Mutual funds have grown to be one of the most popular types of investments in the world for both individuals and institutions. Their diversification and flexibility make them ideal vehicles for accomplishing almost any type of investment objective, and billions of new dollars continue to pour into them each year. Knowing how they are created, structured, and offered can help you to understand how they can work for you.
What Is A Mutual Fund?
A mutual fund by definition is a collection of individual securities that are selected, bought and sold by professional portfolio managers. Each fund is also classified as a separate individual security by the SEC. Every share that is offered by the fund effectively represents a tiny portion of ownership in each security held by the fund.
Many financial advisors and brokers explain how funds work using the stewpot analogy. When you make a stew, you combine a group of ingredients into a single pot and cook them through together. Then, when you take a spoonful of stew, your spoon will be holding a small amount of each ingredient. Mutual funds work the same way. The portfolio managers purchase a basket of securities using the pooled money from the investors and then trade the securities in an effort to achieve the investment objective that is stated in the fund charter.
Be sure to read the 7 Questions to Ask When Buying a Mutual Fund
For example, a large cap value fund would buy blue-chip stocks that the management team believes are undervalued and sell them when they are perceived to become overvalued. Mutual funds rarely guarantee the investor’s principal and can produce dividends, interest, or capital gains depending on the fund.
How They Are Structured
Mutual funds are packaged and sold in several different ways. Open-end funds simply offer additional shares to any new buyers with no set limit to the number of shares that can be offered. Some funds have sales charges built into them while others do not. Those that have these charges typically offer several different share classes, such as A shares that assess the charge at the time of purchase or B shares that assess the charge when the shares are redeemed. Funds that have no sales charges are called “no-load” funds and are usually less expensive to own than their load-bearing counterparts.
Mutual funds also charge ongoing management fees known as 12b-1 fees that are assessed periodically. Brokers and advisors who work on commission typically sell funds with sales charges because most of the sales charge is paid to them as commission. A broker who sells ABC fund A shares that charge a 4.75% sales load will usually get paid 4 percent, with the rest going to the fund.
Mutual funds are sold by banks, insurance agents, stockbrokers, financial advisors and of course directly by the fund companies themselves. Some advisors trade no-load funds on a fee basis in an effort to provide unbiased portfolio management, where they are not incentivized to choose a fund because it will pay them a sales commission.
Types of Mutual Funds
There are now several thousand mutual funds available from several hundred companies, and they can be categorized in several different ways. Some funds invest in several different types of securities while others focus on only one. Here is a list of the major types of mutual funds:
- Growth Funds – these funds seek capital appreciation through the purchase of securities that are projected to rise in price over time.
- Income Funds – seek to produce current income through the purchase of fixed-income securities such as bonds, preferred stock or senior secured loans.
- Growth and Income Funds – combine the two aforementioned objectives to produce both growth and income.
- Money Market Funds – invest in short-term money market instruments to maintain complete liquidity.
- Sector Funds – invest in a specific sector of the market, such as healthcare or energy.
- Index Funds – simply own all of the securities in one of the market indexes, such as the Standard and Poor’s 500.
- International and Global Funds – invest either solely overseas (international) or both domestically and abroad (global).
As mentioned previously, there are also funds that purchase a single type of security, such as junk bonds or small-cap stocks. Absolutely every type of security or sector of the market has a fund somewhere that invests solely in it (and in most cases, such as large-cap growth, there are dozens or hundreds to choose from).
Mutual Funds vs. Individual Stocks
Although they are both individual securities, mutual funds behave differently than individual stocks. Open-end funds can only be bought and redeemed directly from the issuing fund company and do not trade in a secondary market or on the exchanges. Open-end funds also have forward pricing, which means that their price does not fluctuate during the trading day. Instead, the fund’s price is updated at the end of each trading day to reflect the composite prices of all of the securities that it holds.
Closed-End Funds and Exchange-Traded Funds
There are two other types of mutual funds in addition to open-ended funds. Closed-end funds are professionally managed funds that do trade on the exchanges like stocks or other securities. Exchange-traded funds also trade like stocks during market hours, but they are seldom actively managed. They usually consist of a group of securities that are preselected by the issuer and then trade as an individual security.
The Bottom Line
Mutual funds are popular with investors because they offer diversification, liquidity and convenience, as they provide a way for small investors to obtain professional portfolio management at a reasonable cost. Before mutual funds became popular, the markets were controlled largely by wealthy individual speculators. After they went mainstream in the 1970s, the markets began to be controlled mostly by institutional investors, such as mutual funds. All in all, there is a type of mutual fund for every possible investment objective, from aggressive growth to conservative income to tax efficiency.