What Are Mutual Funds? Overview & How They Work

What Are Mutual Funds? Overview & How They Work
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Point Editorial

A mutual fund is a collection of investors’ money reinvested into assets like shares or securities. Mutual funds are tradable financial entities like stocks, bonds, and commodities

Read on to learn more about what constitutes a mutual fund, how they work, how you can buy and sell a mutual fund, and the benefits and drawbacks of doing so. 

What is a mutual fund?

Mutual funds are a type of investment that produces returns by investing in an array of market entities. Stock funds, for example, focus on investing in publicly available shares. Others may focus on securities that earn a steady stream of income, also known as a fixed income. 

But when you decide to invest in a mutual fund, you’re essentially buying a portion of the total portfolio that composes that fund. The inherent value of a particular fund depends on the company’s performance. 

A professional fund manager typically handles mutual funds, deciding on investment strategies on shareholders' behalf. Mutual fund investors don’t have any say in organizational decisions, unlike those who own individual stocks. Many different investors can invest in the same mutual fund. 

A mutual fund is a great way to earn capital gains, or the returns made from an asset rising in value, and helps build a diversified portfolio.

There are multiple types of mutual funds, including bond funds, money market funds, income funds, balanced funds, and ETFs or exchange-traded funds. 

The overall price of a mutual fund is the Net Asset Value (NAV). You can calculate the NAV by dividing the total value of the assets in the portfolio by the total number of shares owned by all investors. Mutual funds are relatively stable entities since their prices don’t fluctuate during the day. Instead, prices are set at the end of each trading day when the NAV is determined. 

How do mutual funds work?

Mutual funds function as both a company and an investment. How can this be? 

Well, mutual funds are essentially a company in their own right, and their business focus is making investments. Individual investors can participate in the market and purchase partial ownership in the mutual fund, which is, in turn, invested. 

Mutual funds generate returns in the three following ways:

One: Through dividends. Dividends are a distribution of money that an entity generates over a year. Investors who receive dividends can usually choose whether they want to receive a check or to buy more shares with that money instead. 

Two: Capital gains. When an asset’s value rises and is then officially sold, the earnings it generates are known as capital gains. There are short-term capital gains, or the total returns an asset generates after less than a year, and long-term capital gains, which refers to assets that are sold after more than a year. 

Three: Sales. You can generate returns by selling your part of the mutual fund back on the market for a profit. 

Mutual fund fees

Fees vary from fund to fund, but a fund with high costs must perform better than a low-cost fund to generate the same returns for you. These fees range between one and three percent. 

The majority of mutual funds charge an annual management fee, if not all. Mutual fund portfolio managers usually own the fund themselves. Investors may also face sales and commission fees. Re-evaluation of costs occurs either when the manager buys or sells shares. 

In some instances, selling your portion of a mutual fund before a predetermined period may result in an early penalty fee. 

How to buy and sell mutual funds

Investors can buy mutual fund shares from the fund itself or through a broker for the fund instead of other investors. It typically costs anywhere between $1,000 and $5,000 to invest in a fund. 

Investors can purchase or sell funds whenever the market is open, but the trade order isn’t filled until the end of the trading day when the current price of the fund and the NAV are determined. 

Advantages of mutual funds

Below is a list of advantages of investing in mutual funds. 

One: Diversification. Not only will diversification help you gain access to a variety of market sectors and businesses, but it can also increase your potential to earn high returns quicker. Large mutual funds have fingers in multiple pies, but it can be expensive to participate in this type of fund. 

Two: Easy access. Mutual funds are highly liquid, meaning you can convert them to cash easily. They also provide easy access to the stock market at a relatively affordable cost for investors who are just starting out. 

Three: Economies scale. Since mutual funds buy and sell in bulk, the fees are lower than if you choose to buy individual stocks. 

Four: Professional management. Financial managers assume the majority of the responsibility for conducting research, trading, and making decisions based on the fund’s performance and earnings, amongst other things. Mutual funds are a good option if you’re new to investing or prefer a more hands-off approach, since an expert makes the hard decisions. 

Disadvantages of mutual funds

No market vessel is perfect; just as there are benefits to investing in mutual funds, there are some drawbacks. 

One: Fluctuating returns. Mutual funds don’t guarantee higher returns. The fund can decrease in value due to market trends and poor company or industry performances. 

Two: High costs. Although mutual funds are a simple way to gain experience with the market and you can take a relative back seat in such a process, a fund company's services can be pricey. The manager’s salary, constant monitoring of the fund, and producing periodic statements for investors are just some of the costs that investor fees cover.

Three: "Diworsification" and dilution. Some argue that mutual funds are too complex. A mutual fund can invest in too many market sectors, diluting one’s portfolio. “Diworsification” refers to the fact that investors' money can be spread too thinly across too many industries, bringing in smaller returns, making the diversity of a mutual fund harmful instead of helpful. Alternatively, some mutual funds may only invest in one or two sectors, decreasing diversification and raising risks if that industry doesn’t perform. 

Four: Fund management. Is an investment manager better at picking which shares are better for investing? Management stems from human activity, and humans make mistakes. 

How mutual funds affect the economy

Ultimately, a good mutual fund reflects how an industry or another market sector is doing. Their values and subsequent returns change regularly due to market volatility and because consumer trends are constantly evolving, too. Until March of 2020, the technological sector was booming, and the values of tech stocks soared. But when the tech bubble burst, they didn’t earn as much profit due to lagging sales. 

Point's contributions

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