8/20/2012 2:45 PM ET
What is a mutual fund?
FUNDS 101: When you buy a mutual fund, you're actually buying an ownership stake in a corporation that in turn hires a money manager to invest its money.
Buying a mutual fund is a lot like going in on a group gift or joining a co-op -- with people you'll never meet. Mutual funds allow a group of investors to combine their cash and invest it. By pooling their money, mutual fund investors can sample a broader range of stocks or bonds than they could if they were buying on their own.
Many people think of mutual funds as "products." But when you buy a mutual fund, you're actually buying an ownership stake in a corporation that in turn hires a money manager to invest its money. The price of a single ownership stake in a fund is called its net asset value, or NAV. If you have $1,000 to invest in a fund with an NAV of $118.74, for example, you'll get 8.42 shares. ($1,000 / $118.74 = 8.42.)
The fund manager combines your money with that of other investors. Together, those investments are called the fund's assets.
The fund manager invests the fund's assets, typically by buying stocks, bonds or a combination of the two. (Some funds buy more complicated security types.) These stocks or bonds are often referred to as a fund's "holdings," and all of a fund's holdings together are its "portfolio."
A fund's type depends on the kinds of securities it holds. For example, a stock fund invests in stocks, while a small-company stock fund focuses on the stocks of small companies. What you get as an investor or shareholder is a portion of that portfolio. Regardless of how much you invest, your shares are the portfolio in miniature.
For example, the three largest holdings of Vanguard 500 Index Investor (VFINX +0.20%, news) are Exxon Mobil (XOM -0.95%, news) (3.13% of its portfolio as of Sept. 30, 2010), Apple (AAPL +1.16%, news) (2.45%) and Microsoft (MSFT +0.18%, news) (1.88%). A $1,000 investment in that fund means you own about $31.30 of Exxon Mobil, $24.50 of Apple and $18.80 of Microsoft. In fact, you own all 500 stocks in the fund's portfolio. (Microsoft is the publisher of MSN Money.)
Mutual funds offer some notable benefits to investors.
1. They don't demand large upfront investments.
If you had just $1,000 to invest, it would be difficult for you to assemble a varied basket of stocks or bonds on your own. For example, with $1,000, you could buy one share of stock from the largest U.S. company, then one from the next largest, and so on, but it's likely that you'd run out of money sometime before purchasing your 20th stock.
If you bought a mutual fund, though, you would be able to sample many more types of stocks or bonds with your $1,000. You can make an initial investment in several funds with just $1,000 in hand; $2,500 will get you into many more funds. If you invest through an individual retirement account, you can often get your foot in the door with even less than $1,000. You can even buy some funds for as little as $50 per month if you agree to invest a certain dollar amount each month. (We'll cover different investment methods in an upcoming lesson.)
2. They're easy to buy and sell.
Whether you're buying funds on your own or hiring a broker or financial planner to do it for you, funds are easy to buy. Once a fund company has your money, it often takes just a phone call or mouse click to buy shares in a fund. Of course, there are exceptions: Closed funds, for example, no longer accept money from new shareholders.
By the same token, it's also easy to sell a fund. Unlike with many other security types, such as individual stocks, you don't need to find a buyer when it's time to unload your shares. Instead, the vast majority of mutual funds offer daily redemptions, meaning that the fund company will give you cash whenever you're ready to sell. Investors who own closed funds can also sell at any time.
3. They're regulated.
Mutual fund managers can't take your money and head for some remote island. Security exists through regulation set by the Investment Company Act of 1940. After the stock-market madness of the two decades prior to 1940, which revealed some big investors' tendencies to take advantage of small investors (to put it nicely), the government stepped in to put safeguards in place for investors.
Thanks to the 1940 regulation (often called "the '40 Act"), your mutual fund is a regulated investment company (regulated by the Securities and Exchange Commission) and you, as a mutual fund investor, are an owner of that company. As with other types of companies, mutual funds have boards of directors that represent shareholders. Among other duties, boards are charged with ensuring that the best available managers are running funds and that shareholders aren't overpaying for the managers' services. For example, the board of directors at Fidelity Magellan (FMAGX +0.20%, news)has hired Fidelity to run the fund on behalf of shareholders.
The fact that mutual funds are regulated shouldn't give investors a false sense of security, however. Mutual funds are not insured or guaranteed. You can lose money in a mutual fund, because a fund's value is based on the value of all of its portfolio holdings. If the holdings lose value, so will the fund. The odds that you will lose all of your money in a mutual fund are very slim -- all of the stocks or bonds in the portfolio would have to go belly-up for that to happen. And history suggests that such a mass implosion is unlikely in the vast majority of fund types.
4. They're professionally managed.
If you plan to buy individual stocks and bonds, you need to know how to read a company's cash-flow statement or assess the likelihood that a given company will fail to meet its debt obligations. Such in-depth financial knowledge is not required to invest in a mutual fund, however. While mutual fund investors should have a basic understanding of how the stock and bond markets work, you pay your fund managers to select individual securities for you.
Still, mutual funds are not fairy-tale investments. As you will learn in later sessions, some funds are expensive and others perform poorly. But overall, mutual funds are good investments for people who don't have the money, time or interest necessary to compile a collection of securities on their own.
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