What is a Mutual Fund?

In the world of investing, a knowledge of some of the basic terms crucial to managing your money successfully. One of those terms is “Mutual Fund.” If you’re not familiar with the definition of mutual fund or how mutual funds can work for you, read on to learn more.

What is a Mutual Fund?

A mutual fund is a portfolio of stock, bonds, and other securities. In other words, rather than being a single stock, a mutual fund is made up of many different and diversified assets that are typically spread over a large area. Investing in mutual fund is slightly different because you are not actually purchasing stock in companies. Instead, you are purchasing a stake in the overall fund, which grows or shrinks depending on the performance of the various companies and securities that the fund is invested in.

What are the Advantages of a Mutual Fund?

There are several reasons to consider investing in mutual funds. First, a mutual fund is typically managed by a professional. This is important because, as the market fluctuates, the investment manager is able to make decisions, trading various investments to try and make the mutual fund as profitable as possible. With a seasoned manager at the helm, a mutual fund can often outperform market expectations and prove to be an excellent investment.

Second, mutual funds are a great way to diversify your portfolio, because investing in a mutual fund automatically spreads your capital out across a wide variety of holdings. This means that, even if one company or area of the market performs poorly, you’re less likely to take a significant hit, since your fund’s performance is based on more than just that one area.

Third, mutual funds are relatively an easy investment. The initial investment is typically small, and government regulations make it easy to keep tabs on how your money is being managed.

What are the Disadvantages of a Mutual Fund?

Mutual funds aren’t without their own set of problems, however. First, that investment manager mentioned earlier needs to get paid, and he/she gets paid even if the fund performs poorly. This can cut into your overall holdings. Passive funds, however, are not as actively managed and incur less fees, however.

Second, while the spreading out of investments in a mutual fund helps you keep your money even when certain areas are doing poorly, the opposite is true as well: a fast-growing stock or area will not affect your money as much, since your investments are diluted across many areas.

Third, in addition to fees, mutual funds often have a higher tax impact due to capital gains taxes. This is because the capital gains from the transactions the fund makes on your behalf are passed on to you, and because the fund holds a large number of stocks (or other assets), capital gains are more likely than if you were to manage an equity portfolio yourself. Investing in a tax-deferred fund, such as an IRA, can help to offset this.

Types of Mutual Funds: Closed End and Open End Funds

You wil come across the two main types of mutual funds: Closed End Funds and Open End Funds. Let’s take a quick look at each of these types.

Closed End Mutual Funds

A closed end fund is basically an investment company that you buy shares into. Typically, the number of shares of the closed end fund are fixed – when you buy a share, you buy it from some one else who is selling them. These shares trade in the secondary market. You do not buy from or sell to the mutual fund company.

The shares of a closed end mutual fund could trade at a premium or discount to the NAV (Net Asset Value). The NAV is defined as the sum of the value of all the stock that the closed end fund has invested in expressed as a per share value.

Closed end mutual funds are typically bought and sold through a brokerage acocunt.

Open End Mutual Funds

An open end fund does not have fixed number of shares outstanding. Every new investor in the fund is issued new shares in exchange for the capital the investor invests. These shares are issued at the current NAV, therefore an open end mutual fund always trades at the NAV. NAVs are calculated once a day after the market closes.

Open end mutual funds can be bought or sold through a broker (what is a broker?), or also directly through the mutual fund company. A broker may assess additional commissions for the transaction. An open end mutual fund typically has a minimum investment requirement.

There is no right or wrong option when you are choosing which type of mutual funds to invest in. However, if you are buying a closed end mutual fund, it is better to buy them when they are trading at a discount to its calculated NAV. In either case, you will want to read the mutual fund prospectus and understand the investment criteria, management skills and fees before you invest in the fund.

Types of Mutual Funds: Active Funds and Passive Funds

Another way to look at mutual funds is to see if they are actively managed or passively managed.

Let me explain.

Active Mutual Funds

Active mutual funds typically have a portfolio manager with a team of analysts that constantly evaluates investments to include or exclude from the fund portfolio. These funds perform according to the investment skills of the managers. Therefore when selecting these funds, the management skills, past performance track record and the stability of the management is of great importance.

Actively managed mutual funds may also conduct large number of transactions in any given year. This means that the fund expenses can be high and the funds may not be as tax efficient as you like. However, a skilled manager will generate enough excess profits for you to make these extra costs worthwhile.

Passive Mutual Funds

Passive mutual funds on the other hand have very little involvement from a portfolio manager or analysts. Normally these funds track a stock index and they buy or sell an entire index with not much thought or human involvement.

This way these funds can keep the expenses really low. If your investment goal is to keep expenses low, you should look for passive index funds. On the flip side, there is absolutely NO chance of you ever earning excess profits.

Passively managed index funds are not any less risky than most actively managed funds. A skilled manager can hedge against many risks in an active fund, while a passive fund has no defenses against many risks other than hoping that the sheer number of stocks they own via an index gives them some level of diversification.

I generally do not recommend passive index funds for investment at all, unless all you want from your investment portfolio is to earn a little bit less than average (yeah, there are fees to pay), year after year, and keep compounding the underperformance over time. These are the fast food for the investment world – convenient and easy for investors who are short on time and unwilling to do any work to secure their financial future. For anyone else who cares about their portfolios and wealth, there are better options.