How Do Mutual Funds Work?
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Mutual funds are perhaps the easiest and least stressful way to invest in the market. In fact, more new money has been introduced into funds during the past few years than at any time in history. But before you jump into the world of mutual funds and select one in which to invest, you should know what they are and how they work.
A mutual fund is a form of collective investment that pools money from many investors and invests their money in stocks, bonds, short-term money market instruments, (money market being short-term borrowing and lending, typically up to thirteen months) and/or other securities.
A fund manager then invests the fund's underlying securities, realizing capital gains or losses, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. The value of a share of the mutual fund, known as the net asset value per share (NAV), is calculated daily based on the total value of the fund divided by the number of shares currently issued and outstanding.
Mutual funds are divided along four lines: closed-end and open-ended funds; the latter is subdivided into load and no load.
- Closed-End Funds
This type of fund has a set number of shares issued to the public through an initial public offering. These shares trade on the open market; this, combined with the fact that a closed-end fund does not redeem or issue new shares like a normal mutual fund, subjects the fund shares to the laws of supply and demand. As a result, shares of closed-end funds normally trade at a discount to net asset value.
- Open-End Funds
A majority of mutual funds are open-ended. In simple terms, this means that the fund does not have a set number of shares. Instead, the fund will issue new shares to an investor based upon the current net asset value and redeem the shares when the investor decides to sell. Open-end funds always reflect the net asset value of the fund's underlying investments because shares are created and destroyed as necessary.
Load vs. No-Load.
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Load vs. No Load
-A load, in a mutual fund, is a sales commission. If a fund charges a load, the investor will pay the sales commission on top of the net asset value of the fund’s shares.Or simply put: If you invest $ 100.- per month and the load is 5%; then $ 5.- go away in commissions and the remaining $ 95.- get invested for you.
-No load funds tend to generate higher returns for investors due to the lower expenses associated with ownership. But watch out! In many cases this “No Load” is a fallacy. I don’t know of any high quality fund that runs for nothing! I can’t help laughing every time someone speaks of “No Load”. Do people really believe that the fund manager is going to do his responsible and delicate work for free?
Believe it when I say that, at the end of the day, you will pay for the service a fund provides for you. You may never see what it costs you because these costs are hidden. But know this: No fund runs on autopilot!
Benefits
Mutual funds are actively managed by a professional money manager who constantly monitors the stocks and bonds in the fund's portfolio. Because this is his or her primary occupation, they can devote considerably more time to selecting investments than an individual investor. This provides the peace of mind that comes with informed investing without the stress of analyzing financial statements or calculating financial ratios.
A mutual fund may hold investments in hundreds or thousands of stocks, thus reducing the risk associated with owing any particular stock. Moreover, the transaction costs associated with buying individual stocks are spread around among all the mutual fund shareholders.
Another benefit about a mutual fund and someone else doing the professional work for you is that, mostly we just don’t have the time to sit and watch the markets all day long. Usually during a work-week, we do exactly that; we work. Spending most of our time doing something else that’s not related to our investment. And when you come home from work at night, everything has already been said and done before you get wind of things.
You see, when bad news hits the markets, a fund manager can act and react much faster than you.
Mutual funds, however, are not immune to risks. Mutual funds share the same risks associated with the types of investments the fund makes. If the fund invests primarily in stocks, the mutual fund is usually subject to the same ups and downs and risks as the stock market.
Ricky Schmidt
January 25, 2007
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