The Basics

Introduction to Mutual Funds

A Mutual Fund is an investment pool that brings a group of people together and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund. Use the information below to help you determine whether or not you should buy mutual funds. If you feel online mutual fund investing is right for you, open a personal investment account at Firstrade to get started today or to take advantage of this options research tool!

Advantages of Mutual Funds

Advantages of investing in mutual funds include diversification, professional management, relatively high liquidity, and accessibility for people with small amounts of capital. Mutual funds are particularly suitable for investors who lack the inclination, capital, or time to set up and maintain sufficiently diversified portfolios. An investor profits when the mutual fund in which he or she invests: 1) receives dividends on stocks and interest on bonds, which are then paid to the holders in the form of a distribution. 2) sells securities that have increased in value, and then redistributes its capital gain to fund holders. and 3) increases in share value.

Disadvantages of Mutual Funds

Compared to stock, mutual funds offer less flexibility. Mutual funds are priced once a day, so you would not know the price at which you purchased the funds until the end of the business day. In addition, the fees associated with purchasing and redeeming mutual fund shares are usually higher than that of stock.

Investing in Mutual Funds

For some mutual funds, investors can buy shares directly from the fund company. Other funds are sold through brokers, banks, financial planners, or insurance agents. Mutual funds redeem shares sold back by investors. According to U.S. regulations, fund companies must send investors proceeds within seven days after redemption.

Fund Objectives and Investment Style

A Fund objective is a goal or financial result that a mutual fund wants to achieve. The approach that a fund manager follows in making investments so as to achieve the fund's goal is called the investment style.

Since the fund objective and investment style vary between different mutual funds, all of them have different risk and expected return. In general, the higher the potential return, the higher the risk of loss. Like other investments, mutual funds have some level of risk, although some funds have less risks than others.

Long-term Characteristics of Different Types of Mutual Funds

Equity Funds

Capital Gain PotentialIncome PotentialRisk LevelTotal Return Potential
Aggressive GrowthVery highLowVery highVery high
Industry SpecificVariesVariesVariesVaries
Precious MetalsHighLowHighVaries
InternationalVery highLowHighHigh

Income Funds

Capital Gain PotentialIncome PotentialRisk LevelTotal Return Potential
High-Grade Corporate BondLowHighLowMedium
Junk BondVery highHighVery highHigh
Money MarketVery lowLowVery lowLow
Municipal BondLowMediumLowLow

Picking the Right Fund for You

First, ask yourself how much you want to make and the mutual funds risk level you can tolerate. When investing in online mutual funds, investors should pick mutual funds based on their personal objectives and risk tolerance. Before making an investment, make sure that you have done some research and have enough understanding of the fund that you are buying. Investors can find information about a fund's goals, strategy, performance, management, and fee structure in its prospectus. When evaluating a fund, investors should compare its relative performance over various periods of time (for example, 1, 3, 5, and 10 years) and in different kinds of economic and stock market environments. A fund manager's experience and record, the fund's level of consistency, and its major investment holdings are other important factors to consider. Investors can also find information and rankings of mutual funds in various publications such as Forbes, Value Line, Barron's, Business Week, and Morningstar.

Important Terms

Below are some common terms to know when you buy mutual funds:

Net Asset Value (NAV)

A fund's NAV value is calculated as the fund's assets minus its liabilities. The NAV per share is calculated by dividing the NAV by the number of fund shares outstanding

Open-End Versus Closed-End Funds

Mutual funds can be divided into two main categories: open-end funds and close-end funds. The former continuously issues new shares, accepting new funds for investment. In general, open-end funds redeem shares at the current net asset value (NAV). On the other hand, close-end funds raise capital by issuing a fixed number of shares. Their shares, like common stock, are traded on an exchange.

Different Types of Mutual Funds

Since all mutual funds have fund objectives, they focus on different products or investments. In general, mutual funds are divided into three groups according to their asset allocations: equity funds, fixed-income funds, and money market funds.

  • Equity Funds: Equity funds are mutual funds that contain equity securities, mainly stock. The objectives of these funds are usually long-term growth with some income. However, performances of these funds vary since there are many types of equities.
  • Fixed-Income Funds: The main objective of fixed-income funds is to generate steady cash flow for fund holders by investing in government or corporate debt, such as bonds. Fixed-income funds are a relatively safe investment since they promise to generate steady income flow. However, these funds are not without risk. A fund investing in junk bonds, which have high yields but also high default risk, is much more risky than other fixed-income funds.
  • Money Market Funds: Money market funds invest in short-term debt products, such as Treasury Bills, CDs, and other short-term money market instruments. These funds bear very little risk and are therefore particularly suitable for conservative investors. The return of the money market funds is generally much more than what you would receive by putting money in a regular savings account and a little less than the return of a certificate of deposit (CD).

Of course, this is only a general classification of mutual funds. In fact, many funds possess a mixture of different types of securities (often referred to as "balanced funds") according to the funds objectives. As more investment products are invented, investors can expect to see more types and combinations of online mutual funds in the future.