What is a mutual fund?
by Jim Steel, CFA, CFP
Similar to an exchange-traded fund (ETF), a mutual fund is a vehicle used to pool money from many individual investors into one big pot to invest in securities like stocks, bonds or other assets. When you buy or invest in a mutual fund, you receive units of that fund, which represent your share or ownership and entitle you to all returns (positive or negative) generated by that portfolio, including interest and dividends, on a proportional basis.
The main difference between a mutual fund and an ETF is that an ETF trades on a stock exchange and can be bought and sold at any time during normal trading hours. In contrast, mutual funds do not trade on an exchange and can only be bought and sold once per day, after markets close, at the end of the day’s price.
Consider this example:
Ten thousand investors each have $10,000 to invest and they decide to pool their money to create a larger, more diversified portfolio in which they will all share in the gains or losses of the fund. The fund would begin as a $100 million portfolio with 10,000 unitholders. Each unit holder would own 1,000 units at $10 per unit representing their initial $10,000 investment.
The mutual fund would be run by a professional money manager, who charges a fee to buy and sell securities for the fund, with a goal to make money for the investors. The $100 million would be invested in individual securities ranging from a few dozen to several thousand.
Some of the individual securities in the fund will increase in value while others will decline. If more securities increase in value, then the fund will generate a positive return. Conversely, if more securities decline in value, then the fund will generate a loss.
Determining the value of a unit:
While the individual securities in a mutual fund trade continuously on markets, the mutual fund is valued only after markets have closed. At the end of the day, the fund totals the value of all securities it owns and divides by the number of units outstanding to determine the unit price. In the example above, if the value of all securities increases by 20% from $100 million to $120 million, then the value and cost of each unit increases from $10 to $12. Your initial 1,000 units bought at $10 each are now worth $12 each. Since you own 1,000 units, your initial investment is now worth $12,000. Conversely, if the value of all securities in the fund fall, then the value of your initial investment will fall.
Investors, even those not part of the original fund, can invest in the fund by buying units at the price determined at the end of each day. These units are either issued by the fund (i.e. there would now be more than 10,000 units outstanding) or purchased from existing unit holders, or a bit of both. The money paid by the new unit holder is used by the fund manager who invests that cash in additional securities for the fund.
Types of mutual funds
Mutual funds can invest in virtually any type of security. Common mutual fund types are:
- Equity funds:
they hold only stocks
- there are many “flavours” of equity funds such as: small company funds, value funds, growth funds, large company funds, etc.
- Fixed income funds:
- they invest only in bonds and other fixed income investments
- Real estate funds:
- they invest only in real estate companies
- Balanced funds:
- they invest in a combination of assets such as those mentioned above
- Index funds
- they invest in the same securities as an underlying index (stock, bond, real estate, etc.) and provide returns almost identical to that index
- these types of funds are usually the least expensive as they do not require an active fund manager and do not have high trading costs
Mutual funds are a way for individual investors to access diversified, professionally managed portfolios.