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Find out how mutual funds work
Get exposure to a wide variety of securities and benefit from professional management expertise with this common investment vehicle.
Investment used to be reserved for those with high capital. Now, investors with lower incomes can get in on the action, pooling funds together to create a mutual fund.
What is a mutual fund?
A mutual fund is a single portfolio containing a diverse array of stocks and bonds that are managed by one or more professionals on behalf of a group of investors. Because mutual funds pull together money from many different investors, the minimum investment is often very small.
Mutual fund managers buy and sell securities within the fund with the aim of “outperforming” the stock market by generating higher-than-average returns. Using their expertise, they carefully pick assets they believe will help the fund meet its goals (long-term growth, high dividends etc.). They continually monitor the fund and add or remove assets as they see fit based on market conditions.
Of course, this service comes at a cost. The management expense ratio (MER) is an annual percentage reflecting the amount spent on management fees, operating costs (like transaction fees) and taxes.
Investors’ gains are based on how well the mutual fund performs and the proportion of the funds’ shares they own. If the price of their mutual fund shares increase, they can sell those shares for a profit. Some mutual funds also make regular payments to investors in the form of stock dividends or interest from bonds held within the fund.
Units of mutual funds can be bought and sold much like stocks. In fact, mutual funds can even contain stocks in other mutual funds.
The price of a mutual fund share is known as its net asset value (NAV). This reflects the combined price of the securities in the fund and is typically set at the end of the trading day.
Types of mutual funds
There are several types of mutual funds. These are typically categorized based on the type of assets they invest in such as stocks of large companies or investment strategies. In some cases, it’s a combination of both. Here are some examples.
- Stock (equity) funds: As you guessed, these mutual funds invest primarily in stocks. There are subcategories of stock funds, typically based on the size of the companies they invest in and the investment strategy.
- Large-cap mutual funds: These mutual funds invest in companies with market capitalizations of more than $10 billion. Market cap is taken by multiplying the price of a single share of a company’s stock by the number of shares outstanding.
- Small-cap mutual funds: These mutual funds invest in companies with market caps between $300 million to $2 billion.
- Mid-cap mutual funds: These funds invest in companies with market caps that fill the gap between large-and-mid caps.
- Strategy mutual funds: In some cases, stock funds are named after the size of the companies they invest in and the investment strategy employed by the fund managers. An example would be a large-cap value fund. These mutual funds invest in large companies that are in fundamentally good financial shape but may be undervalued in terms of share price. Meanwhile, growth funds invest in companies that have proven track records and are expected to keep growing.
- Bond (fixed-income) fund: These funds invest in assets that pay interest. These can include corporate bonds, government bonds and more.
- Balanced funds: These invest in different types of assets such as stocks, bonds and real estate. Many balanced funds are named after the level of risk they take on based on the types of assets they invest in. A conservative fund would invest mostly in safer securities like bonds. An aggressive fund would invest mostly in growth-oriented assets like stocks.
- Index funds: These mutual funds invest in stocks within a particular index such as the S&P 500, which contains some of the biggest companies listed on US stock exchanges. To minimize risk, fund managers attempt to match the performance of the corresponding index rather than beat it. That’s the strategy employed by actively managed funds. Index funds can be seen as passively managed funds.
- Money market funds: These invest in generally safe securities like Treasury Bills. It’s a good place to park your money for safety because you’re not likely to lose it. But money market funds generally gain small returns similar to a typical savings account.
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