What is a Mutual Fund?

What is a mutual fund?

A mutual fund is an investment that uses money from many investors (like you and I) to purchase a mix of securities, such as stocks, bonds, and money market instruments. The fund is managed by a single person or a group of people. As an investor in the fund you will pay a fee for the managers’ services and there may be other fees as well. Fees will be the topic of another post. Many companies have mutual funds, including Vanguard, Schwab, T. Rowe Price, Fidelity, and Blackrock. I have only listed a few! There are literally tens of thousands of mutual funds.

Fund Types

A mutual fund may diversify across different types of securities—for instance, it may own both stocks and bonds (called a hybrid fund), or it may focus only on stocks (an equity fund) or only on bonds (a bond fund) or only on short-term debt instruments (a money market fund). Funds may also specialize in a specific type of security. A small-cap emerging market fund will focus on smaller companies in emerging markets. An emerging market is one that isn’t as advanced as say, the U.S. or Japan. The reporting regulations may not be as strict or well-developed and the country may have only recently developed a stock exchange.

Fund Objective

Each fund must list its objective in its prospectus, which is a document the fund must provide investors explaining their fees, objective, investment strategies, risks, etc. This information can also be found online, either at the fund’s website, Morningstar.com and finance.yahoo.com. As an example, this is the objective for the Vanguard 500 Index fund:

The investment seeks to track the performance of a benchmark index that measures the investment return of large-capitalization stocks. The fund employs an indexing investment approach designed to track the performance of the Standard & Poor's 500 Index, a widely recognized benchmark of U.S. stock market performance that is dominated by the stocks of large U.S. companies. It attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index.  Source: finance.yahoo.com

Some years ago there was a movement toward socially responsible investing [SRI] (and there are still many who are interested in this type of investing). SRI involves not investing in companies that generate revenue/profit by engaging in what you may consider irresponsible activities, such as gambling, tobacco use or drinking alcohol. Eventually, a mutual fund was started that ONLY owns stock in companies that operate in the “vice” industries of gambling, tobacco, alcoholic beverages and defense. The fund is USA Mutuals Barrier Investor (VICEX). [The symbol VICEX is the identifier for the USA Mutuals Barrier Investor fund. If you are looking up information about the fund online, you can type in the symbol rather than the entire name. Since I research many mutual funds the ability to search by symbol rather than name is a time saver.] Below is VICEX’s objective:

The investment seeks long-term growth of capital. Under normal market conditions, the fund will invest at least 80% of its net assets (plus borrowings for investment purposes) in equity securities of companies that derive a significant portion of their revenues from a group of industries that have significant barriers to entry including the alcoholic beverages, tobacco, gaming and defense/aerospace industries. It will concentrate at least 25% of its net assets in this group of barrier to entry industries (but no more than 80% of its net assets in any single industry).

Active vs. Passive

A mutual fund can either be actively managed or passively managed. An actively managed fund is one where the manager believes he can, by conducting research, find securities that will outperform the overall stock market in the near future. He’ll buy those securities for the fund (that is called “going long”). He may find securities that he believes will underperform the overall stock market, in which case he may sell (or “short”) those securities with the intention of buying them at a later date once they have fallen in value. This may be the topic of another post. Regardless, an actively managed fund requires that the manager do more work; thus, the fund charges investors a higher fee. VICEX is an actively managed equity fund--its management fee is 0.95%.

A passively managed fund is designed to emulate an index, such as the Standard & Poor’s 500. Perhaps the most famous index fund is the Vanguard 500 Index (VFINX). You can see from the objective I posted above, that its goal is to track the performance of the S&P 500.  As the process of choosing investments is limited by the index the fund is emulating, it is not as difficult to manage an index fund.  Therefore, the management fee for index funds is generally rather low.  The management fee for VFINX is 0.15%.

As this is only my first post, obviously I have a lot more to say!  As the weeks progress I will add posts about why we should consider mutual funds as investments, the fees a fund charges, how to tell how well diversified a fund is, how risky funds are, and what types of returns do funds generate, among other things.