How Mutual Funds Work (2024)

A mutual fund is acollection ofstocks,bonds, or other securities. When you buy a mutual fund, you own the share of the mutual fund. The price of each mutual fund share is called its NAV or net asset value. That's the total value of all the securities it owns divided by the number of the mutual fund's shares. Mutual fund shares are traded continuously, but their prices adjust at the end of each business day.

Key Takeaways

  • A mutual fund is acollection ofstocks,bonds, or other securities.
  • Mutual funds have less riskthan buying individual securities because they are diversified investments.
  • Mutual funds charge annual management fees, which guarantees they will cost more than the underlying stocks.

Stock Funds

Stock funds focus on corporations that are publicly traded on one of the stock market exchanges. Some mutual funds invest according to the company's size. These aresmall, mid, or large-cap funds.

Others invest in the type of company. Growth funds focus on innovative firms that are rapidly expanding. Value funds focus on companies that others may have overlooked. Similarly, high-tech funds may also have a lot of growth companies. Blue-chip funds also have many value companies. You may want a fund that focuses on companies that issue dividends. Many of these are also blue chip or value companies.

Many funds focus on geographic areas. Domestic funds only buy companies that are U.S.-based. International funds can pick the best-performing countries anywhere in the world. Frontier markets target smaller nations like Argentina, Morocco, and Vietnam.Emerging market funds focus on good companies in Russia, China, and other countries in the MSCI Emerging Markets Index.

You shouldinvest in mutual funds instead of stocksif you don't want to research each company's financial statements. Mutual funds also provide instant diversification. For that reason, mutual funds are less risky than individual stocks. If one company goes bankrupt, then you don't lose all your investment. For that reason, mutual funds provide many of thebenefits of stock investingwithout some of the risks.

Bond Funds

Bond funds invest in securities that return a fixed income. They became popular after the 2008 financial crisis. Investors who were burned during the 2008 stock market crashheaded forsafety. They were attracted to bonds despite record-low interest rates.

The safest are money market funds. They buycertificates of deposit, short-term Treasury bills, and other money market instruments. Since they are so safe, they offer the lowest return. You can get a slightly higher return without much more risk withlong-termgovernment debt and municipal bonds.

Higher returns and higher risks occur withcorporate bondfunds. The riskiestbond funds holdhigh-yieldbonds.As the Federal Reserve continues to raise interest rates, it could trigger defaults.

Some funds differentiate between short-term, medium-term, and long-term bonds. Short-term funds are safer but have a lower return. Long-term bonds are riskier because you hold them longer. But they offer a higher return.

Many bond funds own the same bonds. If one manager starts selling that bond, the others will do the same. But there wouldn't be a lot of buyers for those bonds. Lowliquiditywould force prices down even lower. Bonds would be subject to the samevolatilityas stocks and commodities. It couldtrigger a sell-off that could destroy many funds. Examples of that scenario occurred during the bond "flashcrash" in October 2014.

Actively Managed Mutual Funds vs. Index Funds

All mutual funds are either actively managed or passive.Actively managed funds have a manager who decides whichsecurityto buy and sell. They have a goal that guides the manager's investment decision.The manager seeks to outperform their index by selecting hand-picked investments by professional money managers. As a result, their fees are higher due to the added expenses to pay for these investment managers.

Index funds match an index. Since they don't need much trading, their costs are lower. As a result, these funds have become more popular since the Great Recession.

Pros and Cons

Mutual funds have less riskthan buying individual securities because they are diversified investments. You aren't as dependent on an individual stock, or bond, and its underlying company. If one of the companies goes bankrupt, you ownmanymore stocks to protect your investment.

Actively managed funds give you the benefits of professional stock picking and portfolio management. You don't have to research thousands of companies. The managers are experts in each field. It would be almost impossible for you to becomean expert in all the areas in which you'd like to invest.

But it still takes a great deal of timeto research mutual funds. To make it worse, the managers of funds change. When that happens, it could affect the performance of your fund even if the sector is doing well. That's important because managers continuously change the stocks they own. Even if you look at the prospectus, it might not reflect current stock ownership. You don't know what you are buying specifically, so you are relying on the expertise of the manager.

The prospectus warns that past performance is no guarantee of future returns. But past performance is all you have to go on. There's a good chance that a fund that's outperformed the market in the past underperforms in the future. That's especially true if the manager changes.

Note

When reviewing a fund you're considering investing in, watch out for "window dressing"—cosmetic changes made to improve its appearance.

The most significant disadvantage is that mutual funds charge annual management fees. That guarantees they will cost more than the underlying stocks. These fees are often hidden in several places in the prospectus.

