Far too often investment writers assume that their readers understand what a mutual fund is and they might be right; even if you don’t own any, you probably have heard so much about mutual funds already, that you might have an idea about what they are and how they work.
However, I would like to quickly go over a few of the basic terms, just to make sure that we are all starting on the same page. So, before I dive into the definition of a mutual fund, it is important that you have a basic understanding of stocks and bonds.
Stocks represent shares of ownership in a public company. In other words, holding a companyâ€™s stock means that you are one of the many owners (shareholders), and stock itself represents a claim on the companyâ€™s assets and earnings.
Stocks, shares, and equity, are all different words describing the same thing.
Examples of public companies include IBM, Microsoft, Coca-Cola, EBay, British Airways, and Cadbury Schweppes.
Stocks are the most common ownership investment traded on the market.
Bonds are basically a chance for you to lend your money to the government or a company. Such entities (companies, municipalities, states, U.S. and foreign governments) use the funds to finance a variety of projects and activities.
Your reward for lending them your money is an interest rate (coupon) payable over predefined periods of time. The loaned funds (bond principal) are returned on the maturity date of the bond (when the bond becomes due).
As there are quite a few different types of bonds, you might come across the following terms: corporate bonds, municipal bonds, U.S. Treasury bonds, notes and bills, â€œTreasuriesâ€, â€œfixed-income securitiesâ€ (a more generic term).
Bonds are the most common lending investment traded on the market.
There are many other types of investments other than stocks and bonds, but the majority of mutual funds invest in stocks, or bonds, or both.
A mutual fund is simply a financial intermediary that pools money together from hundreds and thousands of investors for the purpose of investing in securities such as stocks, bonds, and other securities with it.
Mutual funds are operated by fund managers (money managers) who construct a portfolio with investments in a group of assets according to the fundâ€™s stated set of objectives (prospectus).
In return for the money the investors give to the fund, investors receive an equity position (shares) of the fund and, in effect, in each of its underlying securities. So when you invest in a mutual fund, you become a shareholder of the fund, much like when you buy stocks of a publicly traded company. The main difference is that when you contribute money to a fund, you get a stake in all its investments, offering a level of diversification, very difficult achieved by small investors.
Fund managers then take the money they receive from the sale of their shares (along with any money made from previous investments) and use it to buy securities, such as stocks, bonds and money market instruments in an attempt to produce capital gains and income for the fundâ€™s investors.
For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily, depending upon the performance of the securities held by the fund.
Mutual funds are very often described as one of the best investments ever created because they are very cost efficient and easy to invest in (especially if someone doesnâ€™t have the knowledge and/or the time to figure out which stocks or bonds to purchase). But of course, we also need to keep in mind that they charge fees and usually require a minimum investment.
Other benefits of mutual funds include lower trading costs due to economies of scale achieved by pooling funds together from many different investors, and professional money management, choice, liquidity and convenience. But, as we already mentioned earlier the biggest advantage to mutual funds is diversification.
And by this we mean, that a mutual fund offers small investors access to well-diversified portfolio of equities, bonds and other securities, which would be impossible to achieve with a small amount of money. For example, if you only have a couple of thousand pounds to invest, you can only buy a limited number of individual stocks and/or bonds, whereas when buying shares of a mutual fund (with the same amount of money) you receive a piece of the total pie of the fund comprising of numerous different investment vehicles. Based on the principle that when one investment goes down another might go up, diversification helps in reducing your overall risk tremendously.
The price of a mutual fund unit (share) is determined by the current net asset value per share (NAVPS or usually referred to simply as NAV), which is the total value of the securities owned by the fund divided by the number of shares outstanding. Each shareholder participates proportionally in the gain or loss of the fund depending on the number of shares he/she owns.
A fundâ€™s NAV changes daily, according to the price fluctuations of the fundâ€™s holdings. For example if a fund has a portfolio of stocks and bonds worth Â£100m and there are one million shares outstanding, the NAV would be Â£100.
Finally, let me stress out for once more that one should always take into account any charges, commissions (â€œloadsâ€), and fees payable to the fund to calculate the real cost of purchasing/selling mutual fundâ€™s shares. There have been a lot of occasions where investors were surprised to see their profits (after fees) shrinking to nothingness, despite the fundâ€™s good returns.