What is a Mutual Fund?

Mutual Fund is an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.

The Investment Company Act of 1940 says no more than 5% of a mutual fund can be invested in any single security. Mutual Fund come in many ways depending of the type of investment is needed. There are stock and bond funds; you can own a fund invested in either large companies or small companies; there are funds that invest in foreign countries and foreign companies; and there are funds that invest in gold and silver. The choices are almost endless.

There are Load funds and Non-load funds. “Load funds” are typically SOLD by a stock broker or other advisors and a commission fee is charged, and there are three main ways to charge commissions on Mutual Fund (A-share where a commission is charged upfront, B-share where the commission is charged in the back-end, and C-share where a certain percentage is charged on a yearly basis).  “No load funds” are usually purchased directly from the mutual fund by simply calling their toll-free number and speaking with one of their representatives, or going to the  mutual fund’s website and placing your order.

The modern era of mutual funds began in Boston in 1924 with the creation of the Massachusetts Investors’ Trust: now known as MFS Investment Management, a fund and manager still in business today! In the U.S. alone, there are more than 10,000 mutual funds, and fund holdings are measured in the trillions of dollars! Mutual Funds still stand as the most popular and widely used investment vehicle today

There are several advantages to investing in mutual funds as opposed to purchasing individual stocks or bonds.  The five primary benefits are as follows:

1.)    Instant Diversification

2.)    Professional Investment Management

3.)    Economies of Scale

4.)    Liquidity

5.)    Simplicity

Probably the most significant advantage that a mutual fund investment has over other types of investments is the benefit of instant asset diversification.  Because mutual funds invest in a wide range of varying securities, the investor's risk is significantly reduced.  Mitigating risk is extremely important to successful investing and mutual fund investment provides investors with the opportunity to diversify at a relatively low cost.  For example, suppose that energy stocks sharply decline in price because of new regulations imposed by the Federal Government.  A mutual fund would help lessen the impact to the individual investor because of its investment in other securities, such as tech stocks or healthcare stocks.  The loss incurred from the energy stock would most likely be mitigated by a gain in another security within the same mutual fund.  Please note that investment in mutual funds will not eliminate risk, only reduce it through diversification.  Investors must also be wary of mutual funds that are industry or sector specific, as these mutual funds will undoubtedly take on more risk than those that are not.

Another advantage of investing in mutual funds is that investors are provided the services of a professional portfolio manager, who will buy and sell securities based on the fund's objectives and market factors.  Investment professionals are able to provide both the expertise and time that is essential to effectively manage a diversified mutual fund.  The cost of these services are significantly less than if an individual investor were to hire a professional to manage his/her individual portfolio.  This is because the cost is spread out amongst all investors of the mutual fund.  The investment professional is compensated by how well the mutual fund does, so the manager shares the same goals as the investors.

Mutual funds also allow investors to achieve economies of scale from their investment.  Because mutual fund pool together money from many investors, their sheer size allows transaction costs from buying and selling to be reduced.  This, of course, saves the investor money.  Another benefit of mutual fund investment is that its shares can be easily traded in and cash can be withdrawn in a very short period of time.  Therefore, mutual fund investments are often characterized as being very liquid investments.

The final advantage of investing in mutual funds is the simplicity behind the investment.  An investor will use little time, money, and effort in the management of a mutual fund.  An investor will be afforded the luxuries of taking a backseat, while his/her professional mutual fund manager does all the research and performs all of the trades.  Investors should not, however, throw money blindly at mutual funds without doing their own research.  They must make sure that the mutual fund's prospectus coincides with their own investment goals and calls for the right amount of risk.       

However, an investor also needs to be aware of some drawbacks in investing in a mutual fund. First, investing in a mutual fund is more expensive than in an ETF because of higher fees associated.  Unlike ETFs or stocks which are passively managed, mutual fund is managed through mutual fund manager(s) and they have to be paid. Second, because these funds are managed through the mutual funds managers or agency, there is an associated agency problem as well as some chance of malpractice in a sense that some unscrupulous managers may follow unethical practice to boost the performance of the various schemes of mutual funds. Another problem associated with mutual fund is its inflexible trading. Unlike stock of which price is updated throughout the day, mutual fund is priced once daily at the net asset value. Moreover, trading in futures and options is not possible. Additionally, there is more exposure to capital gains tax. For example, if the mutual fund manager decides to sell securities for a profit, the capital gain needs to be distributed to the shareholders proportionally to their investment and this is taxable as a capital gain. Or take another example, if another mutual fund holder sells, the capital gain (which is taxed) has to be divided up among the remaining holders even if the overall value of the fund went down.

Notwithstanding the demerits listed, mutual fund offers an excellent vehicle for a portfolio management through diversification. Its characteristics of professional investment management, economies of scale, liquidity and simplicity offer attractive opportunity for an interested investor who otherwise is too busy to follow the market in a constant basis.