As a popular investment option, you have probably already heard plenty about mutual funds. Chances are you own mutual funds in your retirement plan or brokerage account. In fact, according to the Investment Company Institute, more than 92 million individuals in the U.S. (about 45% of U.S. households) owned mutual funds in 2008. But do you know what mutuals fund are and why so many people own them?
Mutual funds are an investment that allows a group of investors to pool their money and hire a portfolio manager. The manager invests this money (the fund’s assets) in stocks, bonds or other investment securities (or a combination of stocks, bonds and securities). The fund manager then continues to buy and sell stocks and securities according to the style dictated by the fund’s prospectus.
All mutual funds charge fees to operate and manage the fund. Management fees pay the fund companies (or managers) to manage the funds. Some funds also charge investors an upfront sales charge/load when he/she first purchases shares in the fund, while other funds charge a back-end load (contingent deferred sales charge) upon sale of fund shares. There are also funds that have no sales charge and these are known as “no-load funds.” 12b-1 fees are imposed by some funds to cover marketing and distribution costs. There are also various share classes of funds that differ in fee structure according to class (Class A, Class B, Class C, etc.)
Technically, mutual funds are “open-end” funds -- one of four basic types of an investment company. Closed-end funds, exchange-traded funds and unit investment trusts are three other types. As investment companies, mutual funds are regulated under the Investment Company Act of 1940.
Regulation of mutual funds, compared to other pooled investment options (think: hedge funds) is extensive. Mutual funds must comply with a strict set of rules that are monitored by the Securities and Exchange Commission. The SEC monitors the fund’s compliance with the Investment Company Act of 1940, as well as its adherence to other federal rules and regulations. Since their development, the regulation of mutual funds has provided investors with confidence in terms of the investment structure.
The beauty of mutual funds is that you can invest a few thousand dollars in one fund and obtain instant access to a diversified portfolio. Otherwise, in order to diversify your portfolio, you might have to buy individual securities, which exposes you to more risk and difficulty.
Another reason to invest in mutual funds is their adherence to a basic principal of investing: Don’t put all your eggs in one basket. In other words, many different types of investments in one portfolio decrease your risk of loss from any one of those investments. For example, if you put all of your money into the stock of one company and that company files for bankruptcy, you lose all of your money. On the other hand, if you invest in a mutual fund that owns many different stocks, it is more likely that you will grow your money over time. At the very least, one company’s bankruptcy will not mean that you lose your entire investment.
Many investors don’t have the resources or the time to buy individual stocks. Investing in individual securities, such as stocks, not only takes resources, but a considerable amount of time. By contrast, managers and analysts of mutual funds wake up each morning dedicating their professional lives to researching and analyzing their holdings and potential holdings for their funds.
There are many types and styles of mutual funds. There are stock funds, bond funds, sector funds, money market funds and balanced funds. Mutual funds allow you to invest in the market whether you believe in active portfolio management (actively managed funds) or you prefer to buy a segment of the market with no interference from a manager (passive funds and index funds). The availability of different types of funds allows you to build a diversified portfolio at low cost and without much difficulty.
While you have a plethora of investment options (individual stocks, ETFs, and closed-end funds, to name a few) mutual funds offer a simple, efficient way to invest for retirement, education or other financial goals.