What is a Mutual Fund?

What is a Mutual Fund?

By Larry Lane for InvestorZoo.com

Mutual funds are investment vehicles which allow you to be broadly diversified by owning a large array of stocks or a particular investment instrument. Funds are managed by a single individual or a team or managers. Their job is to maximize your investment within the fund's investment criteria. The decision made by the fund manager(s) will determine whether you see a financial gain or loss on your investment. Mutual fund managers are responsible for researching investments, as well as buying and selling securities. Mutual fund companies pool money from thousands of investors. Each of those investors becomes a shareholder in that fund.

Types of Mutual funds
There are literally thousands of mutual funds available for you to choose. Virtually every type of asset class is available at your fingertips. There are hundreds of sites which provide information on mutual funds. Morningstar.com is one of the largest and most comprehensive sites available.

Popular types of mutual funds:
General Stock mutual funds-These types of funds can invest in a wide variety of stocks. These can range from large cap to small cap international stocks.

Emerging Market mutual funds-These funds specialize in investing in small developing and emerging nations. Within these types of funds, you can find mutual funds that invest in a particular country such as Vietnam or India.

Sector funds-Do you think semiconductor stocks will do well in future? Do you think that the price of gold will continues to rise? Sector funds may be an ideal investment. Your manager can only invest in stocks in the particular sector you've chosen. If you chose a telecom sector fund and that particular segment of the market sees dramatic results, your telecom sector mutual fund should see similar gains. Sector funds have become extremely popular in the last several years. The thought process behind purchasing a sector fund is to obtain diversity while focusing on a single sector of the market you believe will outperform the market as a whole. You are also hiring a manager who is supposed to be an expert in the particular sector you've invested in. Generally sector funds have higher expenses than general funds.

Bond funds-Do you believe the bond market will outperform the stock market? Yes, bond funds are available and there is a wide variety to choose. There are short term Us Government bond funds, municipal bond funds, international bond funds, high yield (junk bond) funds..well you get the point.

Hybrid funds-to further enhance your portfolio choices, you can elect to purchase a hybrid fund. Also known as balanced funds, these mutual funds typically invest anywhere from 50-70 percent in stocks and the reminder in bonds and cash. The managers of these funds typically have discression how the fund will be balanced.

Index Funds-Index funds are generally passively managed funds designed to closely match their corresponding index. Index funds do not allow their fund manager the latitude of selecting or become overweight a particular stock or sector within the fund. It is their job to match the corresponding index The only time a mutual fund would sell a stock in a passively managed fun is if the corresponding was reconfigured. For example, when Microsoft was added to the S&P 500 Index, those mutual funds who mirrored the S&P 500 Index, were forced to purchase Microsoft so they would stay in lock step. Index mutual funds have three distinct advantages over actively managed funds.

1) Low turnover-This will minimize your tax burden at the end of the year. After all, it's not how much money you make, it's how much money you keep.

2) Low expenses-Low expense ratios let you keep more of your money. An index fund may be 5 times cheaper or more to manage than that of their actively managed funds

3) Over a ten year time period index funds have a huge advantage of those of active managed funds. If you are a large cap investor, you stand a 73% chance of receiving higher returns over an actively managed large cap mutual fund.

Drawbacks to index funds
With their advantages over actively managed mutual funds, index funds do have a drawback. Since every fund has management expenses, you stand to NEVER beat the index you are trying to meet or outperform. If you want large cap exposure and decide to purchase Vanguard's Index 500 mutual fund, you will lag the S&P. If Vanguard's expense ratio was .2% and the S&P 500 return was 10% for the year, your return will be 9.8%.

While expenses are a drawback, you simply cannot acquire diversification for free. Everything comes with a price and investing is no different.

There are vast universes of investment choices available which can enhance your return. While it is difficult to beat the S&P 500, with the correct combination of index funds and proper asset allocation, it is possible to achieve superior returns. This takes know how, experience and nerves not to sell out when the market corrects. A good financial planner will be able to provide you all of these required skills.

Larry Lane is the editor InvestorZoo, a social networking site dedicated to personal finance. Email questions and comments to Larry.Lane@InvestorZoo.com

The article above is information of a general nature and the information provided may not apply to your personal situation. Please consult your financial planner or licensed professional for investment advice.