What is a Mutual Fund?

by Catherine Rein
(last updated June 4, 2009)

Mutual funds are a very common form of investment. They provide investors with an easy way to get started in investing. You can invest a small amount, typically less than $250 to start, and easily buy and sell shares of a mutual fund. Most mutual funds are not closed funds, meaning they create new shares as each new investor is added.

Mutual funds also provide diversification, since most funds buy a wide range of stocks and/or bonds in a number of industries. There are certain types of mutual funds that have very low fees associated with investing in them, particularly index mutual funds. These are funds that have their asset allocation tied to a certain index. Index funds typically have an expense ratio of less than 0.2% per year. This means that on a $100,000 investment you would pay $200 in annual expenses. Higher expenses are associated with actively managed funds. The average expense ratio for these funds is 1.5% per year.

You should consider the following advantages and disadvantages of mutual funds before investing:

  • How Mutual Funds Work. You are purchasing a share in a company in the business of investing money when you buy a mutual fund. The mutual fund manager takes the combined assets of your investment plus all the other investors in the fund and purchases stocks, bonds or other investments depending on the goal of the fund.
  • Benefits. Mutual funds provide investors an easy way to get started in investing. You are not required to deposit a huge sum of money and they are easy to buy and sell, meaning they have high liquidity. You can be reassured that mutual funds are regulated by the SEC, which provides you some protection as an investor. Mutual funds also provide you with an easy way to diversify your portfolio and invest your money with a professional money manager.
  • Risks. You are not protected by the FDIC with a mutual fund the way you are with a savings account or CD. Your investment is also exposed to the stock market, if stock prices go down, the value of your investment in a mutual fund will likely also go down, depending on the types of investments it holds.

Keep in mind that investing with mutual funds involves costs, even if the fund performs poorly. The fund manager receives compensation for their time and expertise whether or not the fund performs well. As an investor in a mutual fund you are also giving up some control over your investment. You cannot directly determine the fund's portfolio make up at any point in time. The fund manager makes the decisions when to buy and sell various holdings.

Author Bio

Catherine Rein

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