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Mutual fund: definition, benefits, and examples

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Last editedMay 20213 min read

Mutual funds can be an attractive option when you need to diversify your portfolio or think you could benefit from the expert eye of a fund manager. However, as with any type of investment, there are pros and cons to consider. Here’s a closer look at how a mutual fund works, as well as how to get started with investing.

What is a mutual fund?

A mutual fund is a company that pools your money together with resources from other shareholders or investors. This pool of combined money is used to invest in any number of securities, including short-term debt, stocks, bonds, and even crypto assets. When you invest in a mutual fund, you purchase shares in this pooled portfolio of holdings.

A professional fund manager is responsible for overseeing the mutual fund’s investment activity, ensuring all decisions are research and market driven. An additional benefit is the fact that mutual funds are less risky than single investments, since your money’s diversified into a range of assets.

How do mutual funds work?

A mutual fund functions as both a company and type of investment. As a result, when you purchase shares in a mutual fund, you’re purchasing partial ownership of the company as well as its investment assets.

So, how do investors make money through a mutual fund? After you pay your money to the fund manager, investments are made on your behalf along with that of the other investors. This builds up the fund’s portfolio with a diverse range of assets. When investments perform well, the fund pays returns to its owners. There are three ways you might be paid returns through a mutual fund:

  1. When shares increase in interest or dividends, these proceeds are distributed to investors. They might also be reinvested back into the fund, depending on the terms and conditions.

  2. When the fund manager sells securities at a profit, you’ll receive capital gains. These are distributed monthly, quarterly, or annually.

  3. Some fund managers will choose to retain shares rather than selling them for profit. In this case, you might receive a net asset value for each share owned.

Types of mutual funds

Although they all function with the same basic structure, there are several types of mutual funds to choose from.

  • Money market funds: Those seeking a low-risk investment might want to choose money market funds, which purchase government-backed or high-quality corporate investments.

  • Bond funds: These might include corporate bonds, government bonds, or a mixture of both. The risk vs reward can vary significantly depending on the type of bonds purchased.

  • Stock funds: Mutual funds focusing on corporate stocks fall into this category, including index funds, growth funds, and income funds for regular dividend pay-outs.

  • Target date funds: These contain a mix of stocks, bonds, and other securities handpicked to yield the highest returns by the end of a lifecycle or date. These are often used by those with specific investing goals or retirement in mind.

In addition to these core types, there are also mutual funds that fall into more specialist categories. For example, you could invest in sector-specific or location-specific funds. Ethical or socially responsible funds are also growing in popularity, purchasing shares in companies that follow corporate social responsibility guidelines.

How to invest in mutual funds

If you’re interested in purchasing shares, the next step is to figure out how to invest in mutual funds. Fortunately, this process is streamlined for easy investment. Investors can purchase shares directly from the fund, or through a broker. You’ll then be able to sell shares back to the mutual fund at any time.

One thing to note is that terms, including fees, will vary widely between mutual funds. Each fund must publish a prospectus for potential investors, which should clearly outline investment goals, risks, and past performance. As with any business, mutual funds incur expenses as part of their daily operations, which are passed down to investors in the form of fees.

The pros and cons of mutual funds

There are plentiful advantages of mutual funds, which are prized for their hands-on management and relatively low investment risk. This makes them a popular option for retirement savings. Here are some reasons to look into mutual fund investment:

On the other hand, there are a few cons to consider. Mutual funds can involve high fees or commissions. As with any investment, returns can fluctuate. While mutual funds can be a great choice for those with less investing experience, professionals might want a more hands-on option. To make the most of your investment, be sure to research your options carefully.

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