The Concept of Mutual Fund
A mutual fund is a form of collective investment, where investors own shares in the fund’s property. The fund’s activities are managed by a professional financial market participant, a management company.
In simple terms, it is a kind of trust management, where unit holders’ money is pooled together to be used by the company for transactions in the securities market.
Profits are distributed among fund members pro rata with the number of equity units held by each them. An equity unit is defined as a special security confirming the right of its holder to part of the mutual fund’s property.
This form of investment would be a smart move for those who have no special financial education and no desire to disentangle the intricacies of the market. People just choose the company they like and entrust it with the management of their money. Virtually any person can become a mutual fund member, because you can start investing with very small amounts of money, which makes this tool especially attractive to regular citizens.
What types of mutual funds are there?
There are three types of mutual funds:
- Open-ended funds. It is the most popular form of mutual funds intended for regular citizens. Under open-ended schemes, the management company can sell and buy units at any time. In other words, an investor can join or withdraw from the fund any time.
- Interval funds. Where mutual funds operate under interval schemes, units are bought and sold during pre-agreed time periods. As their name suggests, this process takes place at intervals, i.e. equal periods of time.
- Closed-ended funds. Investors may withdraw from closed-ended funds at the end of the fund’s existence period. Investments are mostly made in real estate.
The pros of mutual funds
- Professional management. The main advantage of mutual funds is professional investment management by a skilled financial manager who understands how to operate in the market and has a clear action plan.
- Diversification. Large mutual funds usually own hundreds of various shares spanning across many industries. It allows them to avoid numerous risks and secure the investors’ money. Even if some companies go bankrupt or their shares considerably drop in value, profits from other investments will more than make up for all the losses. «Do not put all your eggs in one basket»: that is the main rule of a professional investor!
- Scale. Since a mutual fund buys and sells huge amounts of securities at once, its transaction costs are lower than that of an individual.
- Simplicity. Joining a mutual fund is quite easy, and the minimum qualified investment threshold is rather low.
- Variety. There is a great number of investment companies nowadays that offer different terms, use different trading strategies and promise different returns. And the competition among such funds results in higher service quality.
- Transparency. Mutual funds are regulated by industry standards that ensure accountability and fairness for investors.
The cons of mutual funds
- Management. Many investors doubt whether a professional financial manager would really care to preserve their funds and increase their gains. After all, fund employees get their salaries irrespective of whether stock exchange operations were successful or not… Therefore, in contrast to mutual funds, alternative methods of investing are becoming increasingly popular.
- Costs. Setting up and managing a mutual fund is a very expensive process. All the costs are borne by investors who have to pay for everything: from portfolio managers’ salaries to electricity bills and office supplies.
- Diversification. The fact is that diversification is not only an advantage, but also a disadvantage of mutual funds, as it leads not only to lower risks, but also to low profits.
- Liquidity. A mutual fund needs to have a sufficient amount of cash to be able to pay everybody who want to sell their units. Therefore, a certain part of its assets must be kept in cash, which will not work to increase capital gains, but will be losing its purchasing power.