What are mutual funds?

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A mutual fund is a trading or investing account that gathers and pools funds from individual investors in order to buy stocks or make other investments as one entity, so as to use potential advantages of volume investing. The mutual fund is managed by a licensed professional money manager or brokerage firm that buys individual stocks in large quantities. The ability to make high-volume trades give mutual funds managers the ability to leverage for better deals and more opportunities than would be available to most individual investors.

A mutual fund can have a variety of securities in its portfolio and is not restricted to one particular type of investment. However, there are also specialty mutual funds that do concentrate on a specific area or investment.

One of the ways to categorize mutual funds is by their format or structure. In the United States, the majority of mutual funds can be categorized according to of the following four format types:

  • Open-end mutual funds
  • Investment trusts
  • Exchange-traded funds
  • Closed-end mutual funds

An open-end fund is a mutual fund that has not established any limits on the amount of shares it will issue to new investors. An open-end mutual fund can continue growing in size as new investors join and invest in the mutual fund. Most of the popularly known mutual funds soliciting new investors today are open-end funds.

The investment trust, or unit investment trust, issues shares, or units, to the general public. The buyers of these shares may hold or sell their shares in the open market at their discretion.

A closed-end fund is most commonly associated with an initial public offering (IPO) as a company decides to change its legal status from private to public in order to raise additional capital. Investors can buy these initial offerings and hold them or sell to other investors.

Finally, an exchange-traded fund (ETF) is a recent entry in the mutual fund arena and is a type of fund with investments. An ETF is typically an open-ended type but may also be formed as a partnership, trust or other vehicle and can be tied to a particular index such as stocks and bonds and even currencies.

Mutual funds are perhaps the most common way for individuals to invest their money in stocks, bonds, commodities and currencies. An individual investor may invest directly into a mutual fund or have their investments professionally managed by a professional mutual fund manager. Professional fund managers monitor the markets constantly and attempt to keep their pulse on daily investment activity yet these managers will charge fees to the investor in return for managing the funds.

Categories of mutual funds

Although the above mutual fund formats are ways to categorize funds by structure, most mutual funds can also be categorized by their investment objectives:

  • Equity funds. One of the most popular types of mutual funds is equity funds, which are focused on investing for capital growth over the long term. Although some income may be generated, the bulk of equity fund investment efforts look for stocks and securities that have the potential to rise in value.
  • Money market funds. One of the safest mutual funds, money market funds consists primarily of short-term investments, such as U.S. Treasury Bills and other instruments that offer a guaranteed rate of return. Unfortunately, the cost of safety is usually lower returns (compared to other investment types).
  • Fixed income funds. Also called bond funds, this type of mutual funds are intended to generate a stable stream of revenue, primarily through investments in bonds.
  • International funds. Also called global funds, this type of U.S. mutual funds invest in companies based outside of the United States. A subset of global funds looks for opportunities in emerging markets.
  • Index funds. This type of mutual fund seeks to replicate the performance of specific indices, such as the S&P 500 or Dow Jones Industrial Average (DJIA).

There are other types of mutual funds besides the above, but they are the most prominent when it comes to investment objectives.

As individual investors consider their mutual fund options, the best approach is to first consider investment goals and sensitivity to risk. After identifying how much risk an investor is willing to take on in pursuit of his or her goals, the next step would then be to consult professionals and review the track records of potential investments.

Disclaimer: NetCredit is a direct personal loan provider and does not provide financial advice, nor does it vouch for any vendor or service mentioned on our NetCredit personal finance blog or online consumer loan glossary. Always research and perform due diligence on any service provider or vendor before deciding to use them, and we recommend that you speak with a financial advisor regarding all decisions that will affect your finances.

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