What is a Mutual Fund?

The idea behind a mutual fund is fairly simple: Many investors pool their money in a fund managed by a professional money manager on behalf of these investors.

The manager uses this pool of money to direct investments according to the fund’s objectives, such as long-term growth, high or stable current income, or stability of principal. Depending upon its objective, a fund may invest in stocks, bonds, cash investments or a combination of these financial assets.

For investing in the fund, you will receive either units or shares that represent your proportionate share in the fund’s pool of assets. A fund’s investment returns comprises of the income (dividend or interest) paid on the securities and any capital gains or losses resulting from the sale of securities the fund holds. Your share in these returns will be dependent upon the number of units or shares held by you.

In return for administering the fund and managing its investment portfolio, the fund manager charges fees based on the value of the fund’s assets.

The mutual fund world is divided into open-end funds and closed-end funds. In an open-end fund new investors can contribute money to the fund at any time, and existing investors can return their units or shares to the fund for redemption at any time. There is no limit to the number of units or shares the fund can issue. When you redeem your units or shares of a mutual fund you will receive payment based on the current market value of the fund’s portfolio.

A closed-end fund issues a fixed number of shares or units in an initial public offering and they trade on an exchange. A majority of closed-end funds sell at a discount to their underlying asset value due to a number of reasons. Most investors in closed-end funds bet that the spread between the discount and the underlying asset value will narrow, therefore, they look for funds that are trading at deep discounts. It is advisable for the novice investor to invest in open-end funds unless he/she understands the mechanics for evaluating the discount spread.

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