You might have heard about mutual funds for a few times. But what exactly is mutual fund? What role does it play in the financial world? The article helps you understand mutual funds better.

What is a mutual fund?

Basically, a mutual fund is a kind of investment that pools money from many investors to purchase bonds, stocks, money market instruments, and other securities. And this collection is referred to as a portfolio. A mutual fund is overseen by portfolio managers, who make investment decisions and try to seek returns for those investors. Besides, the types of securities in the mutual fund’s portfolio are set forth in its prospectus, which are in tune with the investment objectives.

Through a mutual fund, even small or individual investors can have access to portfolios managed by professionals. As a result, each shareholder proportionally share the gains or take the losses of the fund. Mutual funds invest in a wide range of securities, whose performance is associated with the change in the price of the fund, which is determined by the total value of the underlying investments.

How does a mutual fund work?

Simply put, a mutual fund is an investment as well as a company. It’s like the relationship between a share of AAPL and Apple company: buying the share means you will have partial ownership of Apple and its assets. The same is true when you buy a mutual fund.

A mutual fund offers three ways for its investors to earn returns:

  • Dividend on stocks or interest on bonds. The investors can choose to receive the income or to reinvest the money for more.
  • Selling out securities whose price increase. By selling securities the fund has a ‘capital gain’. Investors can receive a cheque for distribution from most funds.
  • Fund share price increases. If the underlying securities of the fund see an increase in price, the shares of this fund will increase in price as well. When you sell your mutual fund shares, you can earn a profit in the market.

Pros:

  1. Transparency: the industry regulation ensures fairness to investors.
  2. Diversification: a wide range of investment options can enhance returns while reducing risk.
  3. Professional management: professional managers seek returns for investors that lack the time, expertise, or information.
  4. Freedom of choice: investors can choose freely from the fund managers with various styles and goals.

Cons:

  1. High expenses: professional management comes along with high fees, leading to extra losses if you get no returns yet.
  2. Lack of Liquidity: your shares can be converted into cash only at the end of each trading day.
  3. Taxes: capital gains always lead to tax.
  4. Difficulty in comparing funds: researching and comparing among a variety of funds before you buy one is very complex.

There’s no investment 100% free of risks in this world, so it’s necessary to get well informed before any kind of investment. And of course, never put all the eggs in one basket.

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