What are Mutual Funds?

//What are Mutual Funds?
What are Mutual Funds? 2017-10-06T01:03:08+00:00

Definition: Mutual funds are largely open-ended funds financed by different investors, who invest in a group of assets to meet common investment objectives. Over the past years, mutual funds have gained increasing popularity as an effective alternative investment solution for keeping a portfolio balanced, especially in times of financial uncertainty.

What Does Mutual Funds Mean?

What is the definition of mutual funds? Mutual funds are a suitable alternative investment, especially when the capital markets are highly volatile. By pooling money from different sources, these funds invest in securities of different asset classes, including stocksbonds, etc. Each owner of a security owns a percentage of the investment company’s total portfolio.

The major advantages of mutual funds can be summarized as follows:

#1 Diversification

A mutual fund can include securities from different geographical regions, sectors, industries or issuers. The money invested in a mutual fund is diversified, allowing a higher return potential. Even if some securities lose in value, winning securities will trade off for the losses. So, by investing in a mutual fund, small investors acquire ownership in a diversified portfolio and significantly lower their portfolio risk.

#2 Active management

Novice investors lack the education, skills, and resources to identify diversified investment opportunities in the thousands of securities available in the financial markets. On the contrary, the fund managers have access to research reports and are experienced in identifying investment opportunities to match the investment profile of their clients. Due to active management, though, these funds incur high advisory, management, and administrative fees.

#3 Liquidity

Investors can trade their shares directly from the mutual fund when the market is open. The mutual fund trades are priced at the Net Asset Value (NAV) of the fund, which is the price per share of the fund. However, unlike the stock prices, the NAV does not change during the trading day, but it is updated at the end of the trading day. So, investors are not buying shares, but a share in the portfolio priced in dollars.

#4 Indexing

Investors, who believe in efficient markets, invest in these funds that track indexes. For instance, the S&P 500, the Dow Jones Industrial Average (DJIA), and the Russell 2000 are some indexes that track changes in the value of a portfolio, which consists of the shares contained in the index. Index funds are passively managed and overall less volatile.

Let’s look at an example.

Example

The main types of mutual funds are summarized below:

Equity funds invest in stocks. They may invest in large-caps, mid-caps or small-caps, and are actively or passively managed. Because they invest in equities, they are widely viewed as high risk, but they also offer a potential for higher returns. Generally, the smaller the market cap., the riskier the investment, as the return of the fund is more volatile.

Growth funds are equity funds that invest in stocks with a potential for long-term growth. Companies that generate substantial revenue or earnings growth make up for good growth investments. Fund managers select these companies, expecting that their value will increase even further. On the other hand, growth funds are extremely volatile; hence, their stock prices may experience sharp fluctuations. Value funds are equity funds that invest in companies with low P/E ratios, which are not strongly favored by investors due to poor quarterly results or failing deals. On the other hand, value stocks pay high dividends, thereby generating dividend income and long-term growth.

Fixed-income funds invest in corporate, municipal, mortgage-backed or high-yield bond funds, thereby incurring a lower risk than equity funds. The maturities of funds can be short-, mid or long-term and the funds are actively managed and traded to generate the highest possible returns.

Money Market Funds invest in low-risk securities, aiming to earn interest and provide investors with a safe principal and liquidity. Generally, money market funds invest in short-term securities such as T-bills, certificates of deposit (CDs), and commercial paper, and their net asset value is $1. Money market funds are used for short-term investing.

There may be a more elaborate classification of these funds into sector funds, special funds, balanced funds, and so on. All in all, the popularity of the mutual funds is largely due to their ability to offer shares, which otherwise would cost a fortune to buy individually. At the same time, fund managers provide a comprehensive range of investment solutions to appeal to investors with different risk-return preferences.

Summary Definition

Define Mutual Funds: Mutual fund means a collection of investments grouped in a single fund to mitigate risk for the investors.