Article: What Are Mutual Funds, Anyway?

Location:	Investing

What Are Mutual Funds, Anyway?

by Austin Pryor for Sound Mind Investing

The easiest way to understand a mutual fund is to think of it as a big pool of money.

The Barron's Dictionary of Finance and Investment Terms defines a mutual fund as a “fund operated by an investment company that raises money from shareholders and invests it in a variety of securities.” My plain-English definition is that it’s (1) a big pool of money (2) collected from lots of individual investors (3) that is managed by a full-time professional investment manager (4) who invests it according to specific guidelines. When you put money in a mutual fund, you are pooling your money with other investors in order to gain advantages that are normally available only to the wealthiest investors. You are transformed from a small investor into part owner of a multimillion dollar portfolio!

What do you get in return for your investment dollars? You receive shares that represent your ownership in part of the pool. The value of the shares is calculated anew at the end of every day the financial markets are open. Here’s how it’s done. First, you take the day’s closing market value of all the investments in the fund’s pool. To that number, you add the amount of cash on hand that isn’t invested for the time being (most funds keep 3%–5% of their holdings in cash for day-to-day transactions). That gives you the up-to-the-minute value of all the pool’s holdings. Next, you need to subtract any amounts the pool owes (such as management fees that are due to the portfolio manager but haven’t yet been paid). This gives the net value of the assets in the pool. Finally, you divide the net value by the total shares in the pool to determine what each individual share is worth. This is called the net asset value per share and is the price at which all shares in the fund will be bought or sold for that day. It is also the number that is reported in the financial section of the newspaper the next morning.

What kinds of securities do mutual funds invest in?

That depends on the ground rules set up when the pool was first formed. Every mutual fund is free to make its own ground rules. The rules are explained in a booklet called the prospectus that every mutual fund must provide to investors—that is where you learn what types of securities the fund is allowed to invest in.

Mutual funds invest in just about every type of security around, including corporate, government, and tax-free bonds, federally-backed mortgages, money market instruments like bank CDs, commercial paper, and U.S. Treasury bills, and of course, stock of individual corporations. For the average person, mutual funds are the very best way to assemble a well-balanced, diversified portfolio containing many different kinds of securities. But in order to simplify things, I’ll primarily use mutual funds that are stock-oriented when I’m explaining how funds work.

A mutual fund will usually limit its investments to a particular kind of security. For example, assume you want to invest only in quality blue-chip stocks that pay good dividends. As it turns out, there are a large number of mutual funds whose rules permit them to invest only in such stocks. No small company stocks, stock options, long- or short-term bonds, precious metals, or anything else. By limiting their permissible investments, mutual funds allow you to pool your money together with that of thousands of other investors who wish to invest in similar securities.

So that's what a mutual fund is. Why should they play a central role in your financial future? Find out next week, when we take a look at twenty major advantages of investing in mutual funds.

Adapted from Chapter 10, "What Mutual Funds Are" of Sound Mind Investing, A Step-By-Step Guide to Financial Stability by Austin Pryor. Copyright 2000 by Austin Pryor.