The central idea of a mutual fund is to enable investors to pool their money and place it under professional investment management. The manager makes the trades, realizing a gain or loss, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. There are more mutual funds then there are individual stocks.
Most mutual funds are open-end funds. This means that at the end of every day, the investment management company sponsoring the fund issues new shares to investors and buys back shares from investors wishing to leave the fund. A mutual fund can also be a closed-end fund. The sponsor of a closed-end fund registers and issues a fixed number of shares at the initial offering, similar to a common stock. Investors then can buy or sell these shares through a stock exchange. The sponsor does not redeem or issue shares after a closed-end fund is launched, so the investor must trade them through a broker. A new innovation, the exchange traded fund (ETF) combines characteristics of both open and closed end mutual funds. An ETF usually tracks a stock index, like an index fund, but can be redeemed on demand for its underlying holdings, eliminating the discounts and premiums that are common with closed-end funds and forcing prices to remain very close to the net asset value (NAV). ETFs are traded throughout the day on a stock exchange, just like closed-end funds.
Mutual funds can invest in many different kinds of securities. The most common are cash, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can invest primarily in the shares of a particular industry, such as high technology or utilities. These are known as sector funds. Bond funds can vary according to risk (high yield or junk bonds, investment-grade corporate bonds), type of issuers (government agencies, corporations, or municipalities), or maturity of the bonds (short or long term). Both stock and bond funds can invest in primarily US securities (domestic funds), both US and foreign securities (global funds), or primarily foreign securities (international funds). By law, mutual funds cannot invest in commodities and their derivatives or in real estate. (However, there do exist real estate investment trusts, or REITs, which invest solely in real estate or mortgages, and mutual funds are allowed to hold shares in REITs.) A mutual fund may restrict itself in other ways. These restrictions, permissions, and policies are found in the prospectus, which every open-end mutual fund must make available to a potential investor before accepting his or her money.
Most mutual funds' investment portfolios are continually adjusted under the supervision of a professional manager, who forecasts the future performance of investments appropriate for the fund and chooses the ones which he or she believes will most closely match the fund's stated investment objective. This is called active management, in contrast to indexing, in which a fund's assets are managed to closely approximate the performance of a particular published index. Because the composition of an index changes less frequently than the condition of the market, an index fund manager makes fewer trades, on average, than does an active fund manager. For this reason, index funds generally have lower expenses than actively-managed funds, and typically incur fewer capital gains which must be passed on to shareholders. The majority of actively managed funds usually only match the performance of the index fund, but since they have higher costs they then underperform the index funds. Three fourths of all mutual funds underperform the S and P 500 index. This means the majority of the professional managers can't execute a better stock picking strategy then simply buying the 500 largest companies equally. For this reason, many advisors strongly suggest avoiding mutual funds.
Mutual funds are corporations under US law, but they are subject to a special set of regulatory, accounting, and tax rules. Unlike most other types of corporations, they are not taxed on their income as long as they distribute substantially all of it to their shareholders. Also, the type of income they earn is often unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free municipal bond income are also tax-free to the shareholder. Taxable distributions can either be ordinary income or capital gains, depending on how the fund earned it.
You can buy many mutual funds directly from the fund sponsor. These are called "no-load" funds, because the issuer does not charge a sales commission. Some discount brokers will sell no-load funds, some for a flat transaction fee, some for no fee at all. Load funds are sold through intermediaries such as brokers, financial planners, and other types of registered representatives who charge a commission for their services.
Picking a mutual fund from among the thousands offered is not easy. The following is just a rough guide, with some common pitfalls.
- Unless you are in the highest tax bracket, you probably don't need a tax-exempt fund.
- Match the term of the investment to the time you expect to keep it invested. Money you may need right away should be in a money market account. Money you will not need until you retire in 30 years should be in longer-term investments, such as stock or bond funds.
- There are some funds that invest in both stocks and bonds called "balanced funds." These are not generally as good an idea as a do-it-yourself balance of a stock fund and a bond fund, simply because you get to control the mix yourself. More stock is more aggressive, more bond is more conservative.
- Expenses matter over the long term, and of course, cheaper is usually better. You can find the expense ratio in the prospectus. Expense ratios are critical in index funds, which seek to match the market. Actively managed funds need to pay the manager, so they usually have a higher expense ratio.
- Sector funds often make the "best fund" lists you see every year. The problem is that it is usually a different sector each year (internet funds, anyone?). Avoid making these a large part of your portfolio.
- Closed-end bond funds often sell at a discount to the value of their holdings. You can sometimes get extra income by buying these in the market. Hedge fund managers love this trick. This also implies that buying them at the original issue is usually a bad idea, since the price will often drop immediately.
- Mutual funds often make their distributions near the end of the year. If you get the money, you will have to pay taxes on it. Check the fund company's website to see when they plan to pay the dividend, and wait until afterwards if it is coming up soon.
- Do your homework. Read the prospectus, or as much of it as you can stand. It should tell you what these strangers can do with your money, among other vital topics. Check the performance of a fund against its peers with similar investment objectives, and against the index most closely associated with it.
- Diversification is the best way to reduce risk. Most people should own some stocks, some bonds, and some cash. Some of the stocks, at least, should be foreign. You might not get as much diversification as you think if all your stock funds are with the same management company, since there is often a common source of research and recommendations. Too many funds, on the other hand, will give you about the same effect as an index fund, except your expenses will be higher.
- The compounding effect is your best friend. A little money invested for a long time equals a lot of money later.
In the United Kingdom the term "mutual fund" may be confusing due to the existence of building societies and mutual life companies which in law are owned by their members and which have no share holders to distribute profits to and consequently are referred to as "mutuals" Collectively managed funds are referred to by type, and the following are the principal ones are available:
- investment trusts which are themselves quoted companies, often with a fixed life. The quoted price of the company may trade at a discount (lower) or premium (higher) than the value of the investments it holds at any point in time, giving rise to more volatility and risk as well as opportunities. Investment trusts may also be split into different types of shares to appeal to different types of investor. These are known as split capital trusts.
- Unit Trusts are tradtional arrangements set up as a trust rather than a company and are open ended. The fund is divided into units rather than shares that build in trading and management costs through the canceling of units meet management charges and by way of a dual pricing policy of units to meet trading costs. Units have a bid (buying) and offer (selling) price at a given time and the difference is known as the bid-offer spread.
- OEICs (pronounced "OIKS") is an acronym for "Open Ended Investment Companies" which a rapidly diplacing Unit Trusts which operate under, what is considered to be, archaic rules. Additionally OEICs are easily marketed overseas and are seen as a way of developing the collectively managed fund market. A major difference is that OEICs have shares (but unlike Investment Trusts they reflect asset value like the units in a unit trust) and these are traded with a single price (any initial charges are levied explicitly by reducing capital).
- ICVCs' (Investment Companies with Variable Capital an alternative name for OEICs.
Tax favoured products such as Pensions or Individual Savings Accounts may include any of the above, although separate Pension funds and (subject to involved differences) Life Insurance funds exist with their own legislative control and tax treatment.
- Morningstar uses a star system for its ratings, similar to a restaurant review. This site also lets you search, filter, and screen many mutual funds.
- About Mutual Funds is a site with over 800 pages dedicated towards mutual fund education. Those new to mutual funds should consider taking the free course Mutual Funds 101.
- The Investment Company Institute is the fund industry group. It has some excellent investor education materials on line.
- Yahoo! has a very good fund screener which also uses the Morningstar rating system. It also lets you see the minimum investment amount quickly.
- Advantages and Disadvantages of Mutual Funds - A list of advantages and disadvantages of mutual funds.