolios. Building a portfolio from scratch involves large amounts of research and the piecemeal accumulation of desirable stock over time. Opportunities are often limited by the state of the market and an individual investor’s access to funds at any given time. The more safely and favorably diversified an investor wants his or her portfolio to be, the more time it has historically taken to build that portfolio. Mutual funds offer investors the opportunity to instantly buy into an established, well-diversified fund. This provides investors with a level of safety and return on investment that they would not otherwise have.

Mutual funds also offer investors the chance to benefit from professional investment management and advice. Investors who purchase mutual fund shares do not have to heavily invest their own time and energy in monitoring markets or companies’ performance, or keep track of the details of buying and selling individual stocks to profit or avoid loss. Instead, trained investment professionals handle all of those details for them. Further, because mutual funds operate at economies of scale far larger than most individual investors, they can buy and sell investments at significantly lower costs. These costs are then spread across the whole of the fund.

Mutual funds create opportunities to access the types of stocks, bonds and other investments for investors who only have small or modest amounts of money to invest. Investors can generally buy into a mutual fund for as little as $100 to $1,000. They can then build on that progressively over time. Investors without access to mutual funds might have to wait and save their money for months or years before amassing enough wealth to buy a single bond or lot of stock. Equally importantly, investors can buy or sell their mutual fund shares at any time. They do not have to wait until the price of a certain stock is within their range or they have collected enough money to meet minimum purchase requirements. Nor will they be left scrambling in the event that they need to transfer some of their investments back into spendable cash. By contrast, investors who needed to personally sell stocks or bonds on the open market could expect to face delays, financial loss or both.Like all forms of investments, individuals who invest in mutual funds may suffer losses. Investors may be subject to a variety of fees or face penalties for withdrawing their money too soon. They may be unclear of exactly what their funds are being invested in and the actual level of risk involved. For many investors, however, they are ultimately an ideal investment tool.

 

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