What Are Mutual Funds and How Do They Work?
The definition of a mutual fund
A mutual fund is a different type of a company where the money comes from various investors. In addition to that, they try to invest in securities that do not represent an incredible risk to the participants.
The most important part of a mutual fund is its portfolio. In contrast to regular investing, the portfolio consists of all kinds of investments. Hence, the mutual fund does not have to buy shares in one sector only. Moreover, it is better if they invest in a variety of mixed stocks and money market instruments. That way, there is less risk for all of the members and a higher chance of capital gains or income.
Who are the members?
Mutual funds are the best option for investors who do not have a lot of money or those who are new on the stock market. Furthermore, it is also a fantastic ground for participants who have never invested before and are scared for their income.
However, all shareholders join individually and they split the gains or losses proportionally.
How is it different from other companies?
A mutual fund is a way to become an investor and a company owner at the same time. Once you invest your money in it, you own shares of the fund. However, at the same time, you also have an income based on the assets. Moreover, your profit depends entirely on the performance of the portfolio – not individual stocks you own.
That is the essential difference between owning stocks on your own, and investing in a mutual fund. There is a higher chance of diversification. In addition to that, the risks are lower than usual. You would suffer significant losses in other situations. For example, if you owned stocks from a company that had a bad quarter. However, if they are just a fraction of the portfolio of your mutual fund, your losses would be lower.
How do mutual funds work?
Just like with any other company, it should have a financial advisor. While mutual funds are a virtual business, they have a board of directors that hire a manager. This person can be a shareholder himself, although it is not obligatory.
His job is to do everything he can to preserve the income and the portfolio of the mutual fund.
Apart from him, there are few employees in a mutual fund. Usually, there are also market analysts, an accountant, one or two compliance officers, and an attorney.
Types of mutual funds
- Fixed income funds – their main aim is to invest in government or corporate bonds, or debt investments.
- Index funds – they buy only the stocks that have a significant market index.
- Money market funds
- Balance funds
- Sector funds
- Equity funds
- Funds-of-funds – some mutual funds actually buy the shares of other similar companies.
There are two types of fees in a mutual fund. Those that cover the operating costs during the year, and shareholder fees.
Clean shares funds
There is a newer type of a mutual fund on the market that uses “clean shares.” That way, there is a supreme level of transparency among the shareholders. Furthermore, there is a higher chance of bigger savings.
Pros and cons of mutual funds
- Diversification – mutual funds smartly invest in all sorts of stocks and bonds.
- Economies of scale – the transaction fees are lower.
- The funds are accessible, and they provide individual investors to participate in the market of exotic commodities or foreign equities.
- Professional guidance – financial advisors are there to help you gain an income.
- Perfect for individuals who do not want to participate directly in the market.
- Diworsification – they might make a mistake and buy funds that are closely related.
- Expense ratio costs are high
- Sometimes, there is no transparency. And the purpose of the fund might not be clear to everyone involved.
- Some of the portfolios are cash-based.
- There is no guaranteed return, and FDIC does not insure money market funds.
- The shareholders cannot compare earnings per share and other variables, making it hard for them to determine which fund is the best one.