Mutual Fund - Explained
What is a Mutual Fund?
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Table of ContentsWhat is a Mutual Fund?How Does a Mutual Fund Work?How Mutual Fund Companies WorkKinds of Mutual FundsMutual Fund FeesClean Share Mutual FundsAdvantages of Mutual FundsDisadvantages of Mutual Funds
What is a Mutual Fund?
A mutual fund is a pool of funds collected from many investors with the purpose of investing in securities. Mutual funds are often regarded as investment vehicles because the pool of money realized from investors are for investment. Mutual funds are operated in a professional and structured manner. A company that pools money from many investors is called a mutual fund company. Securities such as bonds, stocks, short-term debt and some other asset are purchased with the money pooled from investors. Mutual funds are managed and operated by professionals who are called money managers, they are responsible for the collection of funds from investors and purchase of securities.
How Does a Mutual Fund Work?
A mutual fund portfolio is the combined funds pooled from investors for the purpose of investing in securities. Individual investors can buy shares, bonds, equities, stocks and other professionally managed securities. Usually, a professional money manager operates mutual funds in order to produce profits or capital gains for investors, although, some losses might also occur. The gains and profits of the purchased shares of securities are also shared by these investors. Units of mutual funds are purchased by investors at net asset value (NAV) per share or NAVPS. The total value of securities in a portfolio divided by the total about of shares outstanding equal the NAV of a mutual fund. A mutual fund refers to both an investment and a company. Usually, a pool of money collected from many investors for the purpose of investing in securities make up a mutual fund. The company that also pools funds from investors to purchase stocks, bonds, equities and other assets is also a mutual fund. An investor that purchases a mutual fund unit has directly or indirectly bought part of the ownership of the mutual fund company alongside the assets. Furthermore, a mutual fund is valued based on the performance of securities or invests in, investors that buy mutual funds automatically share in the performance of the portfolio, whether it results in profits or losses.
How Mutual Fund Companies Work
Mutual fund companies specialize in pooling funds from many investors and using the funds to buy portfolio or securities in the market. A professional money manager handles investment and allocates funds to suitable securities in mutual fund company. The main goal of this fund manager is invest and allocate funds in securities that are profitable to investors. The Board of directors of a mutual fund company often decide on who to hire as a fund manager based on experience and other qualifications. A mutual fund company might also hire analysts, researchers and a few employees alongside the fund manager. The service of a compliance officer or an attorney is often needed in mutual funds companies.
Kinds of Mutual Funds
Due to the fact that mutual funds are invested in diverse categories of securities as decided by the fund manager, there are several types of mutual funds. They are;
- Fixed income mutual fund: in this category are securities that have fixed rate of return no matter how the market looks like. Debt instruments, corporate bonds and government bonds are examples of fixed income mutual fund.
- Index funds: this type of mutual fund suits cost-sensitive investors, they are investments that are purchased with the aim of beating the market. Securities or stocks that match the standard of the S&P 500 or the Dow Jones Industrial Average are often purchased in this category.
- Balanced funds: These are securities purchased to reduce the risk of exposure to an asset. This mutual fund focuses on assets association with lower risk. It is also called asset allocation fund.
There are other kinds of mutual funds which include; sector funds, alternative funds, target-date funds, funds-of-funds, equity funds, smart-beta funds, among others.
Mutual Fund Fees
Annual operating fees and shareholder fees are the two categories of fees in mutual funds. The annual operating fee is between 1% - 3% of the funds that an investor has and is being managed by the mutual fund company. Expense ratio which includes management fee, advisory and administrative fee make up the annual operating fee. Shareholders fees on the other hand are paid directly by shareholders when buying or selling mutual funds, it is otherwise known as commission and redemption fees paid on funds purchased or sold. Commissions on funds are charged based on the load of the mutual funds, whether it is front-end load or back-end load. It is also possible for a no-load mutual fund to be offered to investors, in this case, no commissions or sales charges is attracted.
Clean Share Mutual Funds
Clean shares refer to a new type or class of mutual funds that was developed in response to the U.S. Department of Labors fiduciary rule. Clean Share Mutual Funds enable investors access the same funds that can be accessed in other mutual fund offerings but at reduced costs. Investors save up to 0.50% in returns when compared to other classes. Clean shares mutual funds address conflicts of interests between investors and fund managers or advisors. For instance, in some cases, managers recommend expensive fund options to investors so that they can make more profit, the higher the funds, the higher the commission. Clean shares on the other hand are recommended in investors best interest and not in the interest of advisors. Clean share put an end to conflict of interest by giving standardized fees and loads and enhancing transparency in mutual funds transactions.
Advantages of Mutual Funds
The advantages of mutual funds are as follow;
- Professional management of funds is one of the advantages of mutual funds. Mutual funds are operated by professional managers, alongside analysts and qualified researchers.
- Mutual funds can be diversifies: this means an investor can purchase different securities within a portfolio in order to reduce market risk. A diversified portfolio contains different securities and varying capitalizations.
- There is ease of access when trading mutual funds in major stock exchange markets. Whether buying or selling, trading mutual funds is stress-free. Access to mutual funds also provide investors access to exotic commodities or foreign equities.
- Economies of scale: if an investor purchases only one security, it will give freedom from numerous charges that funds managers attribute to the management of funds. Instead of purchasing diversified portfolios, investors purchase a singly security as economy of scale.
- Mutual funds are investors or individuals-oriented. Generally. Mutual funds are easily-understood, diversified and have high liquidity. Anyone without managerial experience or an individual that does not want to actively manage their money is safe when he invests in mutual funds.
Disadvantages of Mutual Funds
Despite the appealing attractions and advantages of mutual funds, they are certain downsides. The major disadvantages of mutual funds are;
- Mutual funds have no guaranteed rate of returns, there is a tendency of depreciation of value of mutual funds. Price fluctuations or fluctuation of returns are parts of the risks of mutual funds.
- No guarantee of performance for mutual funds because they are not backed up by the Federal Deposit Insurance Corporation (FDIC) unlike government bonds that are FDIC backed.
- Since mutual funds are funds pooled from many investors, there is often daily investment and withdrawal of funds causing instability.
- Vagueness of assets and complicated ranging of assets is another downside of mutual funds. These funds can sometimes lack transparency or be manipulative.
- Investors do not have the access to compare earnings per share or sales of growth of an investment in mutual funds, hence evaluating mutual funds is somewhat difficult.
- Mutual funds are expensive to manage because they require the service of professional fund manager who receives commission, management fees of expense ratio on funds.