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What is a Mutual Fund?

According to a dictionary a mutual fund is an investment company that issues shares continuously and is obligated to repurchase them from shareholders on demand. A mutual fund is also called an open-end investment company.  What does all that really mean? You can look at buying a mutual fund like going in on a group gift for a parent. Instead of going out and spending a lot of money yourself on a single gift that your parents may or may not like, you are able to diversify and pool your money into a joint effort. This way your overall budget will be larger, which will allow a broader range of gifts, therefore, making it more likely that you’ll find a gift they find pleasing (or in the case of our mutual fund… one that makes you money while risking less).

 

A mutual fund is a form of corporation that hires a money manager or fund manager that trades the pooled money on a regular basis. This fund must be registered with the U.S. Securities and Exchange Commission (SEC) and provide a prospectus (legal document used to describe securities offered) to prospective investors. These regulations and standards were set in place shortly after the mutual funds initial founding. Mutual funds were founded in 1924, but were virtually undefined prior to 1940. In 1929, the Great Depression began which led Congress to passing into law the Securities Act of 1933, Securities Exchange Act of 1934, and the Investment Company Act of 1940. These laws were meant to infuse investors with confidence in investment companies.

 

The prospectus tells an investor how to open an account, including minimum investment requirements, how to buy or sell shares, and how to contact shareholder assistance. This is a very important aspect of the mutual fund as it also explains six aspects of the mutual fund that are crucial to your final decision: Investment objective, strategy, risks, expenses, past performance, and management. Investment objective is pretty straight forward. It lets you know what the aim of the mutual fund is. This can vary from long-term investments to a dividend check coming each month. Next the strategy of the mutual fund is very important. The prospectus informs you of the types of stocks, bonds, and other securities that the fund is investing in. This will give you a good idea of the types of companies that the mutual fund is looking for. This can include anything from large, well-established companies to small, growing businesses. The risks of the investments will be revealed within the prospectus as well. Although this is usually written in a very broad form, any risks that come with certain investments are divulged here and explained in the prospectus.

 

Management fees, sales commissions, and operating costs can all be found in the prospectuses expenses section. These costs can then be expected and accounted for when deciding to invest in a specific mutual fund. Past performance can give an investor a good idea of how a mutual fund has been running. This is never a guarantee as to the success or failure of a mutual fund, but can be a good indicator. Income distributions along with year-end NAV can also be found here over a number of previous years. Finally, the management section profiles all the people that will handle investments and that will hopefully be making you money. This section will contain at least the names of the management teams, but some can go as far as including experience of the managers as well. 

 

An addition document called the Statement of Additional Information (SAI) can also provide important information to a potential or current investor of a mutual fund. This document isn’t typically released unless it is requested. These SAIs provide more detail than the prospectus about the dos and don’ts of a certain fund’s investments and can also identify interests on the board of directors along with how much the board is being paid for their work.

 

There are a few different types of mutual funds: Open-end funds, exchange-traded funds, equity funds, bond funds, money market funds, funds of funds, and hedge funds. Mutual funds are classified as open-end investment, which was mentioned in the dictionary definition earlier. Being open-ended means that at the end of each day funds issue new shares to investors and buy back shares from investors that wish to sell. A closed-end fund has a limited number of shares available and is normally not redeemable for cash or securities. An exchange-traded fund (ETF) is a variation that combines aspects of both the open-end mutual fund and closed-end funds. This is typically used on a larger scale where shares are issued or redeemed by investors in large quantities. Thus, by reducing the total number of small transactions they tend to have lower expenses. 

 

Equity funds are the most common type of mutual fund. These typically consist mainly of stock investments and hold fifty percent of all amounts invested in mutual funds in the Unites States. Bond funds have a fixed set of time before they mature. These vary in their fixed times and have many different options that allow for higher yield, which typically will also lead to a greater risk. Money market funds are the last risky of the mutual funds, but also the lowest rate of return. These money market shares are liquid and can be bought or sold at any time.  Funds of funds are mutual funds comprised of other funds. Lastly, Hedge funds are pooled investment funds with loose SEC regulation. These types of funds are typically only open to a limited range of professional or wealthy investors and frequently invest in more risky areas, such as oil & gas futures or shorting specific stocks. 

 

As an investor in a mutual fund you are an owner of that company. Much like many other corporate entities a mutual fund has a board of directors that represents all of the investors (shareholders). It is their job to ensure that the best money manager or fund manager is running the investments the best that they’re able while keeping the shareholders from overpaying for these services. Even with all these regulations, you shouldn’t get the wrong idea that these are always safe or secure. Mutual funds aren’t insured or guaranteed and money can still be lost. In the same respect, the possibility of losing all of your money is unlikely. If some holdings lose value, the overall value of the fund will decrease, but unless all of the stocks or bonds crash within the portfolio you should still have a well diversified fund.

 

When looking at a mutual fund, you will find the net asset value or NAV. This is the price of a single ownership stake in that fund. When purchasing from a mutual fund, often it is seen as purchasing a product. In this case you’re actually buying an ownership stake in that corporation that then hires a money manager or fund manager to invest its money. This money manager combines all the money from the investors (which is called the fund’s assets) and uses these assets to invest in stocks, bonds, or some mishmash of the two. This helps in a few ways, but mainly the transaction costs are shared across all the investors and it allows for cost-effective diversification. A lot of funds have a much more complicated edict, but these are the basics to the mutual fund. The stocks and bonds that have been purchased are then referred to as the fund’s holdings and all of the fund’s holdings together are referred to as the fund’s portfolio. These mutual fund portfolios can be vastly different depending on the fund’s objective.

 

A great benefit to investing in a mutual fund is that a large amount of capital isn’t necessary when starting out. Often a smaller dollar amount can get you investing within a diversified portfolio. This will give you a more varied assembly of stocks and bonds than what you could accomplish on your own with the same amount of money. Overall a mutual fund is an investment opportunity that can be started with a relatively small initial investment. Mutual funds are also easy to buy and sell. Once you have your money in with a fund company buying the shares is a simple process. It can usually be done over the phone and in a lot of cases over the internet. If you decide that you’re going to sell your shares this process is pretty painless as well. There is no need to find a specific buyer like you would with individual stocks, instead, mutual funds typically offer daily redemptions that allow you to get cash for your shares whenever you would like to sell.

 Another benefit to the mutual fund is that not as much in depth knowledge is needed to go out and make sensible decisions. When buying individual stocks and bonds you would need a good understanding of financial statements for those companies in which you wanted to invest. Reading, understanding, and interpreting those financial statements would be necessary to make sound choices. With mutual funds specialists are being paid to do these things for you. A basic understanding of the workings of the financial system and stocks and bonds is obviously of great importance, but not to the same degree as individual purchasing. 

 

Overall a mutual fund can be a great first step to getting into the stock market. There is a lot to learn and almost too many options for a rookie to jump into while still feeling comfortable that his or her money will still be there tomorrow. Mutual funds offer guidance and a diversified investment that can help offset some poor choices made in specific investments. With luck and some sound judgment you should be on your way to choosing the mutual fund (or gift!) that works best for you.

 

 

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Amy T

Amy T

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Sedate technology

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