How Do Mutual Funds Work?

How do mutual funds work? To answer this, we must first understand what mutual funds are. To put it as simply as possible, mutual funds are funds pooled from a group of investors so that they may be invested in one or more type of financial security. The professional mutual funds manager does the actual investing and is ultimately responsible for whatever profit or loss the mutual funds produce. There are several types of mutual funds you can choose from. Ideally, mutual funds are supposed to reduce risk and increase profit, though the reality is more complex than that.

Understanding Securities

Mutual funds are made up of securities. The term "securities" encompasses any type of financial investment. Usually, this means stocks, bonds, commodities such as precious metals (gold, silver, etc.) and shares in other, smaller mutual funds. In recent years, it has come to include rarer investments, such as senior loans and various derivatives. Some mutual funds are made up of only one type of security, while other funds are a bit more mixed (though, even then, one type of security tends to make up a bigger portion of the mutual fund).

Designing Mutual Funds

Mutual funds are created by investment companies. They decide what securities to invest in. A mutual fund must follow a certain theme. This is known as the investment objective. The objective depends on what types of securities it includes. It can be anything from a certain type of industry to a certain group of countries. The company brokers map out the initial investments, while the fund managers are responsible for monitoring the fund and making sure it continues to grow and generate profits for investors and the investment company.

Before they can offer their mutual funds to investors, the brokers must write out a prospectus. This document should explain what securities make up each mutual fund, describe their company, summarize the financial statements, give biographies of its executive officers and directors and account for any legal issues the company may be facing at the time. Once completed, the prospectus must be filed with the U.S. Securities and Exchange Commission (SEC).

Once the SEC confirms that everything the prospectus says is true, the investment companies are free to offer their mutual funds to potential investors. The interested investors look at the potential mutual funds and try to figure out which ones fit their investment goals. Once they settle on a fund, they contact a mutual fund manager, who takes their money and adds it to the mutual fund. The fund manager will charge a fee for his or her labor, and investors may be asked to pay a few other fees depending on the financial circumstances.

The Name Rule

Under the current US law, the name of the fund should reflect at least 80 percent of the securities that make up the fund. This way, the investors know what they are getting into before they purchase it. However, investment companies can get around this rule by giving their funds relatively generic names.

Net Asset Value

For the purpose of mutual funds, net asset value is the value of an individual share of a mutual fund, minus the liabilities. This number is important if the mutual fund is traded in a public exchange (which isn't true for all funds). However, it should be noted that NAVs don't reflect the actual share price, since they don't include the sale charge, nor do they necessarily reflect the value (since the value is influenced by the amount of liabilities). However, that's the closest thing to the true value investors can get until the shares are actually sold. The NATs are updated on a daily basis at the end of each trading day, though some funds update their NATs several times a day.

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