What Is a Mutual Fund and How Does It Work?

Sep 16, 2021 08:44 PM ET
What Is a Mutual Fund and How Does It Work?

A mutual fund is a pool of investment from different investors that are managed by professional money managers. The money invested will be put into different pools of securities such as stocks or bonds. 

The investment portfolio of a mutual fund is catered to meet the investment goals and strategies of the investor. Normally, these funds are diversified because they invest in a variety of securities. Profit can be obtained through capital gains or dividends. 

Gains or losses of the portfolio are distributed evenly to the proportion of shares an investor owns in this funding pool. The value of the mutual fund is calculated through the total market cap. 

A mutual fund is also a company. Therefore, buying a share is equivalent to owning both the shares of the stocks the company owns and parts of the company. Owning mutual fund shares is different from owning stocks because stock owners can vote on a company's corporate decisions, whereas fund owners cannot. 

Types of Mutual Funds

There are various types of mutual funds for different investors, depending on their strategies and goals. These differ by the types of securities that the fund invests in. Below are three main types of mutual funds.

ETFs

Exchange-traded funds (ETF) are a type of mutual fund that functions like a stock. There are two main types of ETFs: stock index and sector-based. The former offers high diversification as it follows an underlying index, whereas the latter is composed of stocks from a particular industry hence, more focused. 

They are versatile as they can be traded throughout the day. Due to this characteristic, there is more potential for profits when combined with options for leverages and futures trading. ETFs are also more tax-efficient when compared to other mutual funds.

On the flip side, owning ETFs also has the same risks as owning stocks which makes this mutual fund more precarious than others. 

Equity

Equity is a type of mutual fund that is made up of stocks. These are usually focused on a particular industry, including both domestic and foreign stocks. 

The size of equity is divided into three categories: large, medium, and small cap funds. They vary in total market cap, which could be an indication of diversification and liquidity. 

Investors tend to consider both the market cap and potential growth of the stocks component. A large market cap is generally safer with less room for growth. High market cap equities are normally called a value fund which is one composed of reliable, high-quality yet low-growth companies. They often have high dividend yields but do not have a high price-to-earnings and price-to-book ratio. Hence, they are categorized as relatively safer. 

On the other hand, a growth fund describes a fund that has slightly lower market caps. It does not yield high dividends and has high price-to-earnings and price-to-book ratios. Mutual funds with features somewhere in the middle are labeled as a blend. 

An investor portfolio should compose of all three types of equities to spread risks but also have sizable room for growth. 

Other types of mutual funds that belong under the umbrella of an equity fund are index funds, balanced funds, international funds, and specialty funds. 

Fixed income

Fixed-income mutual funds generally invest in safer securities like government bonds or corporate bonds. The investments will be used to buy bonds, and the dividends will be distributed between the investors. This portfolio is generally safe as it is a source of passive income, and investors, as well as fund managers, do not have to take massive risks. 

However, some fixed-income funds refer to a fund that trades fixed-income securities. Fund managers will research and buy undervalued bonds and resell them at a higher price. These work similarly to equity. The only difference is that bonds are safer with relatively lower volatility. 

Most bonds investors need to have good knowledge of the effect of interest rates on the price of bonds. Increasing interest rates lead to a lower bond price (and vice-versa) due to opportunity cost. High-interest rates increase the opportunity cost when owning a bond. Investors may choose to put their money into savings as a result which leads to a decrease in demand for bonds. 

As there are two types of fixed-income funds, be sure to do thorough research before investing to avoid confusion and potentially losing money needlessly. 

Advantages

Diversification

Most mutual funds are made up of securities of different sizes from multiple industries except a sector-based ETF. This means that your portfolio will be diverse and risk can be spread out. Your income will be coming from different sources. Hence, even if a company is not performing well, the rest of the mutual fund can act as cover. 

High liquidity 

Mutual funds have high liquidity. It is an investment method adopted by many due to its safety and diversity. This can be an advantage in making trades more efficient and making exits easier. 

Skilled management

Your investments will be managed by a group of expert financial managers. They will have experience with trading and a full understanding of the market. Furthermore, these experts save investors time that is dedicated to doing research and tracking the market. Most fund managers have specialized technology and tools to help them make the best decisions. 

Disadvantages

High fees

As mutual funds are managed by professionals, it comes with relatively high management fees. Also, mutual funds operate as a company; hence, there are different departments that make up the system: creation, distribution, marketing, and operation of the portfolio. The salaries of these workers are all accounted for when sharing dividends. 

Quality of managers

The quality of the portfolio managers will be the make or break of your investment. Although many mutual funds have high-quality professionals, smaller funds with more ambitious gains might not. Make sure you do research on the history of the fund to check the quality of the manager. 

Taxes

As soon as an investor sells a share of a mutual fund, a capital gain tax will immediately be applied. This is one of the features that make investing in a mutual fund more of a long-term option. 

Conclusion

A mutual fund is a conservative, long-term investment option where an investor contributes money to a pool of investment managed by an expert money manager. 

There are different types of mutual funds with varying strengths and weaknesses, therefore do your research and have a good understanding before investing.

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