What Is a Mutual Fund?
By: Source: AARP.org Date Posted: 2005-03-20 12:09:10
A mutual fund is a company that makes investments on your behalf and on behalf of others like you. A mutual fund collects money from hundreds, or even thousands, of investors. The fund then pools this money and uses it to buy a large collection of stocks and bonds. This collection of investments is called a portfolio. As a mutual fund investor, you own a specific number of shares in your fund's portfolio. The larger your initial investment, the more shares you will own.
What You Should Know
Mutual funds can invest in stocks.
When a mutual fund buys stock in a company, it buys a piece of that company. The value of the mutual fund's shares increase or decrease depending on how the company's stock performs. If the mutual fund sells some of its stock, it passes a profit or loss directly on to its investors.
They can also invest in bonds.
When a mutual fund invests in bonds, it makes loans to the companies or governments that issue those bonds. The company or government pays off the bond, with interest, over a fixed number of years. Bond funds own a large collection of bonds that mature at different times. The funds generally provide steady income to their investors, usually by sending monthly dividend checks.
Mutual fund managers are free to buy and sell bonds at any time, even before the bond reaches maturity. As a result, there is no fixed date when bonds in a mutual fund will mature. In addition, your dividend income will go up and down as the bonds in your fund's portfolio change.
Each mutual fund share has a Net Asset Value.
Each mutual fund share is worth a certain amount of money. This is called the Net Asset Value or NAV. The NAV changes daily, depending on the fund's activities that day.
A mutual fund uses a simple calculation to determine its NAV. First, the fund calculates the total dollar value of the securities in its portfolio at the close of trading. Then, the fund divides this figure by the total number of shares held by investors. The quotient is the NAV for that day.
You can find your mutual fund's NAV on the financial page of your newspaper. Multiply the NAV by the number of shares you own to determine the total value of your investment. The statement you receive from your fund will also give you this information.
You can make money from a mutual fund in three ways:
- Capital Gains: During a typical year, a mutual fund continually buys and sells stocks and bonds. When the fund sells stocks or bonds at a profit, it passes that profit on to you in the form of capital gains. These capital gains are passed on to you throughout the year, and you must pay taxes on these gains at year's end. Even if the price of your shares is lower at the end of the year than it was at the beginning of the year, you will pay taxes on the capital gains you realized during the course of the year.
- Dividends: Some mutual funds own stocks or bonds that pay regular income throughout the year. This income is also passed on to you in the form of dividends. You will pay taxes on the dividends that you receive throughout the year.
- Increases in Value: A fund may hold on to a stock or bond until its price increases. When this happens, the value of the fund's shares - and the value of your investment - also increases. If you sell your shares, you will make a profit.
For More Information
The Alliance for Investor Education
You can test your knowledge about mutual funds on a Web site run by the Alliance for Investor Education. The site also features a mutual fund fee calculator and a "Guide to Understanding Mutual Funds."
URL: http://www.investoreducation.org
The Securities and Exchange Commission (SEC)
The SEC Web site offers a variety of useful information for investors. Under "Investor Education," look for online publications about mutual funds and Interactive Tools, including a Mutual Fund Cost Calculator that will help you compare the true dollar cost of mutual funds. Use the EDGAR Database (listed under "SEC Filings and Forms") to find and read a mutual fund's prospectus.
URL: http://www.sec.gov
The Investment Company Institute (ICI)
ICI is a trade organization for the mutual fund industry. The group publishes a host of information about mutual funds, including: "A Guide to Understanding Mutual Funds" and "Mutual Fund Fact Book."
URL: http://www.ici.org
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