A mutual fund pools money from many individuals and/or corporations to purchase investments. Mutual funds have many advantages over buying individual securities. The major advantages of mutual funds are diversification, liquidity, and professional management.
Diversification
Diversification is a way of spreading your funds in order to reduce risk. In common terms, this would be “not having all your eggs in one basket”. The easiest way to achieve diversification is to invest in a variety of assets. If you have millions of dollars it is easy to buy a variety of different stocks, bonds, and other assets so if one is depreciating others may be appreciating. But if you are just starting to invest you can buy a mutual fund to achieve some diversification.
Liquidity
A liquid asset can be sold rapidly with minimal loss of value. The key feature of a liquid market is that there are always ready and willing buyers and sellers. Another way to judge liquidity in a company’s stock is to look at the bid/ask spread. Bid-ask spreads aren’t an issue for mutual fund buyers and sellers, because the fund is priced just once a day, and everyone pays and receives that same price. However, this means that you can’t buy or sell instantly but instead have to enter your order and wait for the close of day to know the exact price. Exchange-Traded Funds are very much like mutual funds but trade on a moment by moment basis like stocks.
Professional Management
A major benefit of a mutual fund is the professional management that picks the composition of the fund. Some funds are based on a particular index and so the managers simply adjust the fund to mimic the index. Other funds, however, may seek to beat the indices by investing only in stocks that they believe will outperform the average. Here the skill of the management can result in vastly more profit than the average earned by the index fund.
Categories / Classification
Mutual funds are often classified based on the makeup of their primary investments such as stock, bonds, or fixed-income funds. They can also be categorized as index funds or funds that invest in a particular asset class like transportation stocks, utilities, a particular country’s stocks, or physical assets like oil or gold.
Primary Structures
Mutual funds can be set up in varying ways including as open-end funds, closed-end funds, exchange-traded funds (ETFs) or unit investment trusts (UITs) .
Open-Ended Funds can issue and redeem shares at any time so there is no limit to the number of shares a fund can issue. Investors purchase shares directly from the fund itself, rather than from existing shareholders. When the fund receives new money it increases the size of the basket of its holdings. When assets under management decrease the fund must sell some underlying securities.
The price per share of an Open-ended fund is calculated at the end of every trading day. It is determined by taking the fund’s assets minus its liabilities divided by the total number of shares outstanding. This is also called Net Asset Value (NAV). Often the fund will have an initial charge or fee called a “front-end load” funds that don’t charge this fee are called “No-Load Funds”.
Closed-end funds, issue a set number of shares when the fund is created, and then shares of the fund are traded like stocks among investors. Thus they can be bought or sold at a set price at any time during the day. And since the price is set by the market rather than fixed to its NAV, closed-end funds can trade at a discount or premium to their net asset value.
Exchange-traded funds (ETFs) are traded on stock exchanges, much like stocks. Most ETFs track an index, such as a stock index, bond, or commodity index. ETFs combine the features of open and closed-end funds in that they can be bought or sold at (or very near) its net asset value, but it can be done at any time of the day. ETF’s are not bought directly from the fund however but from a market maker that buys large blocks of funds by exchanging the underlying stocks for them. This way the fund doesn’t have to manage the day-to-day fluctuations in assets under management and they don’t even have to purchase the basket of underlying assets in the first place. This means that their management fees can be lower as well.
Unit Investment Trusts (UITs) are exchange-traded mutual funds offering a fixed (unmanaged) portfolio of securities having a definite life. Unlike open-end and closed-end investment companies, a UIT has no board of directors. UITs are created and sold by brokerage firms to investors based on perceived investor demand for a particular product. UITs offer a tax shelter from unrealized capital gains taxes typical in a mutual fund. Because individual UITs are assembled and purchased for specific periods of time, the cost basis consists of the initial purchase price of the securities held in the trust thus the tax is not due until the UIT is sold or it ends. A mutual fund, on the other hand, accrues the gains yearly to the individual, who must then pay taxes on it even though they haven’t been sold it yet.
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