Investing in individual common stocks can be an expensive endeavor. Commissions to the broker on every buy and sell can add up over time. Many investors instead choose to invest in mutual funds based on the misconception that mutual funds do not charge commissions. In reality, mutual funds, even funds that are no-load funds, can be costly to buy, sell or simply hold.
What is a Mutual Fund and How Does One Work?
A mutual fund is an open-end investment company. Most mutual funds are corporations, with a state charter like any other corporation. This financial instrument provides an investor a more simple, convenient manner in which to invest rather than purchasing individual common stocks, bonds, etc. A professional manager, the mutual fund manager, manages the underlying investments of a mutual fund. Mutual funds “pool” money from investors to invest and reinvest into different financial instruments such as stocks, bonds, cash-like instruments, and even futures and options in some funds. The fund manager is the person who decides what underlying instruments to purchase in a fund, as well as when to buy, hold or sell these securities.
There is no limit to the number of investors in a fund or the number of shares offered to the public, although some funds “close” voluntarily for various reasons. Therefore, mutual funds are said to engage in continuous offerings. When an investor purchases shares of a mutual fund, that investor owns shares of the fund. Each share represents a percentage of ownership in all of the fund’s underlying securities. The fund manager uses the pool of money to purchase the underlying securities he or she feels will help obtain the particular objectives of that fund. Earnings on the securities are distributed as dividends or capital gains (if a security was sold for a profit). These dividends and/or capital gains are paid out in proportion to the number of shares an investor owns. In some cases, a fund may make a capital gain payout, even if the fund had a negative return for the year.
Mutual funds offer investors a simplistic form of diversification. In order to have a properly diversified portfolio, an investor should have a mix of different investment instruments across different industries, and within different companies of an industry. Before investing in mutual funds, an investor should assess his tolerance for risk, and determine his goals: long-term growth and appreciation of assets, or a more conservative, income-producing portfolio? The correct mutual fund to invest in solely depends on the objective and goals of each particular investor’s situation.
Regulatory Issues Concerning Mutual Funds
The Securities and Exchange Commission (SEC) regulates every mutual fund. In compliance with SEC regulations, all mutual fund companies must provide an investor with a fund prospectus. A prospectus describes the fund objectives, history, background of managers, financial statement, etc. Mutual funds are always considered a new issue, therefore, they are continuously required to provide a prospectus. If a fund is part of an initial public offering, a prospectus must be filed with the SEC and given to prospective buyers of the offering.
All funds are required to provide investors with periodic reports providing information on the fund and how the investments in the fund are performing. Investors also receive an annual statement from the fund.
At Henssler Financial, our investment philosophy states that if you have less than $50,000 to invest, mutual funds are a more viable option to help you formulate a well-diversified portfolio by offering a much more cost-effective way to invest than by purchasing individual common stocks. Mutual funds offer instant diversification, and allow the investor exposure to many stocks in many industries with one purchase. In coming weeks, we will review various types of mutual funds and mutual fund fees and expenses. For more information regarding this topic, please contact Henssler Financial at 770-429-9166 or [email protected].