How Do Mutual Funds Work?

Some Mutual Funds Basics

How do mutual funds work? A mutual fund can be looked at as a cooperative of investors. A number of people pool their investment money together to purchase stocks, bonds, securities of other investments. This fund is then managed by a fund manager who will be an expert in this area.



That is the layman view. In professional speak, they are known as collective investments (because the money is invested as a group). Broadly speaking, collective investments are very similar around the world - known as unit trusts in the UK for example - the fund management firms can adopt similar or identical business models in different countries.

(It is worth pointing out that collective investments are only really known as mutual funds in the United States and Canada.)

By pooling money, an individual investor can invest in companies and projects that may otherwise be too expensive to be involved with. Therefore, they are often an ideal starting point for a new investor. It is possible to invest in a range of companies and sectors with relatively small amounts of money.

In fact, to open investment up to ever wider sections of society, many mass market funds will have a minimum monthly investment that starts at around 50.00 ($, £ or €) each month.

This ability to invest in a number of companies is called diversification and helps to reduce the risk to an investor. Essentially, investment in a stock market is always risky. However, the risks are much higher if an investor only holds one stock. If that company ceases to trade, the entire investment could be lost. But, by using a fund, a small amount is actually invested in many companies. This means that if one firm folds, the fund should lose just a small percentage rather than everything.

As might be imagined, this ability to diversify with very small sums of money and by paying very low fees, makes mutual funds ideal for investors with limited time, experience or money. These can be great investments for beginners!

Types Of Mutual Funds

This means that supply and demand is not a factor in the unit price, unlike most other forms of investment.

This open-ended structure means that popular funds can have millions or tens of millions of units and perhaps hundreds of thousands of individual investors.

For ease, the value of units is normally calculated once per day and trades to buy or sell are carried out based on that price.

For many low or medium risk investors that would like to invest in the stock market and have a time horizon for investing of perhaps 3 years or more, these funds (mutual funds and unit trusts) are likely to be the best, most cost effective and easiest place to start.

Close ended funds: These funds have a pre-set number of shares in existence which means that the price is almost always impacted in some way by the forces of supply and demand. These funds first came into being in the UK. The first fund was formed by Foreign and Colonial. They are now known more generally as investment trusts . The investment trust is actually something of a unique investment format and most investors would be well advised to start with something simpler and more understandable.

As mentioned above, collective investments - including mutual funds - benefit from low costs to the investor, professional fund management and wide market and (sometimes) asset class diversification. This makes them a good starting point to the stock market for most investors.

However, as with any stock market or asset based investment, they are not risk free. Asset prices (property, bonds, stocks, shares) can rise as well as fall in price, as can any income paid by them.