What is a Mutual Fund


If you’ve ever been a customer of a bank, the chance is high that you’ve heard of mutual funds, or invested into them. I myself am invested in 3 mutual funds, and therefore I’ve put together some information that might help you if you think about investing in a mutual fund.

What is a mutual fund?

A mutual fund is an investment fund that consists of deposits of many individual investors, and has a defined investment goal, to which the fund manager has to adhere.

If you want to learn more about what a Mutual Fund is in detail, read on.


What is a Mutual Fund in detail?

A mutual fund is an asset that consists of the deposits of many individual investors. Depending on the fund, the fund’s assets are invested in stocks, bonds, money markets, and other investments, managed by investment experts on the international securities markets. The investors own units in the fund based on the amount of their contribution. The value of these units depends on the price of the securities in the fund’s assets. Fund shares can usually be bought or sold again at any time. Mutal funds are strictly regulated in most countries and must meet certain defined criteria.

The money in the fund is invested in accordance with predetermined investment principles. Mutual funds can for example consist out of stocks, fixed-income securities, and / or real estate.

With the purchase of mutual fund units, the investor becomes co-owner of the fund’s assets and is entitled to profit sharing and unit redemption at the current redemption price.

The redemption price is usually calculated at least daily and the company managing the fund must guarantee that the investor can redeem his fund units at the redemption value.

According to the law in many countries, the investments must be kept strictly separate from the assets of the company. This regulation guarantees the preservation of assets in the event of insolvency of the company managing the fund.


Advantages of investing in a Mutual Fund

A major advantage of mutual funds is that they offer effective investor protection. Investors’ money is safe because mutual funds are generally not affected by the bankruptcy of the company managing the fund. The fund assets are not part of the company’s balance sheet. In the event of bankruptcy, the fund assets are legally segregated in favor of the investors

Investment funds must report their asset allocations and performance in detail at least every six months. Investors, therefore know, how their money is invested.

The costs and fees are also disclosed. The detailed fund reporting includes the simplified prospectus, the prospectus, the fund regulations, the regularly published fact sheets, but also the annual and semi-annual reports.

Transparency and protection are also a central principle in pricing. The so-called forward pricing prevents certain investors from obtaining individual advantages when buying or selling the funds.

The daily liquidity in mutual funds is another advantage. Fund issuers are legally obliged to redeem shares. In addition, most funds can also be bought and sold on a stock exchange.

The usual factors in the pricing of financial assets, such as supply and demand, have no influence on the valuation of fund units.

The value of a fund unit is based solely on the performance of the investments in which the fund is invested.

One of the greatest advantages of mutual funds is undoubtedly the diversification effect. With investment funds, investors don’t put everything on one card. The money in the fund is distributed across a variety of stocks (shares and/or bonds and other investment instruments) and – depending on the fund’s investment strategy – across various investment markets and currencies. This diversification reduces the overall risk of the investment.

With a mutual fund, sufficient diversification and a reduction of individual risks can be achieved with little money.

With mutual funds, the investor has easy access to the financial markets. Many financial markets such as in developing countries are not easily accessible for private investors.

Issues of bonds often have a high minimum volume, which might be too high for private investors. Investment funds provide access to such markets and financial instruments.

Fund managers act as large investors in the financial markets and benefit from better trading conditions than individual small investors. This applies to the availability of individual systems as well as to the pricing and processing speed.

Many investors cannot or do not want to be concerned with financial investments. For this group of investors, investment funds offer the advantage of professional management.

A fund manager is responsible for the investment, administration, and ongoing monitoring of the fund’s assets. The individual investors who invest in the fund have no influence on the investment policy and investment decisions.

The fund manager however can only take decisions based on strict investment guidelines as set out in the fund documents and invests in accordance with the fund’s clearly defined investment strategy.

He buys or sells the individual investments within the fund portfolio or adjusts the weightings of the individual stocks if market conditions require it.


Disadvantages of investing in a Mutual Fund

Despite all the advantages, mutual funds also have certain disadvantages that investors should be aware of before buying.

A major disadvantage of mutual funds can certainly be seen in the fact that only very specific market expectations can be implemented with them.

With a few exceptions, such as hedge or future funds, they particularly show their strengths in rising markets. On the other hand, when prices are falling or in longer sideways phases, they usually do not generate an attractive return.

Mutual funds are usually based on a so-called benchmark. However, many investment funds cannot beat the performance of the benchmark. The investor is therefore dependent on the experience and know-how of the fund manager. Good fund managers are able to consistently outperform the benchmark, but less than half of fund managers are able to achieve this over the longterm.

