What Is a Mutual Fund?

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Mutual Fund Basics

Mutual Fund Education

What Is a Mutual Fund?

Mark P. Cussen Sep 08, 2014

Mutual funds have grown to be one of the most popular types of investments in the world for both individuals and institutions. Their diversification and flexibility make them ideal vehicles for accomplishing almost any type of investment objective, and billions of new dollars continue to pour into them each year. Knowing how they are created, structured, and offered can help you to understand how they can work for you.

What Is A Mutual Fund?

Many financial advisors and brokers explain how funds work using the stewpot analogy. When you make a stew, you combine a group of ingredients into a single pot and cook them through together. Then, when you take a spoonful of stew, your spoon will be holding a small amount of each ingredient. Mutual funds work the same way. The portfolio managers purchase a basket of securities using the pooled money from the investors and then trade the securities in an effort to achieve the investment objective that is stated in the fund charter.

Be sure to read the 7 Questions to Ask When Buying a Mutual Fund

For example, a large cap value fund would buy blue-chip stocks that the management team believes are undervalued and sell them when they are perceived to become overvalued. Mutual funds rarely guarantee the investor’s principal and can produce dividends, interest, or capital gains depending on the fund.

How They Are Structured

Mutual funds also charge ongoing management fees known as 12b-1 fees that are assessed periodically. Brokers and advisors who work on commission typically sell funds with sales charges because most of the sales charge is paid to them as commission. A broker who sells ABC fund A shares that charge a 4.75% sales load will usually get paid 4 percent, with the rest going to the fund.

Mutual funds are sold by banks, insurance agents, stockbrokers, financial advisors and of course directly by the fund companies themselves. Some advisors trade no-load funds on a fee basis in an effort to provide unbiased portfolio management, where they are not incentivized to choose a fund because it will pay them a sales commission.

Types of Mutual Funds

  • Growth Funds – these funds seek capital appreciation through the purchase of securities that are projected to rise in price over time.
  • Income Funds – seek to produce current income through the purchase of fixed-income securities such as bonds, preferred stock or senior secured loans.
  • Growth and Income Funds – combine the two aforementioned objectives to produce both growth and income.
  • Money Market Funds – invest in short-term money market instruments to maintain complete liquidity.
  • Sector Funds – invest in a specific sector of the market, such as healthcare or energy.
  • Index Funds – simply own all of the securities in one of the market indexes, such as the Standard and Poor’s 500.
  • International and Global Funds – invest either solely overseas (international) or both domestically and abroad (global).

As mentioned previously, there are also funds that purchase a single type of security, such as junk bonds or small-cap stocks. Absolutely every type of security or sector of the market has a fund somewhere that invests solely in it (and in most cases, such as large-cap growth, there are dozens or hundreds to choose from).

Mutual Funds vs. Individual Stocks

See also Understanding Mutual Fund Net Asset Value

Closed-End Funds and Exchange-Traded Funds

See also Under the Hood of the Most Popular Mutual Funds

The Bottom Line

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