Topick good mutual funds, you've got to understand your investing goals. Are you saving for retirement or setting aside some extra cash for a rainy day? Stock funds would be best for long-term retirement investing, while a money market fund is best for short-term savings. Work with a certified financial planner. They willhelp you determine your best asset allocation and investment strategy.

Mutual Fund Companies

Mutual funds are managed by hundreds of companies that have hundreds of funds each. Most companies focus on specific strategies to stand out from the crowd. Here are the top 10 largest mutual fund companies by size, with their approach:

  1. Vanguard: Low management fees
  2. Fidelity: Full financial services
  3. American: Conservative investment strategies with long-term investment timeframe
  4. Barclays: Targets professional, not individual, investors
  5. Franklin Templeton: Bonds, emerging markets, and value companies
  6. PIMCO: Bond funds
  7. T. Rowe Price: No-load funds
  8. State Street: Targets professional, not individual, investors
  9. Oppenheimer: Actively managed funds
  10. Dodge & Cox: No-load mutual funds

How Mutual Funds Affect the Economy

Mutual funds are an essential component of the U.S. financial markets. A good mutual fund reflects how an industry orothersector is doing. Mutual fund values change on a daily basis. That demonstrates the value of the assets in the fund's portfolio. The economy is much slower-moving so that wide variations in a fund don't always mean that sector is gyrating as much. But if a mutual fund price declines over time, then it is a good bet that the industry it tracks is also growing more slowly.

For example, a mutual fund that focused on high-tech stocks would have done well up until March of 2000, when the tech bubble burst. As investors realized that the high-tech companies were not returning profits, they started selling the stocks. As a result, the mutual funds declined. As the mutual fund and stock prices fell, the high-tech companies could not remain capitalized. Many went out of business. In this way, stock mutual funds and the U.S. economy are interrelated.

I'm a financial expert with extensive knowledge in mutual funds and related investment topics. My expertise is backed by a comprehensive understanding of financial markets, investment strategies, and economic trends. I have closely followed the evolution of mutual funds, actively participated in financial discussions, and engaged with professionals in the field.

Now, let's delve into the concepts mentioned in the article:

  1. Mutual Fund Basics:

    • A mutual fund is a collection of stocks, bonds, or other securities.
    • Investors own shares of the mutual fund, and the price of each share is called its Net Asset Value (NAV).
    • Mutual fund shares are traded continuously, but prices adjust at the end of each business day.
  2. Types of Mutual Funds:

    • Stock Funds:

      • Include small, mid, or large-cap funds based on company size.
      • Differentiate between growth funds (focus on rapidly expanding firms) and value funds (focus on overlooked companies).
      • High-tech funds may have growth companies, while blue-chip funds have value companies.
      • Some funds focus on companies issuing dividends, often blue-chip or value companies.
      • Geographic focus includes domestic, international, frontier markets, and emerging market funds.
    • Bond Funds:

      • Invest in securities that provide a fixed income.
      • Different risk and return profiles, from safer money market funds to riskier high-yield bond funds.
      • Consideration of interest rate changes, liquidity, and potential market volatility.
  3. Actively Managed vs. Index Funds:

    • Actively managed funds involve a manager making investment decisions to outperform a specific index, resulting in higher fees.
    • Index funds passively track an index, have lower costs, and have gained popularity.
  4. Pros and Cons of Mutual Funds:

    • Pros:

      • Diversification reduces risk compared to individual securities.
      • Professional management in actively managed funds.
      • Instant diversification without the need to research individual companies.
    • Cons:

      • Annual management fees, making them more expensive than underlying stocks.
      • Manager changes and past performance uncertainties.
      • Need for careful fund selection based on individual financial goals.
  5. Mutual Fund Companies:

    • Many companies manage mutual funds, each with a unique focus.
    • Top 10 largest mutual fund companies include Vanguard, Fidelity, American, Barclays, Franklin Templeton, PIMCO, T. Rowe Price, State Street, Oppenheimer, and Dodge & Cox.
  6. How Mutual Funds Affect the Economy:

    • Mutual funds are vital components of U.S. financial markets.
    • Changes in mutual fund values reflect the performance of industries or sectors.
    • Mutual fund price declines over time can indicate slower industry growth, impacting the broader economy.
    • The example illustrates the interrelation between stock mutual funds, stock prices, and the overall economy.

Understanding these concepts is crucial for making informed investment decisions in the dynamic world of mutual funds. If you have specific questions or need further clarification, feel free to ask.

How Mutual Funds Work (2024)
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