A mutual fund is an investment company that pools money from shareholders to invest in a diversified portfolio of securities. When an investor puts money into a mutual fund, the investor is purchasing shares of that fund. Each share represents proportionate ownership in the fund's underlying securities.
Mutual funds are managed by professionals who employ an investment strategy to meet the objectives stated in the prospectus. Although there is no guarantee that the objectives of a particular fund will be achieved, fund managers choose investments based upon the mutual fund's goal - growth, current income, and so on. The funds are generally well diversified to offset potential losses. As economic conditions change, the blend of investment instruments in the fund may change, depending on what the prevailing situation calls for - sometimes a more aggressive stance, sometimes a more defensive one.
Types of Mutual Funds
There are four basic types of mutual funds:
Stock Funds Sometimes called equity funds, the primary purpose of these funds is to provide growth of capital through equity investments, although some also seek to provide dividend income as a secondary objective.
Balanced Funds These funds invest in common stocks, preferred stocks, and bonds in an attempt for high returns with less volatility.
Bond Funds The main goal of these types of funds is to provide current income by investing in U.S. Government, corporate or municipal debt obligations.
Money Market Funds A money market fund is a mutual fund that invests in short-term obligations created by groups of local governments, the federal government, banks, or large corporations. These are the lowest-risk investment among all mutual funds. However, they tend to provide the lowest returns.
An investment in any money market fund is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at one dollar per share, it is possible to lose money by investing in the fund.
Advantages and Disadvantages
Diversification: Mutual funds typically invest in different securities to create a diverse portfolio. Since each share of a mutual fund represents ownership of the fund's underlying securities, one share provides diversification across many securities. Although diversification does not eliminate market risk, it can help reduce risk by offsetting losses from some securities with gains in other securities. There are currently more than 7,000 mutual funds available, ranging from aggressive to defensive. Some concentrate on certain industry sectors, while others draw from a wide base of companies and investments.
Professional Money Management: A professional portfolio manager manages money that is invested in a mutual fund. In-depth market research and analysis is performed in choosing the investments of the fund. The portfolio manager ensures that the investments remain consistent with the fund's objectives as stated in the prospectus.
Liquidity: Fund shares can be liquidated upon request any day that the stock market is open (most funds are priced once a day at 4:00 p.m. ET). Some funds even provide check writing and the ability to link directly with a checking account.
Convenience: Transactions for mutual funds can be done in writing, by phone and over the Internet.
No Guarantee: Unlike bank deposits and CDs, mutual funds are not insured or guaranteed by the FDIC. Money market mutual funds seek to maintain a stable share price; however, their yields may fluctuate. Stock and bond mutual funds may lose value.
Taxes: Since portfolio managers make the decisions to buy and sell securities, the fund's shareholders do not have control over when taxable transactions will occur for a particular fund. You may have to pay taxes for capital gains and/or income distributed by the fund during the course of the year.
Risk and Reward: The diversification that mutual funds provide can help reduce risk by offsetting losses from some securities with gains in other securities. However, this could limit the upside potential that is provided by owning a single security.