What is a Mutual Fund?
A mutual fund is an investment vehicle, in with investors pool their money together to invest in financial instruments such as stocks, bonds, ETF, commodities, interest rates, etc. Every mutual fund has a prospectus, which defines the fund’s investment objectives – and the strategy to achieve them. A fund manager is responsible for implementing the prospectus and managing the fund accordingly.
Investors can buy and sell shares in the fund at its current net asset value (NAV), and then the fund manager will in turn invest their money according to the fund’s strategy and goals. Investors can then profit from their investments in three different ways:
1. Dividend payouts from stocks held in the fund or interest paid on bonds will return to the investor in the form of a distribution.
2. When the fund makes a profit by selling securities that have gone up in value, a portion of this profit will often be paid out to investors.
3. Investors can sell their fund shares and make a profit based on their change in value.
In many cases, investors will choose to reinvest their distributions in the fund, which is an alternative to accepting them and then finding a new asset in which to invest their money.
There are many unique types of funds investing in various markets, sectors, or even counties. One type is a fund of funds, which invests its capital in other mutual funds. That creates the ultimate diversification but includes a high cost of double-layered fund management fees.
Advantages and disadvantages of a mutual fund:
– Diversification: by owning shares in a mutual fund you invest in many different stocks, bonds, or other financial instruments at once.
– Professional Management: a fund is overseen by a full-time manager.
– Economies of scale: Because the money is pooled together, fund managers have more leverage to get better transaction costs and investment research than a private investor could get alone.
– Liquidity: You can buy and sell shares in the fund equivalent to their net asset value at any time.
– Costs and Management: The fund pays management out of the investors’ money pool. These costs can vary but should ultimately justify investing in the mutual fund vs investing alone. Surprisingly, many fund managers have shown they can hardly outperform the benchmark index. This raises the question if it’s not easier to just invest in the much more cost-efficient exchange-traded funds (ETFs) or manage your own portfolio.
– Dilution: Trade volume and company size make it more difficult for extremely large funds to invest profitably. Because they have to distribute their money so much it comes to a point where good investments are barely a factor in the overall portfolio.