What Is a Mutual Fund?
At its core, a mutual fund is a pool of money collected from individual investors, which is then invested in stocks, bonds, and other income-producing assets.
Individual investors can purchase shares of mutual funds in the same way you might purchase the share of an individual stock. In the same way, you are purchasing a small piece of ownership of Amazon when you buy Amazon stock when you buy a share of a mutual fund you are purchasing a small piece of ownership in the mutual fund company.
The value of the share is determined by the number of shares issued and the total net value of the assets held within the fund.
Mutual Fund’s employ a fund manager, whose job is to invest the cash provided by the investors. The fund manager will pick which stocks, bonds, and other assets to invest in that they feel will provide the best return within the context of the funds objective.
Each mutual fund will have a different investment objective to appeal to the specific needs of investors. For example, you may have a mutual fund with an “Aggressive” objective of growth. This type of fund would allocate the majority if not all of the investor’s money into equities. You might have a “balanced” objective of moderate growth and producing some income. This type of fund might have an allocation closer to 50% equities and 50% bonds.
There is a mutual fund for almost every type of investment allocation you can imagine. There are gold mutual funds, there are equity mutual funds there are bond mutual funds, there are mutual funds that focus on specific sectors within the economy such as a technology or health care and there are mutual funds that focus on specific countries and regions of the world. Make sure you do your research and know what you are getting you (and your money) into before investing in a mutual fund.
Diversification for Small Investors
The feature I like most about a mutual fund is that it gives smaller investors who may not have much cash a way to invest in a diversified portfolio. Think of it this way, if you have $100 and you wanted to start investing in a diversified portfolio of say 70% stocks and 30% bonds. How far would that $100 get you? Well, when you consider the stock price for 1 share in Amazon (at the time of this writing) is $1,688 you can see that it’s very difficult for a small investor to spread their money around.
That is where Mutual funds come into play! That same $100 might get you several shares in a mutual fund, which may have stock holdings which include Amazon, Apple, Netflix and all of the other major blue chip companies as well as many different corporate and government bonds. Boom! just like that you are an investor with a diversified portfolio. Sounds very impressive, doesn’t it?
Management Fees Can Impact Your Returns
Mutual Funds sound pretty awesome, don’t they? Before you jump with both feet in and start investing in Mutual funds, do yourself a huge favor and be aware of the fact that many traditional mutual funds have significant management fees. Remember we talked about that fund manager picking the investments? They need to be paid, and they make a LOT of money. In addition to that, a mutual fund has a lot of other fees associated with it such as advertising and paying commissions to its salespeople. Who do you think is paying for all of this?
Before you invest your hard earned money in a mutual fund, take a look at the fund’s Management Expense Ratio (MER). The MER will tell you what % of the money you’ve invested goes towards paying the fund manager and all the other expenses incurred by the fund. That is right, day 1 when you invest a mutual fund you are in the hole by the amount of the MER.
If the fund has an MER of 1% that means the fund will need to earn 1% for the year before you get back to even. If you invest $100 into a fund with an MER of 1% right away $1 goes to pay expenses incurred by the fund, and $99 goes to investing in the assets of the fund.
1% may not sound like a big deal, but for the long-term investor that begins to add up to a huge amount of money over years and decades. High management fees are one of the reasons I choose to invest in low-cost Index Funds.
An index fund is a type of mutual fund, but there is no fund manager picking individual assets so they are typically MUCH cheaper and some have an MER as low as 0.04%.
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This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.