Mutual Funds: What They Are and How They
By Susanna M. Zysk
Mutual funds are a popular investment choice for many investors.
There are currently over 93 million Americans investing in over
10,000 mutual funds.* Although the first mutual funds were established
in 1924, their popularity has grown most significantly in the
last 20 years, since the introduction of Individual Retirement
Accounts (IRAs) and 401(k) plans. Before you invest in mutual
funds, it is important to fully understand what they are and
how they work.
* Source: 2002
Mutual Fund Fact Book: A guide to trends and statistics in the
mutual fund industry, 42nd Edition, Investment Company
What is a Mutual Fund?
A mutual fund is a professionally managed pool of money invested
in a variety of individual securities, such as stocks and/or
bonds. In addition, mutual funds may hold cash or cash equivalents.
Investors purchase shares in a fund that represents an ownership
in the fund’s holdings. Your money is pooled together with
other investors and the fund’s manager invests the money
Benefits of Mutual Funds
There are many kinds of mutual funds, but they all share common
Professional Management. Investment companies
offer mutual funds managed by fund managers who choose investments
that match the
fund’s objectives. Their investment decisions are
based on their extensive knowledge and research of market
and the financial performance of individual companies and
specific securities. When economic conditions change, the
will adjust the investments’ mix in the fund so that
it continues to meet its investment objectives.
Diversification. Mutual funds generally own stocks and bonds
from many companies, which offers instant diversification. Investing
in a variety of securities helps reduce risk by offsetting losses
from some with the gains of others. Your exposure to risk is
reduced by investing in a wide range of securities offered through
a mutual fund rather than one or two individual stocks.
Convenience and Accessibility. Mutual funds are relatively easy
to buy. Individual investors have access to many stocks and bonds
that previously may not have been available, or required prohibitive
Variety. There are thousands of mutual funds representing a wide
variety of investment objectives – ranging from conservative
to aggressive – available to you. The fund types cover
many investment strategies and risk levels, so you should be
able to find a fund that meets your personal financial goals
and risk tolerance.
Strict Regulation. Mutual funds are highly regulated by the federal
government through the Securities and Exchange Commission (SEC).
The regulations require funds to meet certain operating standards,
observe strict antifraud rules, and disclose complete information
to current and potential investors. Disclosure about a particular
fund can be found in the fund’s prospectus. The prospectus
provides such information as investment objective and methods,
how to buy and sell shares, risk assumed, and fees and expenses.
Types of Mutual Funds
There are three basic types of mutual funds: money market, bonds
and stock (also called equity).
Money Market Funds are generally comprised of money market investments,
certificates of deposit (CDs) and U.S. Treasury securities. They
can also include Guaranteed Investment Contracts (GICs) issued
primarily by insurance companies.
· Benefits: A high degree of
security, designed to protect your original investment.
Risks: Stable value funds don’t offer the income potential
of bond funds or the growth potential of stock funds.
Bond Funds invest in many individual government and corporate
bonds. Bond funds generally earn interest, which is also referred
to as income or yield.
· Benefits: Bond funds generally offer greater income potential
than stable value funds and not as much risk as stock funds.
Risks: Typically, bond funds don’t offer the growth potential
of stock funds, and are riskier than stable value funds.
Stock Funds or equity funds offer different investing strategies,
ranging from conservative to aggressive, with varying degrees
of risk and return potential. Stock funds invest in many different
· Benefits: Historically, stocks have provided larger long-term
gains than other asset classes.
· Risks: The value of stocks can go down over short periods of
time. As a result, there is greater risk to your savings, including
your principal, compared to other asset classes.
Common types of stock funds include:
Ø Growth Funds invest in corporations with the potential for
increased future earnings.
Value Funds invest in underpriced stocks that a fund manager
determines are a bargain. For example, if the company’s
industry or business situation improves, so might its stock
Index Funds seek to match the performance of a broad segment
of a securities market, like the Standard & Poor’s
500, which is made up of 500 leading U.S. corporations.
Ø International Funds invest in stock markets of foreign countries.
Foreign investment has the potential to provide long-term growth
Ø Global Funds invest in many countries around the world, including
the United States.
Benefit from Investing Regularly
Making regular contributions to a mutual fund allows you to
take advantage of a strategy called dollar-cost averaging.
Using dollar-cost averaging, you buy more shares when the price
is lower, and fewer shares when the price is higher. The result
is a lower per-share price compared to a lump-sum investment.
Generally, you must pay income taxes on the dividends and capital
gains distributed to you from any mutual funds you own. Each
fund will provide an IRS Form 1099 to you annually that summarizes
the fund’s dividends and distributions. When you sell
shares of a fund, you will realize either a taxable gain or
Before you choose a mutual fund, determine your investment
objectives and decide how much risk you are comfortable assuming.
You may want to speak with a financial
planner to discuss which
mutual funds are right for you.
About the author: Susanna M. Zysk is BPO’s
Family Money Editor. She has more than 14 years experience in
the financial services industry, and holds communications degrees
from Syracuse University and Simmons College. She can be reached