What is a mutual fund?

A mutual fund is an investment fund that pools money from a number of investors to invest in various securities, including equities, bonds and money market instruments. To many investors, choosing individual securities to invest in and manage can seem rather intimidating and risky. As a solution, mutual funds were created. Mutual funds are priced-based on a net asset value (NAV), which is calculated at the end of each trading day by dividing the total value of the securities by the number of the fund's shares outstanding.

Key takeaways:

Investors in the fund may be both institutional or retail. Each one owns units, which represent a portion of the holdings of the fund. The gains generated from the collective investment are distributed proportionately amongst the investors. As it is collective, every investor wins and loses in equal portion.

While some mutual funds are passively managed, the majority of investors look for actively managed ones, in which a professional fund manager allocates the fund's assets, aiming to produce capital gains for the fund's investors. The decision to buy and sell securities are typically made by one or more portfolio managers, supported by teams of researchers.

A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus. Since mutual funds can hold hundreds or thousands of stocks and bonds, they usually come with lower risk as they provide diversification.

Therefore, simply put, a mutual fund meaning a trust that collects money from many investors who share a common investment objective. It is one of the most practical investment options as it offers an opportunity to invest in a professionally managed and diversified basket of securities at a relatively low cost. 

Where have you heard about mutual funds?

If you are interested in investing, you've probably heard of mutual funds many times. Typically, a number of financial advisors recommend them to investors, describing mutual funds as smart yet simple investments. Mutual funds’ accessibility and flexibility make them a powerful investing vehicle for all types of investors, including beginners and pros. These can also be appropriate for a variety of investing and savings objectives.

What you need to know about mutual funds

The origins of the term go back to 1772 – 1773 when the first modern investment fund was created in the Dutch Republic. In response to the financial crisis of that time, Abraham van Ketwich, an Amsterdam-based businessman, established a trust named Eendragt Maakt Magt, aiming to provide small investors with an opportunity to diversify.

In the 1890s, mutual funds were introduced to the US. These were generally closed-end funds. The first open-end mutual fund, known as the Massachusetts Investors Trust, was established in March 1924.

As we have mentioned closed-end and open-end funds, let’s speak about these in detail.

Closed-end funds. This type of fund has a set number of shares issued to the public through an IPO. Just like stocks, these are traded among investors on an exchange. Based on the fact that a closed-end fund doesn’t issue or redeem shares, it is subject to the laws of supply and demand. Because of this, close-ended mutual funds are often at a discount to their NAV.

Open-end funds. A majority of mutual funds are open-ended, which means they don't have a fixed number of shares. Instead, the fund issues new shares when an investor decides to buy and redeem the shares when the investor decides to sell. Therefore, they're bought and sold on demand.

There are thousands of mutual funds available, but they can be divided into a few basic types and categories. The two primary types of mutual funds are stock and bond funds. From there, the categories get more diverse and specialised.

For instance, stock funds can be further divided into three sub-categories of capitalisation: small-cap, mid-cap and large-cap. They are then categorised further as either value, growth, or growth and income.

Bond funds are primarily categorised by the duration of the bonds, which are described as short-term, intermediate-term and long-term. They are then broken into sub-categories of municipal bonds, corporate bonds and US Treasury bonds.

Here is what you need to know about the most popular mutual fund types:

• Equity or stock funds come with the greatest risk alongside the greatest potential returns. Fluctuations in the market can significantly affect the returns of these funds. There are several types of equity funds, including income funds, sector funds and growth funds.
• Fixed-income or bond funds are less risky than equity funds. There are many different types of bonds, so, when investing, you should research each mutual fund individually to determine the amount of risk associated with it.
• Balanced funds invest in a mix of bonds, stocks and other securities. Also called hybrid funds or asset allocation funds, these are often a “fund of funds,” investing in a group of other mutual funds.
• Index funds have become extremely popular in the past few years. The index fund manager buys stocks that correspond with a major market index, such as the Dow Jones Industrial Average or the S&P 500.
• Money market funds typically offer the lowest returns as they carry the lowest risk. Money market funds are legally required to invest in high-quality, short-term investments that are issued by the US government or US corporations.
• Global and international funds. A global fund invests anywhere around the world, including your home country, while an international fund invests only in assets located outside your home country. These tend to be more volatile and carry some political risks. On the other hand, they can reduce risk by increasing diversification as returns in foreign countries may be uncorrelated with the returns at home.

When investing in a mutual fund, you can receive returns from three sources:

• Dividend payments. When a fund receives interest or dividends on the securities in its portfolio, it distributes a proportional amount of that income to its investors. 

• Capital gain. If the fund sells securities that have grown in price, the fund has a capital gain. The majority of funds distribute any net capital gains to investors on an annual basis.

• Net asset value. As the value of the fund increases, so does the price to purchase shares in the fund. You can then sell your mutual fund shares for a profit in the market.

Mutual funds come with both advantages and disadvantages. The main advantages are that mutual funds provide economies of scale, a higher level of diversification, easy access, liquidity, transparency and superior management by professional investors. On the negative side, investors in a mutual fund must pay various fees, commissions and other expenses.

Mutual funds, just like stocks and bonds, involve some level of market risk, which is the possibility of fluctuation in value or even the loss of money you invested. So, whether you're investing in individual stocks or a mutual fund, you need to have some knowledge about how the stock market behaves and prepare yourself for the risks in advance.