Mutual funds

Definition

Mutual funds are investment vehicles that pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. By combining resources, investors can access a broader range of investments than they could individually, and mutual funds are managed by professional portfolio managers who make decisions based on the fund's objectives.

5 Must Know Facts For Your Next Test

1. Mutual funds can be actively managed, where portfolio managers make frequent trades based on market analysis, or passively managed, where they aim to replicate the performance of a specific index.
2. Investors in mutual funds typically pay management fees and sometimes sales charges, which can affect overall returns.
3. Mutual funds provide liquidity, allowing investors to redeem their shares at the current net asset value (NAV) at the end of each trading day.
4. There are various types of mutual funds including equity funds, bond funds, and money market funds, each with different risk levels and investment objectives.
5. Mutual fund performance is often evaluated based on total return, which includes capital appreciation and income generated from dividends or interest.

Review Questions

• How do mutual funds promote diversification for individual investors?
  • Mutual funds promote diversification by pooling money from multiple investors to create a large portfolio of various securities. This allows individual investors to own fractions of many different assets rather than relying on a few investments. By diversifying across different asset classes and sectors, mutual funds help reduce risk since the poor performance of one investment may be offset by better performance in others.
• What are the advantages and disadvantages of actively managed mutual funds compared to passively managed ones?
  • Actively managed mutual funds offer the potential for higher returns through strategic trading and expert management aimed at outperforming the market. However, they often come with higher fees and expenses due to management costs. On the other hand, passively managed mutual funds typically have lower fees as they aim to track a specific index without frequent trading. While they may offer more predictable returns reflective of the index's performance, they lack the potential for excess returns that skilled managers might achieve.
• Evaluate the impact of management fees on the long-term performance of mutual funds compared to other investment vehicles like ETFs.
  • Management fees can significantly impact the long-term performance of mutual funds as they reduce the overall returns received by investors. Over time, even small differences in fee percentages can lead to substantial variations in investment growth due to compounding effects. In contrast, ETFs generally have lower expense ratios than actively managed mutual funds, which can lead to better net returns over time for investors who are looking for cost-efficient options. Therefore, considering fees is crucial when evaluating the effectiveness of mutual funds versus ETFs in meeting investment goals.

Related terms

diversification: A risk management strategy that involves spreading investments across various financial instruments, industries, and other categories to reduce exposure to any single asset or risk.

portfolio manager: A financial professional responsible for making investment decisions and managing the assets in a mutual fund or other investment portfolios.

exchange-traded funds (ETFs): Investment funds that are traded on stock exchanges, similar to individual stocks, allowing investors to buy and sell shares throughout the trading day.