A mutual fund is at its core a managed portfolio of stocks and/or bonds. You can think of a mutual fund as a company that brings together a large group of people and invests their money on their behalf in this portfolio. Each investor owns shares of the mutual fund, which represent a portion of its holdings.
Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give its holders any voting rights. A share of a mutual fund represents investments in many different stocks (or other securities) instead of just one holding.
Investors typically earn a return from a mutual fund in three ways:
- Income is earned from dividends on stocks and interest on bonds held in the fund’s portfolio. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. Funds often give investors a choice either to receive a check for distributions or to reinvest the earnings and get more shares
- If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
- If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. You can then sell your mutual fund shares for a profit in the market.
Mutual funds have some clear advantages for investors, but also some limitations and drawbacks. Here is an overview of the pros and cons:
Advantages of Mutual Funds
• Professional Management – The primary advantage of funds is not having to pick stocks and manage investments. Instead, a professional investment manager takes care of all of this using careful research and skillful trading. Investors purchase funds because they often do not have the time or the expertise to manage their own portfolios, or they don’t have access to the same kind of information that a professional fund has. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments.
• Diversification – By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out across many different holdings. The idea behind diversification is not to put all of your eggs in one basket – instead, spread investments across a large number of diverse assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can seriously hurt your finances. Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn't be practical for an investor to build this kind of a portfolio with a small amount of money.
• Economies of Scale – Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions. Moreover, a mutual fund, since it pools money from many smaller investors can invest in certain assets or take larger positions than a smaller investor could. For example, the fund may have access to IPO placements or certain structured products only available to institutional investors.
• Simplicity – Buying a mutual fund is fairly straightforward. Many banks or brokerage firms have their own line of in-house mutual funds, and the minimum investment is often small. Most companies also have automatic purchase plans whereby as little as $100 can be invested on a monthly basis. Brokers can also purchase any other listed mutual fund on behalf of clients.
• Variety – Mutual funds today exist with any number of various asset classes or strategies. This allows investors to gain exposure to not only stocks and bonds but also commodities, foreign assets, and real estate through specialized mutual funds. Some mutual funds are even structured to profit from a falling market (known as bear funds). Mutual funds provide opportunities for foreign and domestic investment that may not otherwise be directly accessible to ordinary investors.
• Transparency – Mutual funds are subject to industry regulation that ensures accountability and fairness to investors.
Disadvantages of Mutual Funds
• Active Management – Many investors debate whether or not the professionals are any better than you or I at picking stocks. Management is by no means infallible, and, even if the fund loses money, the manager still gets paid. Actively managed funds incur higher fees, but increasingly passive index funds have gained popularity. These funds track an index such as the S&P 500 and are much less costly to hold.
• Costs and Fees – Creating, distributing, and running a mutual fund is an expensive undertaking. Everything from the portfolio manager's salary to the investors' quarterly statements cost money. Those expenses are passed on to the investors. Since fees vary widely from fund to fund, failing to pay attention to the fees can have negative long-term consequences. Actively managed funds incur transaction costs that accumulate over each year. Remember, every dollar spent on fees is a dollar that is not invested to grow over time.
• Dilution – It's possible to have poor returns due to too much diversification. Because mutual funds can have small holdings in many different companies, high returns from a few investments often don't make much difference on the overall return. Dilution is also the result of a successful fund growing too big. When new money pours into funds that have had strong track records, the manager often has trouble finding suitable investments for all the new capital to be put to good use.
• Liquidity – A mutual fund allows you to request that your shares be converted into cash at any time, however, unlike stock that trades throughout the day, many mutual fund redemptions take place only at the end of each trading day.
• Taxes – When a fund manager sells a security, a capital-gains tax is triggered. Investors who are concerned about the impact of taxes need to keep those concerns in mind when investing in mutual funds. Taxes can be mitigated by investing in tax-sensitive funds or by holding non-tax sensitive mutual fund in a tax-deferred account, such as a 401(k) or IRA.
• Cash Drag – Mutual funds require a significant amount of their portfolios to be held in cash in order to satisfy share redemptions each day. To maintain liquidity and the capacity to accommodate withdrawals, funds typically have to keep a larger portion of their portfolio as cash than a typical investor might. Because cash earns no return, it is often referred to as a “cash drag.”
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