Mutual Funds 101: What they are and how to use them
A mutual fund is an investment vehicle in which multiple investors pool their money into one account to be managed by a professional investor. From a money making standpoint, the benefits of using a mutual fund are pretty clear. For one, if you've got extra cash lying around but don't know how to invest it, it pays to hand your money to someone who knows what they're doing. Secondly, mutual funds are heavily regulated by the government, so it's definitely a more secure way to invest. Finally, the primary benefit of investing a mutual fund is the diversification. Mutual funds typically hold many different securities and this diversification is a great way to mitigate risk. It isn't all sunshine and rainbows, however. Investors in a mutual fund have to pay various fees and expenses, and since they're part of group, each investor must sacrifice his/her ability to invest individually.
How do they work?
From a functional standpoint, mutual funds are simultaneously an investment portfolio and, because of their size, a full fledged company. A mutual fund, day-to-day, works much like any other company. A fund manager is elected by the board of directors and is legally obligated to make decisions that benefit the fund's shareholders. Most mutual funds exist as part of a larger investment corporation, with some companies containing hundreds of funds.
Mutual funds invest in multiple securities at once in order to hedge their bets.
What's the difference between a mutual fund and a hedge fund?
Mutual funds are not to be confused with their risk-taking, coke-addled cousin, the hedge fund. The fundamental difference between the two is that a hedge fund's leverages (bets made with borrowed cash or prospective earnings) aren't regulated. While both mutual funds and hedge funds lack a certain level of transparency, investors in a mutual fund can rest a little easier, knowing that the company they're invested is relatively safe (in theory). While the SEC doesn't have the jurisdiction to supervise a mutual fund's investments, it does require these funds to publicly report their earnings. The biggest safety net in the world of hedge funds is its barriers to entry. You must have a net worth of at least $1 million to ride that ride. That said, if you're trying to bet the minimum, you might be better off at a casino.
Are there different types of mutual funds?
Since there are different types of securities (bonds, stocks, derivatives etc.), naturally there are different types of mutual funds. One of the more prominent types is based on fixed income and the collecting of government and corporate bonds. Fixed income funds generate their income via interest. Another type of fund is based around market indexes. These funds are predicated on the belief that the stock market is too hard to judge. Instead of trying to beat the market, investors buy into specific indexes (i.e. Dow Jones, S&P, NASDAQ). The advantage of these funds is twofold. Investing this way is extremely risk averse and feels significantly safer than the other mutual funds out there. On top of this, betting on an index isn't rocket science, so there are way less fees involved with this type of fund. Another relatively secure option is a money market fund, in which the objective is to keep the fund's share price at $1 and to turn a profit on short term investments. These funds move quickly but are a comparatively safe way to invest one's money. There's also no fee associated with entering and exiting a money market fund. There are also sector funds (funds based on specific industries), balanced funds (funds that hold both stocks and bonds), and too many other variants and combinations to mention here. This is the 101 course for God's sake. If you've read this and thought "gee, I didn't know what mutual funds were, but now I'm itching to get involved," I recommend talking to a financial advisor.
Index Funds are the safest way to play
Aren't all funds just scams?
Yes. Invest in real estate you idiot. Sorry, I got ahead of myself there. What I meant to say was:Yes and no. Where mutual funds come up short, is in the idea that picking a company with a star investor or manager is going to to yield better results. An investor's success rate is not predictive of future success. According Henry Blodget and David Swensen the only thing that's predictive of a mutual fund's success is the cost it takes to run it. This is why index funds, with their lower operating costs, always seem to beat out other funds in revenue. So yes, funds that claim to have "inside knowledge" about the stock market and investing, are lying to you. Investing at that level tends to be little more than educated guessing. That said, these funds exist and have been legitimized in the American financial space. The amount of money tied up in US-based mutual funds is about the same as our GDP. So, if you have the money, and are looking to bet it, a mutual fund is closer to blackjack than roulette. Still, unless you're counting cards (or insider trading) it's pretty much all luck.