The fee aspect can be cited as a disadvantage. Due to the sometimes very high issuing commission, the fund investment is to be regarded as a medium or long-term investment.

Mutual Funds are rather unsuitable for investors who like to be active themselves, who want to implement their own ideas and react to market sentiment at short notice.

The annual fees of up to 2% in some cases are deducted from the performance. Some funds even incur a performance-related fee.


What types of Mutual Funds do exist?

There is a huge selection of mutual funds available from numerous providers. The vast majority of banks and insurance companies have their own subsidiaries that specialize in managing funds. In addition, there are several dozen independent asset managers who also offer mutual funds.

Mutual funds are typically differentiated according to the investment areas in which the funds invest. A fund can invest in money markets, stocks, bonds, real estate or commodities, or any combination.

Money market funds invest their capital in bank balances, overnight money, and short-term time deposits, as well as other fixed-income securities with short remaining terms or regular interest rate adjustments. Due to the short remaining term of the debt securities contained in the fund’s assets, money market funds have low price risks. The expected return is accordingly very low.

Bond funds are investment funds that invest in bonds and other fixed or variable interest securities. Bond funds are usually geared towards a specific reference and investment currency. The most common issuers are large companies, state organizations such as the federal and state governments, public institutions and international organizations such as the World Bank or the International Monetary Fund.

Equity funds invest the majority of their capital in domestic and foreign company shares. Equity fund owners participate in the success or failure of the companies contained in the fund assets. At the same time, you participate directly in positive or negative changes in the value of the stocks selected by the fund manager, as well as in any dividend payments made by the companies.

Real estate funds are investment funds that invest in several residential and/or commercial properties. The investor participates in the rental income and any increases in the value of the property. A distinction is made between open and closed real estate funds.

Open-ended real estate funds usually have no minimum investment amount and are usually tradable on a daily basis.

Closed real estate funds have a high minimum investment amount and a fixed term (usually more than 10 years). An early exit is often impossible or very difficult.

More information about real estate funds can be found on the real estate fund page (coming soon).

There are also mutual funds that invest in several investment areas. These funds are called mixed funds or investment strategy funds. They mostly invest in bonds, stocks, and money market assets. In rare cases also in real estate or raw materials.

Investment strategy funds can invest directly in individual stocks, bonds, etc. or they invest exclusively in several mutual funds. This special type is called a fund of funds or funds of funds.

Less well known are commodity funds that invest in commodities via financial derivatives, mostly futures, or they invest directly in the commodity and keep the respective commodity in stock. The most common are funds that invest in precious metals such as gold, silver, or platinum, either through derivatives or in physical form. However, there are also funds that invest in petroleum, base metals, agricultural commodities, or a basket of various commodities.

Exchange Traded Funds (ETF) are a special class of funds. The special features of ETFs are described on the Exchange Traded Funds (ETF) website (coming soon).


Mutual Funds in Summary

Mutual Funds are well suited for investors, that:

  • Prefer a professional fund manager to do the work and monitoring of the fund.
  • Want to diversify over several assets or asset classes.
  • Want to profit from regulation and safety.

Mutual Funds are particularly suitable for savings plans. With a savings plan, the same amount is regularly invested in one or more investment funds. The investor makes use of the cost average effect. The cost average effect has a positive influence on the return on the investment fund, as a higher number of fund units can be purchased at low prices and a correspondingly lower number of fund units at higher prices. In the long term, this effect gives the investor a higher return than, for example, a one-off investment.

With mutual funds, investors can put together a tailor-made portfolio that corresponds to their own return and risk expectations.

As stated earlier, there is an overwhelming number of mutual funds. Finding the right funds from this diversity is not easy.

When making the selection, the most important thing is the quality of the fund manager, who is sustainable, i.e. should achieve good returns over several years.

Each fund usually measures itself against a benchmark. Ideally, the fund manager should continuously outperform the benchmark across various market phases. Unfortunately, many fund managers can’t do that.

Banks love to sell funds to their customers. Especially in-house funds, or funds with companies they partner with and give them a large profit. Therefore if you have the time and interest, do some research yourself. Morningstar is one of the good sources if you want to dig in deeper to how the fund is doing.

Chris

Chris is an IT Project Portfolio Manager within the financial industry. Due to the nature of his role, he is engaged to study Financial Markets and is an active investor.

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