Mutual funds are an extremely popular form of investment, comprising total assets of more than $15 trillion dollars today. But what are they, exactly?
The answer is that they can be many things -- some good, some bad. The nature of an individual mutual fund generally depends on how the fund is built and who is managing it. Below are some key things you should know about mutual funds before you invest.
Characteristics of mutual funds
Here are some basic characteristics of mutual funds:
- They represent an investment pool. A mutual fund is an investment company that pools investor assets to invest in a portfolio of securities. Investors share the gains and losses in proportion to their investments.
- They may contain multiple asset classes. Roughly 80 percent of mutual funds are invested in long-term assets such as stocks and bonds, while the remainder are money market funds that are invested in short-term, liquid investments (unlike bank money market accounts, however, money market funds are not FDIC-insured). Many mutual funds are dedicated to investments in a single asset class, but some represent portfolios blending multiple asset classes.
- They come in indexed and actively managed varieties. An important division in management style is between actively managed funds and indexed funds. An indexed fund seeks to replicate the composition of a given investment index, such as the S&P 500, with the goal of mimicking the return of that index as closely as possible, for better or worse. An actively managed fund uses security selection, asset allocation or other investment strategies in an attempt to beat relevant indexes and competing mutual funds. While active management creates the opportunity to do better than the index, inevitably some managers will under-perform as well.
- They vary in investment latitude. Each mutual fund lays out its investment approach in writing, and while some funds are tightly limited in the type of investments they can make, others allow themselves more latitude. The amount of investment latitude allowed may determine the extent to which you get the type of investments you think are buying.
- They have varying fee structures. This is where things get complicated -- and where you have to pay close attention when considering a given mutual fund. Most mutual fund fees are charged directly to the fund portfolio rather than to each individual investor, so they impact your return without you actually seeing them. The most basic fee is called a management fee, and this is charged for the investment management and administration of the fund. There may also be distribution fees, known as 12b-1 fees. A fund's expense ratio totals all of these ongoing fees as a percentage, and is an important figure to look at when evaluating mutual funds. On top of that though, there may be sales loads, purchase fees and maintenance fees charged to the individual shareholder, so you need to be fully informed before you make a commitment.
- They are priced according to net asset value (NAV). This is essentially the fund's price: the current value of the portfolio's securities net of any fees due, divided by the number of shares in the fund.
- They publish their approaches through a prospectus. This is a detailed description of the portfolio's investment objectives, management team and financial characteristics (including fees). The prospectus is updated regularly to reflect changes.
- They come with a history. Funds will publish a record of their past performance, usually alongside a relevant index. Keep in mind that past performance is no guarantee of future results, and in particular performance may be misleading if it is not measured over a full range of market conditions, such as rising and falling markets.
Advantages and disadvantages of mutual funds
By pooling investor interests, mutual funds can make it cost-effective for ordinary investors to obtain a diversified portfolio of securities. They can also help investors gain access to certain types of investments, such as foreign stocks, that can be difficult to purchase directly. Another advantage is in providing high-level portfolio management for relatively small investments.
Drawbacks include a lack of transparency. With a mutual fund, you don't see what is going on with your investments in real time the way you would in a separately managed portfolio. Fees can also be a little obscure if you don't do your research, and often the expense of a fund can materially detract from your investment return. Finally, mutual funds leave you no discretion to customize your portfolio.
Mutual funds are popular for a reason: They give ordinary investors access to efficient market participation and world-class investment management. However, it is important to remember that there are thousands of mutual funds, with widely varying characteristics. Many are overpriced, poorly managed or inappropriate for your needs.
In short, saying that you're looking for a mutual fund for an investment vehicle is like saying you're looking for a car for a transportation vehicle: The classifications are so broad that they reveal little about your actual plans. In both cases, your success will likely depend less on the classification and more on how well the vehicle is made and how good the driver is.
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