What is Mutual Fund ? Fundamentals | Advantages & Disadvantages

What is a Mutual Fund?

• A way of holding financial and real investments.
• An Investment company that pools money from investors to buy stocks, bonds, and other financial  investments.
• Investors own a share of the fund proportionate to the amount of their investment divided by the total value of the fund.

Mutual Funds : Introduction

Why were they developed?

• To give smaller investors access to professional management and to increase the assets of mutual fund companies.

What are the advantages of Mutual Fund Investing?

Diversification

• While owning a single stock or bond is very risky, owning a mutual fund which holds numerous securities can reduce risk significantly.

Professional management

• Picking your own stocks and bonds to put in your portfolio and beating your benchmarks is difficult and time-consuming. Hiring a mutual fund to make those decisions for you can be beneficial and save time.

Minimal transaction costs

• Buying individual stocks and bonds is expensive in terms of transactions costs.  Mutual funds enjoy economies of scale in purchases and sales due to size.

Liquidity

• Buying and selling individual stocks and bonds takes time. Money from open-end mutual funds can be received in two business days

Flexibility

• Individual stocks and bonds are not flexible. With many mutual funds, you have more flexibility and can often write checks on your account.

Low cost

• “No-load” mutual funds are sold without a sales charge and are redeemed without a charge as well 

The ability to purchase and sell at Net Asset Value.

• “Open-end” mutual funds can be purchased and sold each day at the fund’s Net Asset Value, which is the fund’s assets less liabilities, divided by the number of shares outstanding.

Service

• Mutual funds generally offer service to answer questions, help you open accounts, purchase and sell funds, and to transfer funds as well.

In addition, they may include:

• Automatic investment and withdrawal plans 
• Automatic reinvestment of interest, dividends, and capital gains
• Wiring and funds express options
• Phone switching
• Easy establishment of retirement plans
• Check writing
• Bookkeeping and help with taxes 

What are the disadvantages of Mutual Fund Investing?

Risk of lower-than-market performance

• From 1989-1998, the average annual returns of actively managed stock funds was 15.6% versus the return of the S&P 500 stock index of 19.2%.  Not all mutual funds outperform their benchmarks, and taxes take a significant part of investor returns

High costs

• Unless analyzed carefully, management and other fees can be significant.  Moreover, many mutual funds have “loads” or sales charges and 12-b1 fees which reduce returns.

Other Risks

• Mutual funds are subject to both market and stock related risks, particularly in concentrated portfolios

Inability to plan taxes

• Mutual funds pass through 95% of all capital gains and dividends to the shareholders.
• Even if you do not sell your mutual fund, you can have a significant tax bill each year if your mutual fund trades often and has dividends, interest or capital gains.
• It is difficult to plan for taxes when the tax decision is taken by the portfolio manager, not you.

Premiums or Discounts

• “Closed-end” mutual funds may trade at a premium to  (more than) or discount (less than) the underlying Net Asset Value (NAV).  These premiums or discounts may be based more on investor demand than the underlying shares value.

New investor bias

• New investors dilute the value of existing investor’s shares.  Since new money comes into the fund at Net Asset Value, and since this money must be invested (at roughly 0.5% on average in the U.S.), existing investors are subsidizing new investors coming into the fund.