How do Mutual Funds Work?

The mutual fund prospectus should explain it all!

How do mutual funds work? Individual investors pool their money with other investors. Stock investment specialists then manage the funds. But how does a value investor choose the best mutual fund?

The name used to describe the funds depend on the country. 'Mutual fund' is the term referred to in the U.S., whereas 'managed share fund' is used in Australia.

The discussion here relates to both terms with specific reference to stock market related funds.

Professional stock investment specialists, referred to as fund managers, manage these funds.

So there is no requirement for direct stock investing on the part of the investor.

Types of Mutual Funds

There are many types of mutual funds for mutual-fund investors to choose from.

Of all the types of managed funds available, I prefer absolute return funds which are similar to hedge funds.

Closed end mutual funds behave more like stocks because they trade on an exchange and the price is determined by market demand after an initial IPO process.

Closed-end funds can trade below their net asset value or above it. In some other countries they are called listed investment companies (LICs).

Mutual funds are usually referred to as open ended funds as they allow new units to be purchased. So knowing the distinction between these classed of mutual funds helps you to determine how do mutual funds work.

Mutual funds are not only available domestically. There is a wide variety of international mutual funds available.

Asset allocation funds provide an important role in allowing diversification across asset classes. These asset classes may include cash, bonds and stocks among others. In answering the question ... 'how do mutual funds work', the discussion on asset allocation funds provides important additional information.

How do you choose which fund fits your requirements? Mutual fund screeners make this job a lot easier!

Mutual Fund Ratings and Mutual Fund Returns

The best rated mutual funds can be accessed from websites such as Morningstar that are involved in tracking mutual funds. At this site you can compare mutual funds.

It is a common practice for investors to seek out high-yield mutual funds to invest in based on the previous year's performance.

However the top-ranked mutual funds for one year have a habit of not providing the best performance in following years.

Past performance is not a good predictor of future performance.

REIT funds have provided superior dividends for several decades by investing in real estate such as shopping centers and a variety of other property investments.

But they have been hit hard by the global financial crisis and property valuations have been affected.

Because of the size of some funds, the possibility of achieving significant out performance may be restricted.

This is less of a problem for international funds that have a much wider investing universe.

Managed Fund Characteristics

To further investigate how do mutual funds work, all managed funds have a Product Disclosure Statement (PDS) which explains where the fund invests your money, as well as outlining the investment style of the fund manager.

By pooling your money with other investors, share funds have the buying power to invest in a wider range of stock holdings than an individual investor. This provides greater diversification.

And instead of the individual investor spending her or his own time and money researching and administering their investment, mutual funds use skilled and experienced professionals to do the job on their behalf.

When you invest in a mutual fund, you are allocated units based on the amount invested divided by the current unit price of the fund.

The unit price varies daily depending on the value of the stock portfolio held in the mutual fund.

This makes them different in a number of respects from stock investment companies, in some countries called listed investment companies (LICs), that can be traded on the stock market.

Management Styles

There are a variety of investment or management styles available to investors in mutual funds.

It is important to know the difference between active and passive styles as well as understanding the difference between top-down and bottom-up approaches if you want a good understanding of the question: how do mutual funds work?

It is possible to find value managers who follow a value investing 'style' or approach.

Which style you favor will depend on your objectives, your risk profile and what level of fees you are happy to accommodate.

Benefits of Mutual Funds

Examples of cases where mutual funds may provide a benefit over direct stock investment include the availability of the best international mutual funds.

It is difficult for individual investors to gain information on international companies operating in overseas markets.

The same applies to emerging markets mutual funds that are becoming viewed as a separate asset class by superannuation funds.

Another example may be where an investor uses a small market capitalization (small-cap) share fund to gain a diversified exposure to the small-cap sector rather than making a direct share investment in one or a few small-cap companies.

Index Mutual Funds

Index mutual funds that track the stock market index are suited to passive investors and those who are time poor.

They are also a convenient way to have money invested in the stock market if you are a beginner investor.

A type of fund that is similar to an index fund in that it tracks the index of a wide variety of securities is the exchange traded fund. iShares are exchange traded funds.

Account Management

Knowing how mutual fund accounts can be set up is an important aspect of how do mutual funds work.

There are a number of ways in which a share portfolio, including managed funds, can be managed by an investment manager on behalf of the individual investor.

A Separately Managed Account (SMA) is one example which is considered to be very tax effective.

A mutual fund wrap or wrap account provides access to a large pool of mutual funds for one annual fee (usually between 0.5% and 2%).

The fee 'wraps around' all your mutual fund activity, giving you a clear picture of what is paid to your broker or financial adviser.

These mutual fund wrap programs are most often offered by full-service brokerage houses. In most instances, the wrap fee only covers the services provided by your broker, not the actual management fees of the mutual fund itself.

To Conclude

For me, the major advantage of mutual or managed funds is the level of diversification they provide, as well as easy access to international stocks.

I am also happier if the managers of the fund are investing their own money in the fund. Worth checking?

The advantages of managed funds need to be weighed up against the management fees that need to be paid and the loss of control that results from handing over your hard-earned money.

So getting back to the question, has this discussion answered the question - how do mutual funds work?

Related Article

Mutual fund screeners - Will help you to find mutual funds that follow a value investing approach.

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