Mutual funds are companies that pool money together from various investors then invest that money in various financial securities (stocks, bonds, money markets, additional securities and assets, or maybe a combination of all of these investment types). Also known as open-end companies, mutual funds allow investors to buy from them directly (or through a broker for the fund), rather than from a secondary market of other investors like NYSE or NASDAQ.
The History of Mutual Funds
Mutual funds (also known as open-end funds) have been in existence since at least 1924 when the Massachusetts Investors Trust was founded. However, it wasn’t until the Investment Company Act of 1940 that the mutual fund was officially recognized as one of three types of investment companies available in the United States, also including investment trusts (UITs) and closed-end funds. Since that time, they have grown in popularity because they offer low-cost investment options with ample diversification possibilities. Also, they allow for high liquidity, something many investors yearn for.
How Do the Mutual Funds Work?
Mutual funds invest in a variety of securities to help ensure that the goals of investors (also known as shareholders) are met. The combined holdings that the mutual fund owns are known as its portfolio, and the price that the investor pays for mutual fund shares is known as the fund’s per share net asset value (NAV) plus any additional fees that the fund imposes at the time of purchase. When an investor gets involved with a fund, he buys a share of the fund’s holdings or portfolio, which represents his proportionate ownership. Once a share is purchased, the investor receives a portion of income based on the share of the portfolio he owns.
Unlike some other forms of investment, mutual funds do not allow investors to transfer shares. Instead, if the investor wants to sell a share, he will have to ask the mutual fund to redeem it. Likewise, if the investor wants to buy more shares, the fund will have to issue them for him. The common practice is that the fund will issue or redeem shares by request of the investor at the end of each day.
How Mutual Funds Can be Beneficial
There are a number of reasons that mutual funds can be beneficial to investors. Here are a few:
- Diversification. As mentioned previously, mutual funds offer a high level of diversification because they allow you to invest in more than one financial security at a time. By maintaining your own diversified portfolio, you can have access to high-risk and low-risk investments that can both guarantee returns and maybe bring in high returns.
- Liquidity. Mutual funds allow investors to buy and sell shares at the end of each day. This provides easy access to money, a definite bonus for many investors.
- Low-Cost Transactions. Another benefit of mutual funds is their low cost for purchase. Because mutual funds purchase shares in large bulks, they are able to save money on shares and pass those savings on to investors.
- Cheap to Get Started. As a benefit of low-cost trading on the part of mutual funds, investors with not much to begin investing with can still get in on the action.
- Access to Professional Management. Because mutual funds are maintained by professional money managers, you benefit from their research, selection, and monitoring services, which can help you make better investment decisions.
- Flexibility. Since you’re working with a professional team, you benefit from having them do all the work. This frees you up to live your busy life while your money adds up.
Why Mutual Funds May Not be Beneficial
Here are a few reasons that mutual funds may not work for you:
- No Guarantees. They are not guaranteed or insured by the FDIC or any other government agency.
- Lack of Predictability. Unlike some forms of investment, mutual funds cannot easily be predicted based on past performance.
- Additional Costs. Costs associated with mutual funds can affect your returns, so it’s a good idea to use an online calculator to determine the cost of owning different funds before you decide to invest.
- Tax Implications. A disadvantage of mutual funds is the fund manager’s lack of consideration for your personal tax situation when making decisions about your money. For instance, the selling of securities affects your capital gains, which can cost you royally at tax time.
- Too Much Diversification? If you own a lot of small holdings in different companies, a few large returns won’t mean much. Some fund managers are guilty of over-diversifying.
- Not Enough Control. Some investors complain that they don’t like not being able to ascertain the make-up of the fund’s portfolio. Also, they have no control or influence over which securities fund managers buy or sell.
Are They Beneficial for Your Family?
Mutual funds can be more beneficial for a family than other forms of investment because they offer perks that families need. Their high liquidity, low-cost start-up fees, and diversification allow for some degree of security and the opportunity for high returns in the portfolio. Also, they work because the investor does not have to spend hours researching investments on his own. With the fund manager doing all the work, the investor can have more time to spend with the family.
What to Consider Before Investing
While mutual funds have a decent reputation of security, it’s a good idea to make sure that you work with a fund that weighs the degrees of risk in their investments. It’s possible that if a fund places too much focus on risky investments, you could end up losing most or all of your principal. Also, you want to take time to understand the classes of fund, various fees, in-depth tax consequences and get your copy of your fund’s shareholder report when it comes available to make sure you’re always in the loop.
Mutual funds can provide great opportunities to bring in high returns on investment. However, before diving in and investing, it’s good to research various funds to gauge reputations and determine the most affordable costs for you.