How do Mutual Funds Work

For many years, investors have chosen mutual funds as a way to invest their money. Sometimes these are wise investment choices – sometimes, not so much. Mutual funds offer the benefit of diversification, but they do involve risk. Both fees and taxes can diminish the return on your investment you see with a mutual fund. Let’s take a look at some of the positive and negative aspects of investing in mutual funds. A potential investor should be well educated and prepared to make good decisions.

What is the first thing you must know about how mutual funds work? Well, it’s generally a good idea to know what they are. A mutual fund is a company that pools money from investors. It takes this money and invests it in a variety of stocks, bonds, and short term money market investments. Each funds has operating rules put in place to help define what sort of investments the fund can make. For example, a mutual fund that emphasizes buying bonds will not purchase many (or any) stocks.

Mutual funds are bought and sold by the “share”. A share simply represents a portion of the entire holdings of the fund. If a fund has 10,000,000 shares on the market, and you own 100,000 of them, you would own 1% of the entire assets of that fund. (that would usually be a VERY large amount, by the way)

Investors can usually purchase shares of a mutual fund directly from the fund itself, or through a broker. There are many large companies, such as Vanguard and Fidelity, that operate a large variety of different funds. These funds all have different types of investment portfolios, ranging from relatively safe bond and money market funds, to wildly speculative (and risky) funds dealing in international companies. Buying a fund directly from the fund company is often cheaper than going through a broker. For example, you can buy shares of Vanguard funds directly from Vanguard with no “broker” fees whatsoever.

The price that investors pay for a mutual fund share is called the net asset value, or NAV. Mutual funds are considered redeemable because the investor can sell the shares back to the fund whenever they choose. Mutual funds can often create and sell new shares for new investors. This means that they sell shares on a continuous basis whenever there is a buyer available. However, some funds stop selling new shares if they become too large.

The portfolios of a mutual fund are usually managed by investment advisers who must be registered with the SEC. Mutual funds are not guaranteed or insured by any government agency. You most certainly can loose money from an investment in a mutual fund. Even if you buy the fund through your bank, and the fund has the name of your bank in it, you can still lose money. Past performance is not always a good indicator of future performance. Just because a fund made money last year, doesn’t mean it will next year.

All mutual funds have costs and fees which can lower investment returns. After all, someone has to pay the salary of the fund manger, as well as the general costs of running the fund (websites, marketing, administration, trading fees, etc.).

Mutual funds do offer the advantage of being professionally managed. For people who do not have the time or resources to research companies on their own, they can often be good investments. Diversification, which lowers risk if a single company fails, is another reason to favor mutual funds over individual stocks. A typical stock oriented mutual fund may own shares in hundreds of different companies. In addition, some the funds offer affordability for investors who do not have a lot of money by setting low dollar amounts for initial purchases.