What Are Mutual Funds?
A mutual fund is a fund that pools money from a group of investors to buy financial securities such as bonds and stocks with an aim to minimise costs, diversify investment risks, and maximise returns. Investors in funds don't directly own the securities in the fund but hold shares in the fund.
Origins: Investment Trusts
Mutual fund investing can be traced to the late 1700s in the Netherlands. In 1774, shortly after the financial crisis of 1772-73, a Dutch merchant named Abraham van Ketwich invited investors to participate in a trust called Eendragt Maakt Magt, or "Unity Creates Strength," which was the motto of the Dutch Republic. The purpose of the trust was to allow small investors an opportunity to diversify their investments. The fund invested in a variety of assets spread geographically across Austria, Denmark, Germany, Spain, Sweden, Russia and in colonial territories in Central and South America.
This early fund promised an annual return of 4%. With Eendragt Maakt Magt's initial success, other Dutch mutual funds were founded in its wake. As the Netherlands was a major financier of the American Revolution, together with Spain and France, many of the funds were directed toward offering credit to the U.S.
The first investment trust outside of the Netherlands was the Foreign and Colonial Government Trust, founded in 1868 in London. The fund was modeled after the Dutch trusts, and according to its prospectus, aimed to provide "the investor of moderate means the same advantages as the large capitalist, in diminishing the risk of investing in foreign and colonial government stocks, by spreading the investment over a number of different stocks."
The first pooled fund introduced in the U.S. was the Boston Personal Property Trust, formed in 1893. Many of the early funds in both Europe and the U.S. invested in agricultural and infrastructure activities in the new world, such as farm and railroad development.
Closed-Ended Versus Open-Ended Funds
The majority of early pooled funds, known initially as "trusts," were closed-end funds. A closed-end fund issues a fixed number of shares in an initial public offering and invests the money received in securities, which can include common or preferred stock, or bonds, depending on pre-defined characteristics of the fund. Once issued, closed-end funds are traded on an exchange, and the price is determined by supply and demand.
Open-end funds also invest in stocks, bonds, or both. However, unlike closed-end funds, shares of the open-end funds are purchased directly from the fund itself and the price of the shares is determined by the fund's net asset value per share, or NAV. The NAV is calculated by dividing the total value of the securities in the portfolio by the number of the fund's outstanding shares. The first open-ended fund was the Massachusetts Investors Trust (MITTX), introduced in the U.S. in 1924. It was considered the first modern mutual fund.
Commonly recognised categories of mutual funds include equity funds, bond funds, blended and target-date funds, money market funds and specialty funds.
Equity funds invest in stocks and can often grow faster than money market or fixed-income funds. Equity funds typically involve higher risk and higher returns than other categories of funds. The equity funds category is often divided into small-cap, mid-cap or large-cap funds depending on the market capitalisation of the companies they invest in.
Small-cap funds typically invest in companies with a market capitalisation between US$300 million and US$2 billion; mid-cap funds invest in companies with a market capitalisation between US$2 billion to US$10 billion; and large-cap funds invest in companies with a market capitalisation of more than US$10 billion.
Bond funds invest in longer-term debt securities from governments and corporations, and they can come with a wide variety of risks and returns.
Money market funds invest in short-term investments issued by U.S. corporations, and federal, state and local governments. These funds typically come with lower risk and lower returns than the others.
Balanced and target funds can invest in a mix of equities and bond securities. Their aim is to balance the safety of bond securities with the usually higher return of equities. Often such funds come with target dates where the mix of investments gradually shifts according to the fund's planned life cycle.
Specialty funds focus their portfolios on special categories of investments that can include things like real estate, commodities, currencies and groups of funds. These funds can invest directly in underlying assets in particular asset categories or in companies that are involved with such assets.
Mutual funds can also be classified as growth-oriented or income-oriented funds in addition to actively managed or index funds. Growth-oriented funds seek the growth of capital, while income funds seek to produce a steady income stream with dividends.
In actively managed funds, fund managers can buy and sell investments within the fund's portfolio. With index funds, the composition of the fund is fixed to an established portfolio that doesn't change over time, typically tracking an index for a particular asset group.
Mutual funds can be an attractive alternative for investors to individual stocks and bonds and other types of investment for several reasons, including:
- Professional Management: Mutual funds are often managed by professional managers who monitor the performance of investments within the fund.
- Diversification: Mutual funds allow investors to spread their investments across a broad range of assets in order to lower risk.
- Affordability: Mutual funds may allow investors with limited capital to take position in large volume or costly investments to which they normally may not have access.
- Liquidity: Fund shares can be bought and sold immediately upon demand at their current NAV.
And just as there can be advantages to any investment, there are also disadvantages. They include:
- Costs: Mutual funds can be subject to sales commissions and management fees.
- Price Uncertainty: Unlike stock prices, NAV prices are calculated at the end of each trading session. This means that investors cannot get real-time prices for the funds they hold.
- Lack of Control: Investors cannot alter the investments within their funds after they purchase them.
Like equities and other investments, mutual funds can post a variety of results ranging from losses to returns in the double digits. According to an analysis published by the Federal Reserve Bank of St Louis, the average annual return for investors who bought and held equity mutual funds was about 5.6% for the period 2000-2012, based on quarterly equity mutual fund flow and return data from the Investment Company Institute.
Mutual Funds Versus ETFs
Unlike mutual funds, exchange-traded funds (or ETFs) trade throughout the daily session of the market at a varying price, similar to stocks. Exchange-traded funds are usually linked to a particular asset index.
Mutual Funds Versus Hedge Funds
While similar in some respects to mutual funds, hedge funds usually cater to high-wealth individuals with large volumes of assets to invest. Hedge funds are not subject to the same regulatory rules as mutual funds. This means that while they may be at times more agile and more profitable, they can also be riskier than mutual funds.
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Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…