Mutual Fund Basics

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A mutual fund is a collection of assets from multiple investors that is professionally managed for the purpose of investing in securities such as stocks, bonds, and other assets depending on the fund’s prospectus. A fund’s prospectus is a detailed document of the investment objectives and strategies of a particular fund. The combined holdings of stocks, bonds, and other assets the fund owns is also called its portfolio. Each investor owns shares, which correspond to a portion of these holdings in the fund. These professional managers invest the fund’s capital in an attempt to produce capital gains and income for the investors.

A mutual fund is an open-end fund, meaning there is no limit or restriction as to how many shares can be issued. If investor demand increases, then the money manager would purchase more of each stock in order to increase the number of shares of the mutual fund. If shares in a mutual fund are purchased, more shares are created, and if somebody sells their share, the share is taken out of circulation. Through constantly selling and buying back fund shares, these open-end funds provide investors with a very convenient and useful investing vehicle.

There are four major benefits of mutual funds: professional money management, convenience, diversification, and liquidity. The professional money management provided by mutual funds allows investors to choose a money manager. This money manager not only researches what investments to make and when, but also constantly monitors the stock market and economic changes in order to make the right decisions for each investor. Mutual funds also provide investors with convenience, because it is a way to avoid all the complicated decision-making involved in investing in stocks. In comparison to investing directly in capital markets, mutual funds offer a low cost of investment. Diversification helps mitigate the larger risks of investing, due to the investment across a diverse range of assets. Thus, owning a mutual fund is a convenient way to be diverse without having to take the time and analyze dozens of individual stocks, because mutual funds provide the professional money manager. The fourth benefit of mutual funds is liquidity, which means that investors can easily buy or sell mutual fund shares.

Since mutual funds are not publicly traded individual stocks, most mutual funds are priced once each day. The net asset value (NAV) represents a fund’s per share market value. This is the price at which investors buy fund shares from a fund company and sell them to a fund company. Funds do not trade throughout the day, they only trade and are priced at the end of the day.

One way to diversify a portfolio is to invest among the various sectors of the economy. On the other hand, a sector fund is a mutual fund that invests in a specific sector of the economy, such as real estate or energy. Sector funds are a way to reduce risks through diversification within a single particular industry.

Many mutual funds have something called a load. A load is basically a fee paid by the investor to the money manager selling the fund, similar to a sales commission. Loads can be charged in different ways: front, back, and no load. Front-end loads are charged upfront when someone puts money into the fund and normally range between 3.5%-6.5%. Back-end loads collect these fees when the shares are sold, when someone takes their money out of the fund. No-load funds have no fee at all; however, this means that all the sales are distributed by the investment company itself, rather than through a secondary party.

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