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An Introduction to Mutual Funds – Top 10 Questions Answered

1. What is a mutual fund?

A mutual fund is an investment vehicle which allows individuals and businesses to pool their money together and have it invested by professional money managers. Just as you would hire a mechanic to fix your car, or visit a doctor for medical care, many people find that hiring an investment professional makes sense for them.

 

2. What is the purpose of a mutual fund?

The purpose is to provide diversification as well as risk management. Generally, the goal for a fund manager is to make as much money as possible for the fund’s investors while also protecting them from losses. A manager can do this by investing across many different companies, countries, security types, credit ratings, and also risk levels. The specific strategy for each fund is outlined in the fund’s prospectus, which also provides other important information relevant for investors. You should always read the prospectus prior to making an investment to ensure that a particular fund is right for you.

 

3. Are there different kinds of mutual funds?

Yes, there are actually many different kinds. Mutual funds may provide exposure to certain geographic areas, security types, and/or risk levels. For example, there are income funds, which generally only invest in bonds and other fixed income securities. There are also equity funds which hold primarily shares of public or private companies. Other funds hold a combination of the two and may also utilize derivatives to maximize returns for investors.

 

4. What determines the performance of a mutual fund?

The performance of a mutual fund is actually determined by the underlying securities which the fund invests in. If a mutual fund holds a share of stock, for example, then its investors participate in any increase or decrease in the market value of that share, which is the price that may be quoted on a stock exchange for that particular security. Fund investors may also receive any dividends that are paid out by the companies whose shares are held by the fund. With fixed income securities, such as bonds for example, fund investors participate in any increase or decrease in the market price of the instrument, and also receive the interest that is paid out on the bonds or other fixed income instruments held by the fund.

 

5. What are open-ended investment companies?

You may hear mutual funds being referred to as open-ended investment companies. The term “open-ended” means that the number of shares that can be issued by the fund is unlimited. So instead of buying shares from other investors (as you might do when you purchase a share of stock), you buy and from the mutual fund company itself. Because of this, mutual funds are said to be more “liquid” than other pooled investment vehicles such as hedge funds or private equity investments. Unlike these other investments, which may require you to lock in your money for several months or even years, mutual funds generally allow you to buy or sell your shares within a day.

 

6. What happens when I purchase a share in a mutual fund?

Each mutual fund share you own allows you to participate in the gains or losses incurred by that fund. So let’s say a mutual fund has one investor who puts in $1 million. Then a new investor puts in another $1 million. The fund would then grow to a total of $2 million, with each investor participating in half of the gains and losses incurred by the fund.

 

7. What kinds of investors do mutual funds typically have?

Investors in a funds can be individuals, public or private companies, retirement plans, or even other funds.

 

8. What are the advantages to mutual funds?

The primary advantage of mutual funds is diversification. This means that your money is invested in many different securities and asset types. The purpose of this is to decrease the risk that a loss on any particular investment would be seriously detrimental to the overall portfolio. A fund can hold dozens or even hundreds of securities, which means that each holding might represent only 1 or 2 percent of the entire value of the fund.

Another advantage to mutual funds is that they provide professional management. Investing in securities involves a tremendous amount of analysis and research, which is time-consuming and can be very expensive. When you invest in a mutual fund, you are able to hire a fund manager with significant investment management experience and a proven track record to manage your portfolio.

A third advantage is that fund investors can also benefit from economies of scale, because the fund may receive discounted rates from brokerage firms and other service providers.

Yet another advantage to mutual funds is that they may use derivatives for purposes of speculation and hedging. This is done to maximize returns in some cases and to prevent simply losses in others. Funds may employ a wide variety of derivatives to execute their strategy, many of which are often provided only to reputable investment companies and may be unavailable to individual investors. As a result, someone looking to protect their portfolio may not have access to all the tools that a mutual fund might employ on their behalf. The use of derivatives may also be a disadvantage in some cases, however, as volatile market conditions or improper handling of derivative instruments can negatively affect a fund’s performance.

 

9. What are the downsides to investing in mutual funds?

These advantages do come at a cost. Mutual funds charge fees for their services which are taken out before distributions are made to investors. The fees are charged as a percentage of assets under management, and may range up to 1%, 1.5% or higher in some cases. Passively managed funds generally charge lower fees. The fee schedule for any mutual fund can be found in its prospectus.

One thing investors should watch out for when choosing a mutual fund is sales charges (also referred to as “loads”) that are assessed either when you invest in or pull your money out of a fund. These charges can range up to 5.75% in some cases. When you are charged a front-end load, this means that a sales fee is deducted before fund shares are purchased. So, for example, if you invest $100 with a $5 front-end load, only $95 will actually be put into the market. This is an important consideration for investors, because that $5 takes away not only from the returns you earn in the first year of your investment, but also in future years as you lose the potential compounded returns that the $5 might have provided.

 

10. Can I lose money if I invest in a mutual fund?

Even though mutual funds provide diversification and rely on advanced research and analysis, there are unfortunately no guarantees against loss. Today’s markets tend to move quickly, and even the most well-known and experienced mutual funds managers may underperform at times, which can result in losses for investors. This means that investors should continually monitor the funds which they are invested in and work closely with a financial professional to ensure that there remain on track to achieve their investment goals.