Mutual Fund | Definition | Basics 101 | Types | Pros & Cons (2024)

A mutual fund is an investment vehicle in which a pool of investors collectively put forward funds to an investment manager to make investments on their behalf. The fund is regulated by the Securities Exchange Commission, or SEC.

When involved with a mutual fund, each investor benefits proportionally to the amount of money they invested. Mutual funds may invest in stocks, bonds, money market instruments, or other assets.Depending on the vehicle of investment and redemption patterns, mutual fund investment can offer tax benefits.

The advantages of mutual funds are the ability to diversify a portfolio across industries, low fees, and availability of professional expertise in the guise of fund managers.

The disadvantages of mutual funds are that they do not provide ownership of underlying holdings to investors; hence, investors do not have much say on the composition and constituents of mutual funds.

Mutual funds are also more expensive and riskier as compared to index funds.

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Basics of Mutual Funds

Mutual funds can be a good opportunity for small or individual investors to benefit from a professionally managed investment portfolio.

They usually invest in a large number of securities, and their performance is tracked as the change in the market cap of the fund, which itself is determined by the performance of the underlying investments.

Mutual funds charge a sales commission, known as load, as well as management fees related to the fund’s administration. While all funds charge management or administration fees, there are funds in the market that are no-load, meaning they do not charge a sales commission.

The returns of a mutual fund are based on the performance of its constituents. Therefore, skill and expertise is required to pick equities that provide desired returns. Highly-trained professionals function as fund managers for mutual funds.

You can use fund rankings issued by research firms like Morningstar and Standard & Poor to select funds. Buying shares of a mutual fund does not give investors voting rights in a company; instead the fund manager votes on their behalf.

However, since mutual funds generally incorporate hundreds of different securities, it does give investors the benefit of diversification of their portfolios.

The value of a share of mutual fund is called the net asset value per share, or the NAV. The price is determined by taking the net value of all the securities in the fund and dividing by the outstanding shares.

Mutual funds can be open-ended or closed-ended. An open-ended mutual fund issues an unlimited number of shares in the open market and redeems them at market value from investors.

The share price of an open-end fund is based on the net asset value of its constituents. Closed-end mutual funds function in the opposite manner i.e., they issue a fixed number of shares and redemption is not allowed.

Instead, the only way for an investor to “redeem” a share is by selling it to someone else.

Therefore, their price is based on the dynamics of supply and demand and they always trade at a discount to the net asset value of their constituents.

Types of Mutual Funds

Broadly there are four types of mutual funds. They are as follows:

  • Equity Mutual funds: Equity mutual funds consist of collections of stocks of companies. Investors can allocate funds to funds based on their goals. For example, growth funds are focused on stocks of companies with significant growth potential in the future. Income funds include stocks of companies that pay regular dividends.
  • Money Market mutual funds: Money market mutual funds invest in short-term debt issued by corporates, government, state, and municipalities. For example, they might invest in US treasuries and debt issued by established companies like Apple Inc. or Exxon. The aim of this type of mutual fund is to generate income while minimizing risk.
  • Bond funds: Bond funds are considered conservative investments and provide fixed income to investors in such funds. Like money market mutual funds, their investment portfolio is restricted to government and corporate debt. They are generally favored for retirement planning.
  • Balanced Funds: Balanced funds aim to strike a balance between equity and bond investing. They are long term funds that incorporate a mix of stocks and bonds in a given ratio. For example, they might have 60% stocks and 40% bonds. Rebalancing these funds on a periodic basis adjusts their composition to prevailing economic conditions. Some are rebalanced based on the investor’s goals. For example, they might incorporate a more conservative approach close to retirement.

Tax Implications of Mutual Funds

The tax implications of mutual funds depend on the investment vehicle used to conduct the transactions.

If mutual funds are traded from inside a retirement account, then capital gains accruing from the sale are deferred.

If, however, the trades occur outside a retirement account, then the investor is responsible for paying the prevailing capital gains tax.

Dividends from the mutual fund or redemption of units contained within the fund are also taxed at regular rates for income and capital gains.

Pros and Cons of Mutual Funds

The benefits of mutual funds are as follows:

  • Mutual funds are available in various flavors and help diversify a portfolio across sectors and industries.
  • Mutual funds enable regular investors, who do not have much knowledge about the markets, to access sophisticated and professional expertise of fund managers at low costs.
  • Active mutual funds that take large positions in stocks can make a significant difference to the performance of that equity and generate profits for investors who hold shares in that fund.
  • Mutual funds are a liquid market, meaning it is relatively easy to trade and find a buyer for them. The same cannot be said for several assets.

