What is a Mutual Fund

What is a Mutual Fund
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Investing > Mutual Fund 

Mutual funds are securities “for the rest of us” who cannot afford a diversified portfolio of stocks or bonds. 

Mutual funds invest in a wide variety of stocks, bonds, or money market instruments (or a combination thereof), and enable small investors to achieve a level of diversification generally available only to large investors.

To illustrate, it would be prohibitively expensive to purchase even five shares of each of the stocks representing the S&P 500. On top of this, you would have to research which stocks actually comprise the S&P 500–or worse, research and select 500 fundamentally sound stocks on your own if you were not tracking a list. Adding insult to injury, you would also incur huge transaction costs: at $10 per trade, it would cost $5,000 to buy 500 different stocks. 

On the other hand, the cost of five shares of a large, diversified mutual fund that invests in the 500 stocks of the S&P 500 would be far more attainable for the average investor, require far less research, and involve far lower transaction costs. 

Thus, mutual funds allow investors to participate in the securities market with (a) diversification, (b) professional management, and (c) much lower transaction costs.

The Mechanics of a Mutual Fund

A mutual fund is not some invisible, intangible “account.” In many respects it is just like a regular corporation: 

  • like a corporation, a mutual fund is a company; albeit a federally regulated investment company that invests in cash, bonds, stocks, or other investments; 
  • just as you would buy shares of a corporation and receive dividends, you would buy shares of a mutual fund, and participate in the dividends of the mutual fund’s investments. 
  • just as a corporation is professionally managed, a mutual fund is managed by investment professionals. Each fund has a portfolio manager who buys or sells securities according to its fund’s investment objective, using a pool of investors’ money. 

Mutual fund companies include Fidelity, T. Rowe Price, and Vanguard (each mutual fund offered under these brands is its own separate mutual fund investment company). Each of these brands offers a variety of funds that each have specific investment objectives. 

Depending on the fund objectives, the funds may invest, in order of increasing aggressiveness, in money market securities, bonds, and equities (stocks). 

Not surprisingly, mutual funds have proven to be an extremely popular investment vehicle. In 2003, mutual funds managed $7.4 trillion in assets, and approximately 22% of all publicly held stocks. Almost half of all U.S. households own mutual funds. (Source: Mutual Fund Fact Book 2003, Investment Company Institute.) 

“Open-End” vs. “Closed-End” Funds

There are two types of mutual funds: open-end and closed-end. The vast, vast majority of mutual funds are “open-end” investment companies.

An open-end fund neither limits the number of investors nor the size of its assets. (As a practical matter, some open-end funds will in fact close to new investors if their assets become too large to manage). 

This means an open-end fund issues as many shares as demanded by investors. Similarly, the fund will redeem shares from investors that wish to “cash out” and leave the fund. Open-end funds are sold and redeemed by the fund itself, and are not traded on a public stock exchange. 

In contrast, a “closed-end” fund will have an initial public offering (IPO) of its shares to raise capital for the fund manager to invest. After this IPO, the closed-end fund will not issue any more shares. Nor will the fund buy back shares from the investor who wishes to cash out. The only way to buy shares, or sell shares, would be on a stock exchange or over-the-counter market (e.g., NYSE, American Stock Exchange, etc.), using a broker. 

What is the practical consequence of an open-end fund and a closed-end fund? 

Unlike stocks and closed-ends funds, both of which are traded on a stock exchange, the share price of an open-ended mutual fund will not turn on “market” supply and demand for the fund’s shares. Instead, the share price of an open-end fund will turn on the fund’s net asset value (NAV). As suggested by the name, NAV represents the total market value of the fund’s net investment assets, less liabilities. (Each individual share of the mutual fund, in turn, is roughly equal the NAV divided by the number of outstanding fund shares.) As such, the purchase and “buy back” price of an open-end fund is not subject to “market” supply and demand. The transaction cost will essentially be the load fee (if any).

The price of the shares of a closed-end fund are determined by market supply and demand. This barter process requires the services of a broker, and may entail higher transaction costs. Additionally, for reasons that are not clearly understood, the buy/sell price of a closed-end fund on a publicly traded market is somewhat “irrational” and may not be equal to the fund’s NAV. More often than not, the closed-end fund may sell at a 10% discount to its NAV. (While this means you would “give up” some value as the seller, it also means that the buyer “gains” some value.) On occasion, a closed-end fund may also sell at a premium to NAV.

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