Personal Finance
Lesson 20
4 min

What is a mutual fund?

Investing in an investment fund instead of individual securities offers various advantages. A “mutual fund” is managed by expert brokers to ensure returns for investors. 

  • A security is any type of financial asset such as a share, banknote or bond that is tradable on a securities exchange

  • An investment fund consists of various securities that have been selected to meet the objective of the investment fund

  • By placing investor money across different industries and companies, fund managers “diversify” in hopes of maximising profits while reducing risks. 

  • Investors select funds to invest in based on criteria such as risks, objectives and fees and others. 

In this lesson, you are going to learn everything about mutual funds.

What are funds?

Like you learned in lesson 4, a fund is money set aside for a specific purpose and an emergency fund is money that you set aside for emergencies. You may also have a retirement fund or other types of personal funds. 

Diversification through investing in mutual funds

One of the most basic types of investment funds is a “mutual fund”, an actively managed portfolio or pool of stocks, bonds and other assets that investors can buy shares in. In simple terms, it is an investment vehicle where many investors deposit money together by buying shares and therefore all co-own parts of the fund. 

Unlike passive funds tied to an index, mutual funds are actively managed by capital investment companies. These companies act as brokers and select various securities based on risk parameters and the orientation of the fund. 

One of the most basic types of investment funds is a “mutual fund”, an actively managed portfolio or pool of stocks, bonds and other assets that investors can buy shares in. 

Remember how you learned about portfolio diversification in lesson 16 of the Bitpanda Academy? Equity funds often manage over a hundred different individual stocks. As you can imagine, a private investor is usually unable to spread assets across such a wide range of stocks for financial reasons - this is where investment funds come in. 

A mutual fund is managed by investment professionals. It is usually an “open-end” or “open-ended fund” meaning that shares can be purchased and also be returned to the issuing company by fund managers.

The size of a company based on its market capitalisation is an important factor in the structure of a mutual fund. Funds that are mainly invested in companies with large market capitalisation (“large caps”) have been known to pay steady dividends at low risk for the investor, while companies that are considered “mid-caps” may offer higher returns than “large caps”, albeit at higher risk and “small caps” are putting in strong growth while being highly volatile, meaning stock prices may fluctuate strongly. 

Index funds

An investment fund may also be based on an index, meaning that a fund is replicating the  performance of a stock market index. In this case, the securities in this fund are the same as in the index - here, we are speaking about a “passive fund”. Mutual funds require a high degree of active management by expert managers which is why they are usually associated with higher costs for investors. 

Thanks to such extensive diversification, the consequences of individual company defaults, like a company declaring bankruptcy, are usually much less significant when investing in a fund with many different assets.

 
 
 
 

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Advantages and disadvantages 

Each investor acquires and holds shares in this fund and participates in the income generated by a large number of assets that make up the mutual fund. By placing investors’ money across securities in a broad range of companies in different industries, fund managers “diversify” in hopes of maximising profits and minimising risks. They monitor stock market performance and market developments and rebalance assets if necessary. 

By placing investors’ money across securities in a broad range of companies in different industries, fund managers “diversify” in hopes of maximising profits and minimising risks. 

As a consequence of the extensive management involved in mutual funds, investors have to pay relatively high fees. Before you invest, you should do thorough research on which funds are suited to your needs. Don’t forget about the fees in relation to the amount you are planning on investing and taxation of gains.

In case of index funds, investors should also bear in mind that if a company falls out of an index, for instance because it is knocked out of the stock market index that the index fund is replicating, passive funds - which track a specific index or market segment - may suffer as a result. 

Obviously, at such a time, many funds will simultaneously be selling the stock of a company leaving the index - and quick market players will do this even days before a fund is able to sell, thus significantly affecting the price. 

All in all, the convenience and spread of risk and diversification behind mutual funds has been a decisive factor in making them increasingly popular investment vehicles for beginners and seasoned investors alike.

FURTHER READING 

BOOKS

  • Duarte, John - The Everything Guide to Investing in Your 20s & 30s

  • Swensen, David F. - Unconventional Success: A Fundamental Approach to Personal Investment

Six questions to ask before buying a stock or mutual fund

How mutual funds differ around the world

This article does not constitute investment advice, nor is it an offer or invitation to purchase any digital assets.

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