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  • Writer's pictureKen Holman

What Are Mutual Funds?


Mutual funds typed

What are Mutual Funds?


A mutual fund is a company, created as either a corporation or a trust, designed as an investment company used to pool money from many investors to purchase securities such as stocks, bonds, and short-term debt. The combined holdings of a mutual fund are known as its portfolio. The average mutual fund portfolio consists of 36-to-1,000 stocks.

 

Investors don’t actually own the individual securities purchased by the mutual fund, instead each investor owns shares of the mutual fund itself and participates proportionally in the profits or losses of the mutual fund. Although there are many mutual funds throughout the world, the term “mutual fund” is typically used in the United States, Canada and India.

 

Some attribute the creation of the first mutual fund back to a Dutch merchant, Adriaan Van Ketwich, who, in 1774, introduced the fund under the name Eendragt Maakt Magt (“Unity Creates Strength”). On In 1924, Massachusetts Investors Trust in Boston introduced the concept of pooling resources from multiple investors to purchase a diversified portfolio of securities, offering investors the flexibility to buy and sell shares at the net asset value (NAV) computed at the end of each trading day.

 

By 1929, there were 19 open-end mutual funds competing with nearly 700 closed-end funds. With the stock market crash of 1929 and the ensuing Great Depression, mutual funds that were at first enthusiastically embraced were now met with skepticism and greater regulatory scrutiny. The U.S. Securities and Exchange Commission (SEC) was established in 1934 and the Investment Company Act of 1940 set the regulatory framework for mutual funds, requiring disclosure standards and setting fiduciary responsibilities for corporate governance.

 

By 2018, there were 9,599 mutual funds in the U.S. That number came down to 7,945 by 2019. According to Balance Everything, there is no standard agency that provides a count of all mutual funds worldwide. However, the Investment Company Institute gives a number of regulated open-end funds, which include mutual funds. The figure for 2019, the last year for which data is available, totaled 122,528 worldwide which grew to approximately 177,000 by the end of 2021.

 

Today, around 47% of the mutual fund asset are concentrated in the United States and almost half of all mutual fund assets in the U.S. are held in retirement accounts. With $27.0 trillion in total net assets, the U.S. mutual fund industry remained the largest in the world at year-end 2021; the majority of U.S. mutual fund net assets were in long-term mutual funds with equity funds making up 55% of total U.S. mutual fund net assets.

 

What Types of Mutual Funds Are There?


Mutual funds fit into two broad categories: Closed-end mutual funds and Open-end mutual funds. Closed-end mutual funds raise a fixed amount of capital through its investment company and issue a fixed number of shares through an Initial Public Offering (IPO). They are traded on a stock exchange like any other stock, but they do not accept new money nor do they buy back shares from investors. They can trade at a premium or discount to their net asset value per share, depending on the supply or demand.


Open-end or open-ended fund is what most people think of when they hear the term “mutual fund.” These funds use pooled capital from investors and allow for ongoing new contributions and withdrawals. Consequently, open-end funds have a theoretically unlimited number of potential shares outstanding. Most mutual funds are open-end funds.

 

In addition to these two broad categories, most mutual funds fall into one of four specific main categories: Money Market Funds, Bond Funds, Stock Funds, Balanced Funds and Target Date Funds. Money Market Funds have relatively low risk. By law they can only invest in certain high-quality, short-term investments issued by U.S. corporations and the federal, state and local governments.

 

Bond Funds are riskier than money market funds because they are less secure. However, because there are many different types of bonds and the risks and rewards vary dramatically, the returns are also higher.

 

Stock Funds (also called Equity Funds) invest in corporate stocks listed on one of the major stock exchanges. Each stock fund has its own investment objectives. For instance, some funds focus on value or income. These companies are characterized by low price-to-earnings (P/E) ratios, low price-to-book ratios and dividend yields.

 

Other funds focus on growth. Growth funds look to companies with solid earnings, sales, and cash flow growth. These companies typically have high P/E ratios and do not pay dividends. Still other funds track a particular market index, called an Index Fund, which tracks a specific index such as the Standard & Poor’s 500 Index. Equity funds are also categorized by whether they invest in U.S. stocks or foreign equities.

 

Balanced Funds invest across different securities, whether its stocks, bonds, the money market or alternative investments. The objective of these funds, known as an Asset-Allocation Fund, is to cut risk through diversification. 

 

Target Date Funds, on the other hand, hold a mix of stocks, bonds, and other investments. The portfolio mix gradually shifts over time according to the fund’s strategy. Target date funds, sometimes known as Lifecycle Funds, are designed for individuals with particular retirement dates in mind.

 

Regardless of the fund you invest in, all mutual funds detail their allocation strategies and investment objectives. For example, some funds follow a strategy of dynamic allocation percentages to meet diverse investor objectives. This may include responding to market conditions, business cycle changes, or even the changing phases of an investor’s own life.

 

How Are Mutual Funds Managed?


One of the big advantages of investing in a mutual fund is the benefit of professional management. Active fund managers make important decisions every day about what to buy, sell and hold. These decisions are based on the fund’s investment objectives, which determine the return investors will achieve. Fund managers, also called portfolio managers, are usually given the freedom to modify the ratio of asset classes to maintain the fund’s stated strategy.


In addition to the fund manager, there is usually an entire cadre of researchers, often called investment analysts, who help make investment decisions. They have the technological resources and expertise needed to research companies and analyze market information before making an investment decision. 


Ultimately, it is the fund manager who makes the final decision on which securities to buy and sell. They do this through careful evaluation of individual securities, sector allocation and the analysis of technical factors. For those passive investors who do not have the time, inclination or expertise to oversee their investments, professional management is the best way to go.


The fund managers of actively managed funds often try to outperform the market or a benchmark index, such as the S&P 500. One of the complaints against actively managed funds is that some studies have shown that passive investing strategies often deliver better returns for the investor. This will be discussed in greater detail in another article.

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