The drawbacks of mutual funds are as follows:

  • Mutual funds do not offer ownership of shares. Therefore, it is not possible for investors to select or pick the composition of a fund to align with their values.
  • Mutual fund fees can add up over time. According to 2016 research by the Investment Company Institute (ICI), the after-fee return for $1,000 annual investment averaging 7% return over 30 years for mutual funds is $86,000. Index funds offer $99,000 over the same timeframe due to lower management fees.
  • While they are a type of mutual fund, index funds have become more popular in recent times as compared to regular index funds. This is because they are cheaper and less risky. Unlike mutual funds, whose constituents are selected with rigorous analysis, index funds stick to a tried-and-tested formula and track indices.
  • For those who hold very few units of mutual funds, returns can be negligible or very low, especially when they are compared to similar equity investments.

Mutual Fund FAQs

A mutual fund is an investment vehicle in which a pool of investors collectively put forward funds to an investment manager to make investments on their behalf. The fund is regulated by theSecurities Exchange Commission, or SEC. When involved with a mutual fund, each investor benefits proportionally to the amount of money they invested.

The four types of mutual funds are: equity mutual funds, money market mutual funds, bond funds, and balanced funds.

The advantages of mutual funds are the ability to diversify a portfolio across industries, low fees, and availability of professional expertise in the guise of fund managers. The disadvantages of mutual funds are that they do not provide ownership of underlying holdings to investors; hence, investors do not have much say on the composition and constituents of mutual funds. Mutual funds are also more expensive and riskier as compared to index funds.

If mutual funds are traded from inside a retirement account, then capital gains accruing from the sale are deferred. If, however, the trades occur outside a retirement account, then the investor is responsible for paying the prevailing capital gains tax.

Buying shares of a mutual fund does not give investors voting rights in a company; instead the fund manager votes on their behalf.

Mutual Fund | Definition | Basics 101 | Types | Pros & Cons (1)

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

I am True Tamplin, a Certified Educator in Personal Finance (CEPF®), CEO of UpDigital, and founder of Finance Strategists. I have a Bachelor of Science in Business and Data Analytics from Biola University. As a published author and public speaker, I have shared my expertise with various financial communities, including the CFA Institute and university students.

Now, let's delve into the concepts mentioned in the article about mutual funds:

  1. Mutual Fund Basics:

    • A mutual fund is an investment vehicle where a pool of investors collectively invests funds managed by an investment manager.
    • Regulated by the Securities Exchange Commission (SEC).
    • Investors benefit proportionally to their invested amount.
  2. Investment Options:

    • Mutual funds can invest in stocks, bonds, money market instruments, or other assets.
    • Tax benefits may vary based on the investment and redemption patterns.
  3. Advantages of Mutual Funds:

    • Diversification: Mutual funds allow the diversification of a portfolio across industries.
    • Low Fees: They often have lower fees compared to other investment options.
    • Professional Expertise: Managed by fund managers with professional expertise.
  4. Disadvantages of Mutual Funds:

    • No Ownership: Investors don't have ownership of the underlying holdings, limiting their influence on the fund's composition.
    • Cost and Risk: Mutual funds can be more expensive and riskier compared to index funds.
  5. Types of Mutual Funds:

    • Equity Mutual Funds: Invest in stocks of companies.
    • Money Market Mutual Funds: Invest in short-term debt for income with minimized risk.
    • Bond Funds: Considered conservative investments providing fixed income.
    • Balanced Funds: Aim to balance equity and bond investments for long-term goals.
  6. Tax Implications:

    • Tax implications depend on whether mutual funds are traded inside or outside a retirement account.
    • Capital gains within a retirement account are deferred.
  7. Pros and Cons:

    • Pros include diversification, access to professional expertise, and liquidity.
    • Cons involve lack of ownership, potential fees, and higher risk compared to index funds.
  8. Mutual Fund FAQs:

    • Recap of mutual fund basics and types.
    • Highlights the advantages and disadvantages.

This comprehensive overview provides a thorough understanding of mutual funds, their types, benefits, drawbacks, and tax implications, as presented in the article.

