Zaks Investment Advisory Service

Mutual Funds: what they are and how they work

I am often asked what Mutual Funds are. Mutual Funds are companies in which a large number of people invest money, and which use that money to buy stocks, bonds and other securities. The aggregate of the stocks and bonds purchased by a Mutual Fund is called a portfolio. Each investor becomes owner of a certain portion of this portfolio, proportionate to the amount of money invested in the fund. In other words, if your Mutual Fund has stocks and bonds worth, say, $900, and you added another $100 to the fund, than the net worth of that portfolio will be $1,000 and you will become owner of one-tenth of that portfolio.

There are a vast number of Mutual Fund companies, more than 8,000 of them. The total value of all their assets is more than $9 trillion. Mutual Funds is a general term but within this broad category are different types of funds that have different structure. We will discuss the most common type, the so-called open-ended funds (which are usually simply referred to as Mutual Funds), in this program. There are also things called closed-end funds – but about them, some other time. Quite recently, another type of funds emerged – the so-called Exchange-Traded Funds and Exchange-Traded Notes. We will talk about these when we discuss Index Funds.

Just like regular companies, Mutual Funds issue shares. But, unlike regular publicly traded company, whose shares are traded on a stock exchange, Mutual Funds issue and sell their own shares. In other words, if you wish to buy shares of one of the funds owned, say, by Vanguard, then you hand your money over to them, and in return receive a set of documents confirming that you are a partial owner of the Mutual Fund. If you decide to redeem your share in the Mutual Fund, then you also do this directly through the company: you ask for your share and immediately get back cash corresponding to the value of your share in the Mutual Fund.

The Mutual Fund uses your invested money to purchase additional stocks and bonds. If you decide to redeem your Mutual Fund shares, the Mutual Fund will sell a portion of the stocks and bonds in its investment portfolio on the open market, and return the raised cash to you. In practice, because Mutual Funds operate huge funds, they usually keep a small percentage of their assets in cash for just such eventualities.

The board of directors of each Mutual Fund is required to form a certain investment policy, which the Mutual Fund in turn must strictly follow. For example, a certain Mutual Fund’s investment policy may require all holdings to be invested only in large US companies. Some other fund’s investment policy may demand that they be invested in smaller companies whose market value does not exceed a certain amount; or, only in biotech companies; or, only in Treasury bonds, etc. In either case, this investment policy is outlined in an official document called the prospectus, which every investor should read.

What is the point of investing in Mutual Funds, and why do many investment advisers suggest you do just that? Why not use the money to buy stocks and bonds on the open market? Mutual Funds have several advantages. The first and, in my opinion, most important advantage is that Mutual Funds allow you to diversify your investment. Mutual Funds usual own dozens, and in some case – hundreds of different financial instruments. When you invest money in a Mutual Fund, you receive a small piece of a vastly diversified portfolio. It is almost impossible for a lone investor to create a similar portfolio by purchasing individual stocks and bonds on the open market. Besides, this would be a very expensive proposition, considering the brokerage fees involved. So it is almost always cheaper to buy shares in a Mutual Fund rather than trying to obtain the same stocks and bonds on your own. A well-diversified investment portfolio has much better “risk profiles” (i.e., it offers a better return for the same amount for risk) than a portfolio consisting of just several stocks.

Second, Mutual Funds are managed by professional investors. One may argue about their actual ability to pick stocks that will grow the fastest, but they may be trusted in one respect: they operate within the frameworks of a certain investment policy set by the board of directors. So, if its prospectus says that this Mutual Fund is broadly diversified, this will indeed be the case. And if the prospectus claims that the fund invests money in high tech companies, you may rest assured that this is what the fund managers actually do.

After initially investing a certain amount in a Mutual Fund (almost every fund sets a minimum initial investment amount), you are free to add very small sums to it over time – just $100 a month, if you wish. Almost every Mutual Fund allows this.

On the other hand, each fund has certain expenses, which may be fairly high and which the individual investor must certainly take into account. We will talk about this in our next program.

And with this, we will draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.