A mutual fund refers to a financial vehicle that pools money from multiple investors to buy stocks, money market instruments, bonds, ETFs (Exchange Traded Fund), and any other securities. Mutual funds are run by money managers who allocate the funds in the most profitable way for investors.
All mutual funds have a prospectus. The fund’s prospectus includes a clear investment objective. The money manager must structure the mutual fund’s portfolio to meet these objectives. Often an individual investor does not have access to portfolios managed by experts as there is a minimum investment.
Mutual funds offer them this opportunity, with principal investments being as low as $2500 for some funds. Bear in mind that each mutual fund investor will have an equal share of the profits and losses proportional to the amount he invests.
Mutual Funds: The Basics
As mentioned above, mutual funds collect funds from several investors and use them to buy securities. These securities are usually bonds and stocks, and the value of the mutual fund will be determined by the performance of the stocks that it has bought.
If you purchase a mutual fund share, you invest in a portion of the portfolio’s value. It is different from buying company shares on the stock market. That is because purchasing shares in a mutual fund investment does not give investors voting rights. The fund represents a variety of stocks and other securities in place of a single holding.
The Net Asset Value
Since one share represents several stocks, the share price in a mutual fund is called the net asset value. An accountant calculates this value by dividing the total securities value in the portfolio by the total shares outstanding. Outstanding shares refer to those shares held by institutional investors, shareholders, and other insiders investing.
These are bought as required at the current net asset value and settled at the end of every trading day. Unlike stock prices which are constantly adjusting during the day, this price only changes at the end of the day.
Benefiting From Investing In A Diversified Portfolio
Generally, a fund includes many different securities, which means investors benefit from a diversified portfolio and a low price. A diversified portfolio is beneficial because it reduces the risk tolerance for investors. If, for instance, investor A only buys Company X shares during a bad quarter, they are likely to lose a lot of money investing.
If they invested in a mutual fund that has some Company X shares and also contains a basket of others, they are likely to lose significantly less as this volatility is balanced against gains of other shares.
How Investing In Mutual Funds Work
A mutual fund operates both as an investment and an actual company. Although it seems unusual, it is the same as GOOG, representing a share of Google, and when an investor buys Google stock, they are investing in a portion of the company and its assets. Unlike Google that produces electronics and software, the mutual fund company deals in investments.
How Do Investors Earn Returns?
Investing in a mutual fund, you can earn returns in the following ways.
- Mutual funds pay out the income they earn throughout the year as dividends. The fund will give you a choice between reinvesting your dividends or receiving a check.
- When the fund sells its securities at a profit, it makes a capital gain. The gain is passed on to investors in a distribution.
- In case the fund’s holdings increase in price and the fund manager does not sell, individual investors can sell and make a profit.
A mutual fund can be a virtual firm, in which case the fund manager is the CEO and is often referred to as the investment adviser. The mutual fund board of directors hires the investment adviser. Bear in mind that most of the time, the Money Manager owns the Mutual fund but can hire analysts to find the best investment opportunities.
What is NAV?
A mutual fund should also have an accountant to calculate the NAV, which determines whether the share price goes up or down. It should also have a lawyer and a compliance officer to help keep up with government regulations.
Mutual funds are usually part of an investment company, and the largest investment companies have hundreds of mutual funds. Examples of such investment companies include Oppenheimer, T. Rowe Price, and The Van Group.
Types of Mutual Funds
Here are the main types of mutual funds.
Equity funds (also known as Stock Fund) refer to mutual funds that invest in stocks and are divided into several subcategories. The company size and its investing approach determine the subcategories. The company can be large, medium, or small.
The investing approach refers to whether the company has an income-oriented, value, or aggressive growth investment strategy. Equity funds are also categorized depending on whether they invest in foreign or domestic stocks.
Fixed Income Funds
Government bonds, corporate bonds, and several other debt instruments pay investors at a fixed rate. As the name suggests, fixed-income funds focus on these types of investments. The Portfolio Manager will share funds generated from the bond fund among the investors in a distribution.
Investment advisors must actively manage fixed-income funds. That is why they buy undervalued stocks and sell them at a profit. Fixed-income funds generate large amounts of revenue, but like all investments, they have a significant risk.
Income funds, as the name implies, are meant to provide steady income to investors. Fund managers invest these mutual funds in high-quality corporate and government debt. Income funds are popular with retirees and conservative investors. They are also not the best choice for people who are tax conscious because they produce regular income.
An index fund is created on the basis that it is difficult and expensive to beat the market. The fund manager will buy stocks that correspond with indexes like the Dow Jones Industrial Average. Such a strategy uses up fewer funds and involves less research.
Balanced funds invest in a wide array of securities to reduce your investment risk exposure.
Why Invest In Mutual Funds?
Mutual funds are an excellent way to diversify your portfolio when investing. They are a way for people who do not have large amounts of money to make profitable financial investments.