What are funds?
Mutual funds are a way of buying into a wide range of shares, bonds, money markets or other securities all at once. They are professionally managed, so you are basically buying part of a larger portfolio.
Definition of
Mutual funds come in several different varieties, but the core concept is always the same: the fund is a pool of money contributed by many different investors that is used to buy a bundle of securities. All contributors to the fund receive shares in proportion to how much they contributed, and they receive returns based on the performance of the underlying security. Mutual funds are also sold in shares, just like stocks. However, unlike shares, there may be a limit to the number of shares outstanding at any given time (depending on the type of equity fund), and it can be very common to own fractional shares in an equity fund.
Types of funds
Mutual funds usually fall into one of three categories: open-ended, closed-ended and investment funds.
Open funds
Open ended means that there is no limit to the number of shares in these funds that can exist at any given time. However much money investors have contributed will be issued shares and will be used to buy more underlying securities. Investors can also cash out on any day they want and sell their shares in the fund at the market price for that day. This also means that investors cannot trade funds during daytime hours. Because the allocation of assets is handled by professional portfolio managers, the actual value of each share is not precisely known until the end of the day. Investors can only buy and sell their shares from the fund managers themselves, not on the open market. In practice, this means that you buy open-ended funds for a fixed amount, rather than as a number of shares. You will actually receive these shares at the end of the day, and will most likely have a decimal value (for example, 10.1252342 shares). Conversely, when you want to sell your shares, your order will be executed when the transactions for the fund settle.
Closed-end funds
Closed Ended means that there is a fixed number of shares, so these funds can be traded on an exchange (similar to an ETF). These funds are still professionally managed, but the total amount invested is determined only once; at the time of the IPO.
Unit Investment Trusts
These are much less common than the other types of funds and are also closed-ended. These funds are special in that they have a limited lifespan; they are issued once, but the fund eventually matures and all investors are paid out based on their investment and the returns on the underlying assets. These funds are also special in that they are not professionally managed. The holdings are set at the time of the IPO and are fixed while the fund is active. In contrast, investors can redeem their shares from the fund managers at any time, or even sell shares on the open market (although this is very rare).
Advantages of using funds
Mutual funds can be a very easy way to diversify, as there are many different types of funds, it is usually possible to find a selection that complements your portfolio. Mutual funds have historically been an important part of retirement planning; because they are professionally managed, they don’t require as much frequent attention compared to a portfolio of stocks you actively select, buy and sell. Funds also send out dividends to their shareholders. If a share owned by the fund pays a dividend, it is paid directly to the fund unit holders.
Disadvantages of using funds
The main disadvantage is that the professional management of the fund comes at a price; mutual funds generally charge a fee based on the initial capital invested. This can increase rapidly, especially if the fund underperforms. A major problem with retirement accounts during an economic crash is that funds will still charge fees on your capital even if the value of the fund itself declines, which acts as a double penalty. Another major drawback is that you have no ability to customize the holdings of a mutual fund. You are stuck with whatever the fund manager chooses. Of course, you should always diversify your portfolio outside of owning a single (or even multiple) funds, but you may end up in a position where you short a stock while having a long-term holding in a fund you own.
Differences with ETFs
At first glance, there is very little difference between a closed-end mutual fund and an ETF: both trade on a stock exchange and both have a wide range of assets. However, there are a few important key differences: 1. ETFs are typically not “managed”, as they usually have holdings that mimic a particular index (for example S&P 500) and the fund managers do not actively move the holdings outside that index. This means that it is possible to “buy into an index” that you want to hold, and you will know the actual holdings of the fund (and thus the net asset value) at any given time. 2. Because they are not actively managed, the fees associated with ETFs are usually much lower. 3. The tax structure of owning an ETF is more similar to owning stocks than mutual funds. When choosing between ETFs and mutual funds, these are all important considerations; due to the lower fees alone, ETFs have become increasingly popular over the past 10 years. But the fact that mutual funds are actively managed can make them more attractive for long-term retirement planning (depending on your personal tastes).
Please note when trading funds
Unlike shares, ETFs or most other security types, when you buy mutual funds you specify how much you want to buy in amounts, not shares. This is because the actual value of the shares is not known when you make your purchase. It is only calculated at the end of the day. If you want to trade funds, remember to enter the exact amount you want to trade, not the number of shares!
About the Vikingen
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