When you invest in a mutual fund, you are investing in a company that, in turn, buys shares of stock and debt obligations issued by companies and governments.
Mutual funds are called pass-through investments since federal law requires them to distribute, or "pass through," most of the earnings on their investments to shareholders. Mutual funds have been around since the 1920s and are regulated by the Investment Company Act of 1940.
A mutual fund sells you shares of itself to raise cash. The fund invests these proceeds in a portfolio of securities. These securities are also referred to as a portfolio's holdings.
A team of professional fund managers and analysts is tasked with managing a mutual fund. The team selects individual securities that have the risk-return characteristics that are consistent with the fund's investment strategy.
The fund team monitors the investment performance of the portfolio daily. If one of the portfolio's holdings falls out of favor, the team may sell the security and buy another. Alternatively, instead of immediately reinvesting the cash elsewhere, it may decide to park the money temporarily and earn a risk-free interest rate until a better investment opportunity comes along.
Active versus passive
Mutual funds can be sliced and diced in different ways. One way is to distinguish between actively managed funds and passively managed mutual funds. Actively managed funds seek to exploit higher-than-normal investment returns that may be found in carefully screening and selecting individual securities on their own merits. Most mutual funds and mutual fund assets are invested in actively managed funds.
Passively managed funds construct a fund that is identical to the composition of a popular benchmark index such as the S&P500. Passively managed funds are also called index funds.
Net asset value
A mutual fund buys and sells its shares at a price equal to its net asset value. To calculate a fund's net asset value, first subtract its debts and expenses from its assets. For example, if a fund has $600 million in assets and $100 million in debts and expenses, its net assets are $500 million.
Next, divide net assets by the number of shares the fund has issued. If the same fund has issued 100 million shares, its net asset value is $5. Net asset value of most stock and bond funds fluctuate daily with changes in the market value of its portfolio. In addition, the number of shares outstanding fluctuates daily.
Capital gains from redemptions
Selling shares of a mutual fund back to the fund is called redeeming your shares. When shareholders redeem their shares en masse back to the fund, the fund is often required to sell some of its portfolio holdings to raise the necessary cash to return to departing shareholders. Funds routinely keep some of their assets in cash to accommodate normal patterns of shareholder redemptions.
When a fund sells its holdings, it incurs capital gains or losses. The capital gains are distributed to the remaining fund shareholders, sticking them with a capital gains tax bill even if fund's share price declines. To discourage shareholders from redeeming their shares too soon (often within 90 to 180 days of buying the shares), mutual funds often charge a redemption fee. The cash raised from redemption fees is plowed back into the fund's assets, in part to compensate remaining shareholders for the capital gains that they incur from heavy shareholder redemptions.
The U.S. mutual fund industry has substantial assets under its management. According to the Investment Company Institute, an industry trade group, there were more than 8,000 mutual funds in the U.S. with combined assets of around $12.08 trillion at the end of November 2007. Based on the 290 million mutual fund accounts that existed at that time, the average value of each account was more than $41,000.
Mutual funds offer several advantages, including:
Professional money management. Managers and analysts that manage a mutual fund are well educated and well informed people who spend their days spotting investment trends. Fund managers and analysts save you time and effort by researching and analyzing securities that may be hard to find out about on your own.
Diversification. A basic investing principle of investing is diversification, which says that you should not put all your eggs in one basket. When Enron Corporation filed for bankruptcy in late 2001, the retirement plans of employees who had invested mostly in Enron stock were wiped out. By investing in mutual funds with different investment strategies, you invest in a broad basket of stocks, bonds and cash whose investment returns often move independent of each other.
Access to hard-to-get securities. Buying shares of a mutual fund gives you access to securities that may otherwise be too expensive or require too much time and effort to learn about. For example, if you buy a corporate or government bond, you may have to fork over $5,000 or more. However, if you buy shares of a bond fund that invests in those kinds of bonds, your required investment is much less.
Lower transaction costs. Mutual funds trade many times more shares than does the average investor. As a result, brokerages are often willing to accept lower transaction fees as a necessary cost of doing business with mutual funds. As an individual investor making your own trades, you're unlikely to get as good of a price.
Liquidity.Liquidity is the means of being able to sell your shares quickly and at a fair price. For most mutual funds, the fund company itself is always ready to buy back your shares.