Mutual Funds

Overview of Mutual Funds

Stocks chart with dollar billA mutual fund is a company that combines, or pools, investors' money and, generally, purchases stocks or bonds. Ideally, a fund's size and resultant efficiency, combined with experienced management, provide advantages for investors that include diversification, expert stock and bond sand convenience.

In terms of legal structure, a mutual fund is a corporation that receives preferential tax treatment under the U.S. Internal Revenue Code. The assets of a mutual fund consist almost entirely of the securities it holds in its portfolio. The most common type of mutual fund, called an open-end fund, allows investors to buy and sell stock in it on an ongoing basis.

How it Works. The mutual fund issues shares of stock (just like any other corporation) to investors in exchange for cash. It is interesting to note that funds do not issue a pre-determined amount of stock, as do most corporations; new shares are issued as each new investment is made. Investors thus become part-owners of the fund itself, and thereby the assets of the fund. The fund, in turn, uses investors' cash to purchase securities, such as stocks and bonds. As mentioned above, the primary assets of a fund are the securities it invests in (other assets, such as equipment, are a relatively small part of the total assets of a fund).

Pricing and Valuation

The value of the shares of an open-end mutual fund is readily determined. Each day, the accounting staff of a fund simply adds up the value of all the securities in the portfolio, adds in other assets, deducts liabilities, and comes up with a net overall value. It is then a simple matter to divide the net assets by the number of shares outstanding. This is called the net asset value, and is the price at which investors buy and sell shares from the fund. The net asset value is listed in the financial section of many major newspapers.

Load and No-Load Funds

Many people have heard the words load and no-load in connection with mutual funds, but do not understand what these terms refer to. Simply put, a load, or loaded, fund is one that has a sales charge. A no-load fund has no sales charge.

As noted above, not all funds have sales charges. Those that do simply add them on to the net asset value of the fund, thus coming up with a new, higher offering price per share. It is important to note that the underlying value of the fund's shares do not change; and further, that an investor selling shares will still receive only the net asset value.

Fund Objectives and the Prospectus

Mutual funds are investment companies, and they may invest in securities of various kinds, such as stocks and bonds. Money market mutual funds, which constitute a major portion of the fund universe, invest only in very short-term bonds. A fund's objective, described in the prospectus, gives broad indications of the types of investments a fund may make. The prospectus discloses important specific details about the fund that the prospective investor should be aware of, including allowable investments, expenses, risks, and financial statements. Therefore, investors should always read the prospectus carefully before investing or sending money.

Advantages and Disadvantages of Mutual Funds

The primary advantages of mutual funds are summed up in an oft-heard litany: diversification, professional management and convenience. By and large, most funds do achieve this basic mission. Over and above that, funds offer lower costs by virtue of their size; they may receive breaks on trading costs, and they certainly spread many internal costs over a large shareholder base, allowing for economies of scale. On the negative side, funds make tax planning difficult (because the timing of taxable distributions is uncertain), and may be somewhat difficult to track in terms of what they actually are investing in (which is generally not disclosed until after the fact for competitive reasons). In addition, so-called non-substantial changes in the way the funds are managed (such as manager switches) may not be disclosed to investors by fund companies in a timely manner.

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