Mutual Fund | Definition | Basics 101 | Types | Pros & Cons (2024)

FAQs

What is mutual funds in simple words? ›

A mutual fund is a pool of money managed by a professional Fund Manager. It is a trust that collects money from a number of investors who share a common investment objective and invests the same in equities, bonds, money market instruments and/or other securities.

What is mutual funds and its pros and cons? ›

Mutual funds come with many advantages, such as advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing. Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.

How do you explain mutual funds to a layman? ›

Mutual funds let you pool your money with other investors to "mutually" buy stocks, bonds, and other investments. They're run by professional money managers who decide which securities to buy (stocks, bonds, etc.) and when to sell them. You get exposure to all the investments in the fund and any income they generate.

What is the main function of mutual funds? ›

The primary function of a mutual fund is to pool money from multiple investors and invest it in a diversified portfolio of securities, aiming to generate returns and spread risk across various assets.

How does a mutual fund make money? ›

Mutual funds make money by charging investors a percentage of assets under management and may also charge a sales commission (load) upon fund purchase or redemption. Fund fees, called the expense ratio, can range from close to 0% to more than 2% depending on the fund's operating costs and investment style.

What is the downside of mutual funds? ›

Mutual funds provide convenient diversification and professional management through a single investment, but can have high fees, tax inefficiency, and market risk like the underlying securities.

What is the main drawback of a mutual fund? ›

Potential for loss: Mutual funds are not FDIC insured and may lose principal and fluctuate in value. Cost: A mutual fund may incur sales charges either up-front or on the back end that are passed on to the investors. In addition, some mutual funds can have high management fees.

Why people don t invest in mutual fund? ›

As the funds are invested in market instruments, they carry certain stock market risks like volatility, fall in share prices etc., which deters us from investing in mutual funds. As we don't want to lose money, we often let it stagnate in our savings accounts.

How do I withdraw money from a mutual fund? ›

You will need to visit the website of your mutual fund and log in with your credentials. You will need to select the fund and the number of units you want to redeem and confirm your request. You will receive the redemption amount in your bank account within a few days, depending on the type of fund.

Can a mutual fund go to zero? ›

The chances of a mutual fund becoming zero are very low. This is because a mutual fund invests in several assets. So, even if a few assets do not perform well, other assets can generate returns. This can balance the losses of non-performing assets.

How do mutual funds work step by step? ›

Mutual funds pool money from multiple retail investors. Retail investors receive a share in the form of units. The fund managers, using their expertise, then invests in stocks and bonds on behalf of the investors. Once the fund earns returns, it is distributed to the investors in the proportion of their investment.

What are the 4 P's of mutual funds? ›

One such guiding framework is the 4 Ps—People, Philosophy, Process, and Predictability serving as a comprehensive guide in this regard. Let's delve into each of these aspects to help your investors make informed decisions: People: The individuals behind a fund house play a pivotal role in shaping its performance.

What is the average return on a mutual fund? ›

Highlights: Average Mutual Fund Return Statistics

The average mutual fund return for a balanced mutual fund for the last 10 years as of 2021 is nearly 9-10%. In 2019, the average return on mutual funds was 16.3%. As of 2020, the average five-year return for large-cap mutual funds was around 11.9%.

How safe are mutual funds? ›

In the category of market-linked securities, mutual funds are a relatively safe investment. There are risks involved but those can be ascertained by conducting proper due diligence.

What is the difference between a stock and a mutual fund? ›

Stocks represent shares in individual companies while mutual funds can include hundreds — or even thousands — of stocks, bonds or other assets. You don't have to choose one or the other, though. Mutual funds and stocks can both be used in a portfolio to help you grow your wealth and meet your financial goals.

Why mutual funds are best for beginners? ›

Mutual funds offer flexibility and liquidity and provide easy entry and exit options. Liquidity allows beginners to access their money whenever they need it without penalties or waiting periods. Thus, mutual funds provide investors with various options to suit their investment goals and risk appetite.

Is mutual fund good or bad? ›

Mutual fund investments when used right can lead to good returns, keeping risk at a minimum, especially when compared with individual stocks or bonds. These are especially great for people who are not experts in stock market dynamics as these are run by experienced fund managers.

What is mutual fund and its benefits? ›

A mutual fund is an investment vehicle that holds different asset classes. Basically when you invest in a mutual fund scheme, you're contributing to a big pile of money to buy an asset, such as stocks, bonds, gold, etc., which need to be in line with the scheme's investment mandate.

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