Blog- What is a Mutual Fund? And How Does It Work?

What is a Mutual Fund? And How Does It Work?

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What is a Mutual Fund? And How Does It Work?

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So, you have started to look at investment options…. But, with so many choices, finding a short-term or long-term saving strategy that fits your budget and goals can be challenging, especially when you are not familiar with each of your options.

One of the most common investment strategies is a mutual fund. According to MarketWatch, almost half of American households own shares in a mutual fund (April 12, 2012, Kirk Spano). However, before you jump on the bandwagon you should know what a mutual fund is and how they work.

 

What is a Mutual Fund?

A mutual fund is an investment strategy, which allows individual investors to pool their money together to purchase a collection of stocks, bonds, and other securities that might be difficult to obtain on their own; often called a portfolio.

Mutual funds typically invest in four different investments: money market, bonds (also called “fixed income”), stock (also called “equity) and hybrid, meaning combinations of the other categories. The advantage of this investment method is reduced risk, as the buying a variety of stocks, bonds or other investments minimizes the investor’s reliance on the performance of an individual stock, bond, or security.

The mutual fund is typically managed by a financial professional, who helps actively monitor the portfolio’s performance/growth and make decisions to buy and sell securities.

 

Basic Types of Mutual Funds: Open-End vs. Closed-End?
Open-End Funds

A majority of mutual funds are open-end, which means they are willing to buy/sell stocks from investors. There is no set number of share in the mutual fund, instead, shares are available to an investor based upon the current net asset value and the investor redeems the shares when they decide to sell.

When a new investor enters an open fund, the portfolio manager uses the investment to purchase additional securities/investments for the mutual fund.

Closed-End Funds

A closed-end fund has a set number of shares that are available to the public only once, through an initial public offer and do not repurchase shares from investors. Once the public offering is over, investors can sell their shares to other investors. As a result, shares of closed-end funds normally trade at a discount to net asset value.

 

What are the benefits of a Mutual Fund?
  1. Portfolio Management- A financial professional manages the buying and selling of stocks, bonds, and other securities.
  2. Dividend Reinvestment- As dividends and other interest income is declared for the fund; it can be used to purchase additional shares in the mutual fund or reinvested to help the fun grow.
  3. Reduced Risk- Because mutual fund portfolios are diversified with anywhere from 50 to 200 different securities, the performance of one or two securities has a reduced chance of impacting the overall portfolio.

 

What are the disadvantages of a Mutual Fund?
  1. Locked in Clause- There are different structures to mutual funds; some allow you to exit and enter at any time. However, some require 5-7 year agreements and will charge you if you take money out earlier.
  2. Mutual Fund Charges- Many mutual funds charge a fee to redeem your money. Other expenses include operating expense fees, which is typically a percentage of your overall investment.
  3. Dilution- Although diversification can reduce risk when it comes to investing, it also is a disadvantage because of dilution. If a single stock in a mutual fund doubles in value, the mutual fund itself would not double in value because that security is only a small part of the entire fund.

 

Knowing when and how to invest is important to your overall financial goals; Contact one of our experienced financial professionals to learn how they can help you secure your financial future!