An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus. One of the main advantages of mutual funds is that they give small investors access to professionally managed, diversified portfolios of equities, bonds and other securities, which would be quite difficult (if not impossible) to create with a small amount of capital. Each shareholder participates proportionally in the gain or loss of the fund.
Just as shares represent the extent of equity ownership in a company, units represent your extent of ownership in a mutual fund. Mutual fund units, or shares, are issued and can typically be purchased or redeemed as needed at the fund's current net asset value (NAV) per share, which is sometimes expressed as NAVPS.
You can make money in 3 ways from mutual funds:
The returns of stocks, bonds, and cash investments usually don't all rise or fall at the same time. When returns for one asset class fall, those of another asset class may be rising. Diversification—the simple concept of not putting all your eggs in one basket—takes advantage of this investment principle. When you diversify, you invest in different asset classes—and even in different segments of those asset classes. In this way, if an investment in one asset class does poorly, the loss may be tempered by an investment in another asset class. Although diversification can never eliminate the risks of investing, it lowers your overall risk by spreading the risk around. Investing in mutual funds is a proven diversification strategy. By investing in a mutual fund’s array of assets, you reduce the risk that comes with owning any single stock or bond.
One big advantage of mutual funds is the ability to get in and out with relative ease. In general, you are able to sell your mutual funds in a short period of time without there being much difference between the sale price and the most current market value. However, it is important to watch out for any fees associated with selling, including back-end load fees. Also, unlike stocks and exchange-traded funds (ETFs), which trade any time during market hours, mutual funds transact only once per day after the fund's net asset value (NAV) is calculated.
In an actively managed fund, a fund manager tries to outperform similar funds or an appropriate market benchmark. To do this, managers use research, market forecasts, and their own judgment and experience to buy and sell securities. Index funds, sometimes called "passively" managed funds, don't try to beat the market. Instead, managers of index funds seek to closely track the performance of a target market index. Index funds buy and hold all, or a representative sample, of the securities in the index.
Both actively managed funds and index funds can play a role in an investment portfolio. Some investors who seek to outpace the market favor actively managed funds. However, actively managed funds may also do worse than the market average—and they often do. Index funds typically enjoy a bit of a head start compared with actively managed funds because their operating and transaction costs are usually very low. Also, reduced trading activity tends to make index funds more tax-efficient, because index funds typically generate smaller capital gains distributions than actively managed funds. (Capital gains distributions are subject to taxes when the investment is held in a taxable account.)
The fees and expenses charged for investments vary. The fees usually depend on the type of investment and the investment company with which you are investing. Typical fees and expenses charged by investments include but are not limited to: administrative expenses, advisory fees, and load fees (front-end and back-end).
Administrative expenses are fees charged for daily administrative functions that the investment manager needs to do. Some of those administrative functions include recordkeeping and investment maintenance. Some managing companies might charge a fixed fee or a percentage of the assets (money) in your investment portfolio.
Another fee charged by managing companies is advisory fee. Some managing companies charge this fee when they help an investor design a portfolio or for giving investors financial advice about their investment alternatives. Advisory fees are standard business practice which compensate the manager for his/her services. Mutual funds and professional portfolio managers will charge approximately 1-3% annually of the total assets under their management.
Another fee charged by managing companies is a load fee. When managing companies want to buy or sell its parts, they have additional costs. The managing company passes this cost onto the investor by charging a load fee which is used to pay the brokers. There are two types of load fees: front-end load and back-end load. Front-end load is charged when a purchase is made for the investor's portfolio. Back-end load is charged when a sale is made from the investor's portfolio.
Like most investments, mutual funds have risk — you could lose money on your investment. The value of most mutual funds will change as the value of their investments goes up and down. The mutual funds are not protected by the State, or state deposits insurance fund.
The level of risk in a mutual fund depends on what it invests in. Usually, the higher the potential returns, the higher the risk will be. For example, stocks are generally riskier than bonds, so an equity fund tends to be riskier than a fixed income fund.
Some specialty mutual funds focus on certain kinds of investments, such as emerging markets, to try to earn a higher return. These kinds of funds also tend to have a greater risk of a larger drop in value.