Mutual Fund Basics: What Are Mutual Funds?

You probably know that mutual funds are an extremely popular way to invest. But you may be in the dark about the different forms they take, and how they actually work. We're here to shed a little light on the subject.

A great big money pool
Imagine that you want to buy stock in a dozen companies -- but you only have $100. With that paltry nest egg, you might be able to buy one or two shares of one or two companies, but you probably can't buy all the holdings you want.

Now suppose you've got a friend who also has $100. In fact, you have 20 friends, each with $100. If you all pool your money together, you'll have $2,000 -- enough to buy a few shares apiece in a bunch of different companies. Scale that scenario up to include thousands of people chipping in with their own contributions, and you've got the basics of mutual funds.

Many people love mutual funds because they require very little work from individual investors. You send in your money, and the manager or managers running each fund decides how to invest it, often with the help of dozens of employees who research stocks. Some mutual funds have billions of dollars at their disposal, and own chunks of hundreds of different companies in the form of stocks and bonds.

Most mutual funds are "actively managed." Shareholders in these funds pay a yearly fee, usually collected as a percentage of  their holdings (the expense ratio), to compensate the fund's manager for actively researching, buying, and selling stocks or bonds within the fund. When you buy mutual fund shares, you become a shareholder -- an owner -- of that mutual fund, with voting rights in proportion to your ownership of the fund.

Mutual funds come in every possible size and shape. Here's a quick list of their general categories.

Bond funds
Bond funds invest in the IOUs, or debt, issued by companies or governments. A bond's purchaser is essentially lending money to its issuer. In return, the issuer pays regular interest on the amount borrowed, and returns the total amount of money at the end of a fixed period of time. Usually, the amount of interest paid (the coupon) is fixed at a set percentage of the amount invested. That's why bonds are called "fixed-income" investments.

General equity or stock funds
Each share of stock represents partial ownership, or equity, in a corporation. Stock investors hope to see the value of that company increase over time. Stocks are often categorized by their capitalization or "market cap" -- the number of shares they have outstanding, multiplied by their current share price. Like fountain drinks, cars, and basketball players, market caps come in three basic sizes: small, medium, and large. Many mutual funds invest primarily in companies fitting one of these sizes, making them large-cap, mid-cap, or small-cap funds. Additionally, mutual funds are often categorized by the type of stock they buy: fast-growing stocks, stocks currently selling at an excellent value, or a blend of the two.

Balanced funds
Balanced funds mix stocks and bonds. A typical balanced fund might contain about 50%-65% stocks, and hold the rest of the shareholder's money in bonds and cash. The ratio of stocks to bonds in a specific balanced fund is crucial to understanding that fund's inherent risks and rewards.

Global or international funds
Global and international funds invest in companies headquartered outside the United States. In general, international funds are much more volatile than domestic funds, generally investing only in foreign companies. In contrast, global funds may invest in both foreign and U.S.-based companies.

Sector funds
Sector funds invest in one particular slice of the economy: technology, banking, computers, the Internet, llamas, etc. (OK, maybe not that last one.) Sector funds can be extremely volatile, because individual portions of the broad market can quickly gain or lose favor in Wall Street's eyes. Energy stocks, for example, may be red-hot while gas prices are high, only to cool off rapidly when prices fall.

In addition, there's one more form of mutual fund that's even easier and more popular than many of its peers. Read on to discover the ins and outs of index funds.


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