An open-ended fund operated by an investment company which raises money from shareholders and invests in a group of assets, in accordance with a stated set of objectives. Mutual funds raise money by selling shares of the fund to the public, much like any other type of company can sell stock in itself to the public. Mutual funds then take the money they receive from the sale of their shares (along with any money made from previous investments) and use it to purchase various investment vehicles, such as stocks, bonds and money market instruments. In return for the money they give to the fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily, depending upon the performance of the securities held by the fund. Benefits of mutual funds include diversification and professional money management. Mutual funds offer choice, liquidity, and convenience, but charge fees and often require a minimum investment. There are many types of mutual funds, including aggressive growth fund, asset allocation fund, balanced fund, blend fund, bond fund, capital appreciation fund, closed fund, crossover fund, equity fund, fund of funds, global fund, growth fund, growth and income fund, hedge fund, income fund, index fund, international fund, money market fund, municipal bond fund, prime rate fund, regional fund, sector fund, specialty fund, stock fund, etc.
Advantages and Disadvantages
Every investment has advantages and disadvantages. But it’s important to remember that features that matter to one investor may not be important to you. Whether any particular feature is an advantage for you will depend on your unique circumstances. For some investors, mutual funds provide an attractive investment choice because they generally offer the following features:
Professional Management: Professional money managers research, select, and monitor the performance of the securities the fund purchases.
Diversification: Diversification is an investing strategy that can be neatly summed up as “Don’t put all your eggs in one basket.” Spreading your investments across a wide range of companies and industry sectors can help lower your risk if a company or sector fails. Some investors find it easier to achieve diversification through ownership of mutual funds rather than through ownership of individual stocks or bonds.
Affordability: Some mutual funds accommodate investors who don’t have a lot of money to invest by setting relatively low amounts for initial purchases, subsequent monthly purchases, or both.
Liquidity: Mutual fund investors can readily redeem their shares at the current NAV, plus any fees and charges assessed on redemption, at any time.
But mutual funds also have features that some investors might view as disadvantages, such as:
Costs Despite Negative Returns: Investors must pay sales charges, annual fees, and other expenses regardless of how the fund performs. And, depending on the timing of their investment, investors may also have to pay taxes on any capital gains distribution they receive – even if the fund went on to perform poorly after they bought shares.
Lack of Control: Investors typically cannot ascertain the exact make-up of a fund’s portfolio at any given time, nor can they directly influence which securities the fund manager buys and sells or the timing of those trades.
Price Uncertainty: With an individual stock, you can obtain real-time (or close to real-time) pricing information with relative ease by checking financial websites or by calling your broker. You can also monitor how a stock’s price changes from hour to hour, or even second to second. By contrast, with a mutual fund, the price at which you purchase or redeem shares will typically depend on the fund’s NAV, which the fund might not calculate until many hours after you’ve placed your order.
Risks
Every type of investment, including mutual funds, involves risk. Risk refers to the possibility that you will lose money (both principal and any earnings) or fail to make money on an investment. A mutual fund’s investment objective and its holdings are influential factors in determining how risky a mutual fund is. Reading the prospectus will help you to understand the risk associated with that particular mutual fund.
Generally speaking, risk and potential return are related. This is the risk/return trade-off. Higher risks are usually taken with the expectation of higher returns at the cost of increased volatility. While a mutual fund with higher risk has the potential for higher return, it also has the greater potential for losses or negative returns. The school of thought when investing in mutual funds suggests that the longer your investment time horizon is the less affected you should be by short-term volatility. Therefore, the shorter your investment time horizon, the more concerned you should be with short-term volatility and higher risk.
Different mutual fund categories have inherently different risk characteristics and should not be compared side by side. A bond fund with below-average risk, for example, should not be compared to a stock fund with below average risk. Even though both funds have low risk for their respective categories, stock funds overall have a higher risk/return potential than bond funds.
Mutual funds face risks based on the investments they hold. For example, a bond fund faces interest rate risk and income risk. Bond values are inversely related to interest rates. If interest rates go up, bond values will go down and vice versa. Bond income is also affected by the change in interest rates. Bond yields are directly related to interest rates falling as interest rates fall and rising as interest rise. Income risk is greater for a short-term bond fund than for a long-term bond fund.
Similarly, a sector stock fund (which invests in a single industry, such as telecommunications) is at risk that its price will decline due to developments in its industry. A stock fund that invests across many industries is more sheltered from this risk defined as industry risk.
Mutual funds involve risks, depending on the investments made, including but not limited to the following:
- Call Risk. The possibility that falling interest rates will cause a bond issuer to redeem – or call – its high-yielding bond before the bond’s maturity date.
- Country Risk. The possibility that political events (a war, national elections), financial problems (rising inflation, government default), or natural disasters (an earthquake, a poor harvest) will weaken a country’s economy and cause investments in that country to decline.
- Credit Risk. The possibility that a bond issuer will fail to repay interest and principal in a timely manner. Also called default risk.
- Currency Risk. The possibility that returns could be reduced by investing in foreign securities because of a rise in the value of the local currency against foreign currencies. Also called exchange-rate risk.
- Income Risk. The possibility that a fixed-income fund’s dividends will decline as a result of falling overall interest rates.
- Industry Risk. The possibility that a group of stocks in a single industry will decline in price due to developments in that industry.
- Inflation Risk. The possibility that increases in the cost of living will reduce or eliminate a fund’s real inflation-adjusted returns.
- Interest Rate Risk. The possibility that a bond fund will decline in value because of an increase in interest rates.
- Manager Risk. The possibility that an actively managed mutual fund’s investment adviser will fail to execute the fund’s investment strategy effectively resulting in the failure of stated objectives.
- Market Risk. The possibility that stock fund or bond fund prices overall will decline over short or even extended periods. Stock and bond markets tend to move in cycles, with periods when prices rise and other periods when prices fall.
- Principal Risk. The possibility that an investment will go down in value, or “lose money,” from the original or invested amount.
As it is mentioned above, every type of mutual fund has its own risk profile. So it is particularly important that you are fully aware of the risks involved before acquiring any such product. Such information can be found, for example, in the relevant product literature (i.e.fund’s prospectus etc).
