Mutual funds have become an increasingly popular way for investors to gain exposure to securities. Securities include stocks, bonds, commodities and derivatives of these. Mutual funds can offer ready-made diversification as well as professional management and, for this reason, they are perceived as offering certain advantages over purchasing individual stocks, commodities and bonds.
Nevertheless, like investing in any security, investing in a mutual fund harbors certain risks, including the potential for capital loss.
A mutual fund is an investment company that pools money from many investors and invests it to achieve specific investment goals. The mutual fund raises money by selling its own shares to investors. This money is used to acquire a portfolio of stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments. Each share represents an ownership slice of the fund and gives the investor a proportional right, based on the number of shares he or she owns, to income and capital gains that the fund generates from its investments.
The actual investments a fund makes are determined by objectives set out in its prospectus and, in the case of an actively managed fund, by the investment style and skill of the fund's management team. The investments the mutual fund holds and the performance of those investments are called its underlying investments and its investment return respectively.
Although there are thousands of individual mutual funds, the number of major fund categories is rather limited and include the following:
- Stock funds invest in stocks
- Bond funds invest in bonds
- Balanced funds invest in a combination of stocks and bonds
- Money market funds invest in very short-term investments and are sometimes described as cash equivalents
- Commodity funds invest in commodities
Be aware that mutual funds are equity investments, in the same way that individual stocks are. When you buy shares in a fund you become a part owner of the fund. This is the case whether the fund invests in bonds funds, commodities or stocks. Investors should understand the clear distinction between owning an individual bond and owning equity in a fund that owns the bond.
Put simply, when you buy a bond, the issuer promises you a specific rate of interest and return of your principal (the capital you spent buying the bond). That's not the case with a bond fund, which will own a number of bonds from different issuers and most likely with different rates of interest and maturities (the dates by which the capital you spent must be paid back). Your ownership of equity in the fund entitles you to a share of what the fund collects by way of interest, realizes in capital gains (if it sells the bonds before maturity) and what it receives back if it holds a bond to maturity.