As a financial professional, you already know why investing is important. But occasionally you meet a client who doesn't understand even the most basic concepts and tools of successful investing. What do you say? The following is an easy to follow explanation to help you explain to clients why they should invest.

What Is a Mutual Fund?

As you probably know, mutual funds have become extremely popular over the last 20 years. What was once just another obscure financial instrument is now a part of our daily lives. More than 80 million people, or half of the households in America, invest in mutual funds. No matter what type of investor you are, there is bound to be a mutual fund that fits your style.

A mutual fund is nothing more than a collection of stocks, bonds or other securities. You can think of a mutual fund as a company that brings together a group of people and invests their money for them. Each investor owns shares, which represent a portion of the holdings of the fund. You can make money from a mutual fund in two ways:

  1. Interest and dividend income from stocks and bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution.
  2. Capital gains - 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.

Types of Mutual Funds

It's important to understand that each mutual fund has different risks and rewards. Although some funds are less risky than others, all funds have some level of risk - it's never possible to diversify away all risk. Each fund also has a predetermined investment objective that tailors the fund's assets, regions of investments and investment strategies. At the fundamental level, there are three varieties of mutual funds:

  1. Equity funds (stocks) - Funds that invest in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth with some income. There are, however, many different types of equity funds because there are many different types of equities.
  2. Fixed-income funds (bonds) - These funds provide current income on a steady basis. These terms denote funds that invest primarily in government, municipal and corporate debt.
  3. Money market funds - The money market consists of short-term debt instruments, mostly Treasury bills. This is a safe place to park your money. 

All mutual funds are variations of these three asset classes. For example, while equity funds that invest in fast-growing companies are known as growth funds, equity funds that invest only in companies of the same sector or region are known as specialty funds. Some of the other fund categories include:

Balanced Funds 

The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. These funds typically invest in a combination of fixed income and equities. A balanced fund might have a weighting of 60% equity and 40% fixed income.

Global/International Funds 

An international fund (or foreign fund) invests only outside your home country. Global funds invest anywhere around the world, including your home country.

Specialty Funds

  • Sector funds - Target specific sectors of the economy such as financial, technology or healthcare. Sector funds are extremely volatile.
  • Regional funds - Focus on a specific area of the world. This may mean focusing on a region (say Latin America) or an individual country (such as Brazil). 
  • Socially-responsible funds (or ethical funds) - Invest only in companies that meet the criteria of certain guidelines or beliefs. Most socially responsible funds don't invest in industries such as tobacco, alcoholic beverages, weapons or nuclear power.
  • Index Funds - This type of mutual fund replicates the performance of a broad market index such as the S&P 500 or Dow Jones Industrial Average (DJIA).

Advantages of Mutual Funds

Mutual funds offer several major benefits that have made them very popular with investors. They provide small and uneducated investors with access to professional portfolio management and a broad level of diversification that is impossible to duplicate with a small amount of money. Mutual funds can be bought and sold at any time and most shareholders can get their money within a few days. Money market mutual funds are like checking accounts and their funds can be withdrawn instantly.

Disadvantages of Mutual Funds

Despite their credentials and experience, the majority of mutual fund portfolio managers are not able to trade the securities in their funds well enough to beat the performance of the benchmark indices like the S&P 500. This is often because the gains that are realized by the winners in the fund are not enough to move the overall share price upward.

Many mutual funds also have very high expenses; some assess a sales charge of as much as 6% upon purchase or redemption, and funds can also have annual administrative fees and costs of up to 2% per year. Most mutual funds also typically pass on the accumulated gains or losses in the portfolio to investors once per year, and those who buy shares of the fund right before this happens will be presented with a tax bill for investment income that they did not receive.

Mutual funds also pass along the risks that are inherent in the securities in which they invest, such as market risk, inflationary risk, interest rate and reinvestment risk and political risk.

The Bottom Line

Mutual funds act as pass-through entities that assign shareholders a proportionate amount of all interest, dividends and capital gains or losses. The type of income that is realized depends upon the securities that the fund invests in, but this income is ultimately taxed in the same manner as from any other type of investments. Dividends and interest are taxed as ordinary income (except for muni bond interest) and capital gains and losses from securities are also reported as such. Investors also realize a separate gain or loss from the share price when they sell their funds.

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