What Are Mutual Funds? Essay, Research Paper
What is a Mutual Fund and How Does It Work?
Think of a mutual fund as an investment company that pools the money
of people just like you for one common reason — to make more. Not all
pots of money, though, are alike. Each mutual fund has its own strategy
and investment objective for making money. It’s up to you to select the
right mutual fund for you based on your own needs.
There are two types of mutual funds. The most common, which this
book primarily talks about, is open-end funds. In essence, they are open
– money flows directly into the fund when investors buy and goes
directly out when they sell. The other type is closed-end funds, which
technically are not mutual funds. You’ll learn more about them in
Chapter 16.
With a mutual fund, the big pool of money we talked about previously is
managed by a company, which frequently the organization that started
the fund. This management company either serves as or hires the
fund’s investment advisor. The advisor employs a portfolio manager and
his or her research staff to select the investments for the mutual fund.
Mutual funds are subject to strict federal regulations. The fund broker or
other salesperson is required to give you a prospectus before you
invest. The prospectus is an important document that spells out the
investment objectives of the fund, risks, fees, and other important
information. You’ll learn more about what’s in a prospectus and what you
should look for in Chapter 9. The Securities and Exchange Commission
(SEC) is the U.S. government agency in charge of regulating mutual
funds.
Generally, mutual funds continuously offer new shares to the public.
They also are required legally to buy back outstanding shares at the
shareholder’s request. When you sell shares in a fund, you receive a
check based on its share’s price or net asset value (less any sales
charges, if applicable). The net asset value is obtained when the fund
figures the value of its investments, less liabilities, divided by the number
of shares outstanding at the end of the day.
Technobabble: The investment advisor is an organization hired by the
mutual fund company to manage a mutual fund’s investments. A
portfolio manager is the professional who actually manages the fund.
The investment objective describes what your mutual fund hopes to
accomplish. Assets represent any investment that the mutual fund
holds, including stocks, bonds, and cash reserves. A mutual fund share
is a unit of ownership in the fund. A mutual fund investor who owns
shares is called a shareholder and has voting rights.
Introducing: The Cast of a Mutual Fund
Like any company, the mutual fund management company is an
organization with a number of people that run the show. You want to
understand how this company works because you’ve entrusted it with
your hard-earned cash. Although mutual funds are set up under state
law, usually as corporations, they differ from other companies.
First, they are legally entitled to hire companies to handle the bulk of their
services. They typically hire the investment advisor, also known as an
investment advisory firm, to manage your mutual fund. They also make
arrangements to have the fund sold through a brokerage firm.
The following sections review the cast of characters who make a mutual
fund work.
The Investment Advisor
The investment advisor is one — or in some cases, a group — of the key
people in a mutual fund, including the portfolio manager(s) and
his/her/their staff. You’ve probably seen some portfolio managers on
TV’s “Wall Street Week,” spotted their quotes in magazines, or read
some of their books. This person selects, buys, and sells the
investments based on the fund’s investment objectives. The investment
advisor is paid an annual fee based on a percentage of the value of the
fund’s cash and investments, or assets.
The Board of Directors
A mutual fund has a board of directors to make major policy decisions
and oversee management. These are important people. The directors
steer the fund’s course, determining investment objectives and hiring out
help.
The Shareholder
Mutual fund investors are also known as shareholders. When you invest
in a mutual fund, you actually buy a share or portion of a mutual fund.
Each share has a price tag. If a fund sells for $10 a share and you invest
$1,000, you’re the proud owner of 100 shares of the fund! Mutual funds,
like many other companies, are very democratic. Because you own
shares in the fund, you have voting rights. As part owner, a shareholder
gets to vote in the election of the board of directors. The shareholder
must approve many operational changes within the fund, including
accounting procedures and the investment objective.
Custodians and Transfer Agents
As you can imagine, the millions of mutual fund transactions executed
each year require a gargantuan behind-the-scenes record-keeping
effort. The securities a mutual fund invests in are kept under lock and
key by an appointed custodian, usually a bank. The custodian may
respond only to instructions from fund officers responsible for dealing
with the custodian. The custodian safeguards the fund’s assets, makes
payments for the fund’s securities, and receives payments when
securities are sold.
Fund transfer agents maintain shareholder account records, including
purchases, sales, and account balances. They also authorize the
payments made by the custodian (referred to previously), prepare and
mail account statements, maintain a customer service department to
respond to account inquiries, and provide federal income tax
information, shareholder notices, and confirmation statements.
The Underwriter
The underwriter is an organization with a staff of salespeople who either
administers sales directly to the public or meets with the brokerage
firms to convince them to sell the fund. Brokers sell fund shares to the
public and collect a commission for the sale. Chapter 8 goes into more
detail about what you pay for a mutual fund and who sells them.
Mutual Funds Make It EZ to Invest
Boy, there are a lot of important people and ingredients that go into the
making of a mutual fund. The end result, however, is that mutual funds
provide one of the simplest ways to invest — especially if you count
yourself among us working stiffs, and lack time and training to manage
money like the Wall Street big boys.
The major difference between investing in a mutual fund and investing in
an individual stock or bond is that with a mutual fund, instead of buying
just one stock or bond, you really buy a portion of a variety of
investments. Exactly how much money you make or lose in a mutual
fund can change daily, as you’ll learn in later chapters. It all depends on
how many shares you own and how well your mix of investments
perform. As Chapter 3 explains, owning a lot of different investments
helps to protect you against losing money. If one investment in your
mutual fund does poorly, you have a number of others to cushion the
blow.
Sidelines: There are approximately 6,000 mutual funds, but not all are
alike. Depending on your particular needs, you can find a mutual fund
that’s right for you. In Chapters 3 and 5, you’ll learn more about the
different types of mutual funds.
The 10 Commandments Of Mutual Fund Investing
Have we whetted your appetite? Good. Let’s get ready to proceed.
However, we don’t want you to invest one penny in a mutual fund until
you read and thoroughly digest these 10 critical rules of mutual fund
investing.
1.Always understand what you are investing in. You can lose a
bundle if you pick the wrong kind of mutual fund. Read carefully the
free literature that mutual fund companies provide on their funds.
2.Don’t rush out and buy the first mutual fund that looks good.
You first have to identify your investment goals, determine how
much you need from your investment (see Chapter 2), and figure
out how much you’re willing to risk losing (see Chapter 6).
3.Don’t try to make quick profits. Always invest for the long term.
You should plan to keep some of your mutual funds an absolute
minimum of 5 to 10 years.
4.Mix up your investments. You can cut your chances of losing
money by putting your money in different types of investments.
Chapter 6 shows you how.
5.Invest regularly with each paycheck — before you have a
chance to spend all your money. Mutual funds have automatic
investment programs. Money is electronically taken out of your
checking account and invested in the fund.
6.Do your homework. Once you determined how much money you
need and by when — as well as how much you can afford to lose
– research the best investments to meet your goals. Most library
business sections carry information on mutual funds.
7.Avoid paying high commissions and fees for mutual funds.
Make your money work for you, not for your stock broker. Read
about this in Chapter 7.
8.Make sure your mutual fund investment earns enough so
that your nest egg at least keeps pace with rising prices.
Chapter 5 discusses this further.
9.Know when to sell your mutual funds. Chapter 16 explains
ways to evaluate how a fund is doing. You’ll learn when to get rid
of a mutual fund that’s a lemon.
10.Invest to beat the tax man. Take advantage of an Individual
Retirement Accounts (IRAs) and other tax shelters. Chapter 22
discusses how you can make tax-deductible contributions and
watch your money grow tax-free until you retire
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