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Grow Your Business Finances

What is a Mutual Fund?

Mutual funds Each type of investment, including mutual funds, comes with different features, risks and rewards. / Credit: arka38 | Shutterstock

A mutual fund is a type of company that takes money from multiple investors, pools the money and invests in securities. Mutual funds are operated by money managers, who make investment decisions with the fund's capital, to produce capital gains and income for the investors. The holdings of the mutual fund are known as its portfolio, and investors buy shares in mutual funds. Each share purchased represents an investor's partial ownership in the fund and the relative income it generates.

Mutual funds became popular over the last 20 years, as more than 80 million people have invested in mutual funds. In the United States alone, trillions of dollars are invested in mutual funds.

Mutual funds give small investors access to a professionally managed and diversified portfolio of various assets, including equities, bonds and other securities. These investments would otherwise be difficult to recreate with a small amount of capital, making mutual funds more affordable. This diversification lowers the risk to investors if a company fails. Mutual funds also ease the process of liquidation, as investors can easily redeem their shares at any time for the current net asset value (NAV) plus redemption fees.

Types of mutual funds

Almost all mutual funds fall into four categories: money market funds, bond funds, stock funds, and target date funds. With each type of mutual fund come different features, risks and rewards.

Money market funds are low risk investments in specific high-quality, short-term investments issued by U.S. corporations and governments, like Treasury bills. The return won't be particularly high, but it is more unlikely you'll lose your principal. The typical return is generally twice the amount earned in a regular savings account, and less than the average certificate of deposit (CD).

Bond funds aim to produce higher returns, and thus provide higher risks than money market funds. Also known as income funds, the purpose is to provide current income on a steady basis and denote funds that invest primarily in government and corporate debt. Bond funds can vary dramatically depending on area of investment and are subject to interest rate risk. Different types of bond funds include municipal, high-yield, corporate, and U.S. government.

Stock funds invest in corporate stocks, and are also known as equity funds. The largest category of mutual funds, the investment objective is long-term capital growth with some income. There are many different types of equity funds due to the diversity of types of equities. Examples include:

  • Growth funds, which focus on stocks that may not pay a regular dividend
  • Income funds, which focus on stocks that pay regular dividends
  • Index funds, which track a particular market index
  • Sector funds, which specialize in specific industries

Target date funds hold a mix of stocks, bonds and other investments. Target date funds, also known as lifecycle funds, are designed for individuals with particular retirement dates in mind. In target date funds, the mix of stocks, bonds, and other investments will gradually shift according to the fund's strategy.

Mutual funds are considered one of the wisest investments to be made. Beyond professional investment management and portfolio diversification, they offer three different ways of earning money:

  • Dividend payments are paid out when a fund earns income from dividends on stocks or interest on bonds. The fund pays shareholders nearly all the income.
  • Capital gains distributions can be earned when the price of securities in a fund increase. When sold, the fund now has a capital gain. Annually, the fund distributes these capital gains to investors, minus any capital losses.
  • Increased NAV brings in funds because if the market value of a fund goes up, then the value of the fund and its shared also goes up. The higher NAV reflects the higher value of investment.

Risks of mutual funds

That is not to say that mutual funds are without risk. Like any investment, you could lose some or all of the money invested depending on the investments made by the mutual fund. Securities can go down in value, and dividends or interest payments may change with market conditions. While funds can be lucrative, there is still a risk based on the fund's volatility. The best way to assess this volatility is to assess the past performance of a fund. The more volatile a fund, the higher the investment risk.

Another way to diminish risk is to avoid mutual fund fraud. By law, mutual funds are required to file a prospectus and regular shareholder reports with the SEC. Read the prospective and shareholder reports to make sure you know what you're getting yourself into. Because investment portfolios are managed by investment advisors, make sure your advisor is registered with the SEC before investing.

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