Wednesday, April 21, 2010

What the heck is a mutual fund anyway?

The last post drew a comment from a long-time reader of this blog. Rather than answer the question in the comments section, I thought I would use it for a blog post. Daniel is now in the business and asks me the following question:

How can I define/describe mutual funds to a "normal" person? I know the financial definition of it, but I can't seem to reword it properly.

RESPONSE: I would tell investors first that they could always purchase shares of stock or individual bonds all by themselves without going through a mutual fund. Trouble is, if they only have a few hundred or a few thousand dollars, they will not be diversified that way, and it is very inefficient to purchase less than $100,000 worth of bonds due to the high markups or commissions that brokers charge. Rather than invest a few hundred or thousand dollars into just a couple of stock issues or one bond issue that could easily end up defaulting, most investors prefer to buy shares of a portfolio that is already diversified and run by a team of professional investors. We call these portfolios "mutual funds" because each investor mutually owns his percentage of each security in the portfolio. Now, a few hundred or a few thousand dollars can be invested and provide the investor with immediate diversification--it is safer to own little pieces of, say, 100 different stocks or bonds, versus putting all the money an investor has to invest into just a couple of stocks or bonds. Also, a mutual fund investor can liquidate some shares without losing the diversification he enjoys. If he, on the other hand, owned shares of stock, he would have to decide which issue to sell, and if he liquidated all of his GE, his diversification would be lost. In exchange for the diversification and the professional management mutual fund investors sometimes pay sales charges to buy or sell the shares and always pay expenses (management fees, 12b-1 fees usually, and other expenses). If the expenses are reasonable, it's a fair bet that most investors are better served through mutual funds as opposed to trying to pick stocks and bonds on their own.

In the textbooks I often describe a mutual fund as a big "portfolio pie" that serves up as many slices as investors want to buy. Every investor mutually owns his percentage of the portfolio pie. If the ingredients of the pie go up in value, so does the value of the investor's holding. If the ingredients (stocks and bonds) pay dividends and interest to the portfolio, that also makes the slices owned by the investor much sweeter/more valuable. If investors want to turn their slices of pie into cash, the mutual fund will do so any day the markets are open. There's no guarantee as to what a share will be worth on any given day, but that's always true of the investment world.


  1. Ah, thank you very much. I remember your describing a mutual fund as a big "portfolio pie" in your Series 7 book.
    So, mutual funds are relatively safe when compared to stocks, correct?
    I know a lot of my clients and prospects are interested in investing, but they don't have $100,000, for example, and the risk tolerance to purchase stocks.

  2. Hi, Daniel.
    You couldn't say that mutual funds are safe relative to stocks, necessarily. You could say that mutual funds offer diversification that an equal investment in individual stocks or bonds wouldn't achieve. Mutual funds can lose money really fast, actually, especially over the short-term. Look at a prospectus for a growth fund and see how volatile and unpredicatble the returns are--how they can lose 40% or more of their value in a year, before figuring in expenses or any sales charges. Compliance departments determine exactly how a firm's registered reps should phrase things--and how they shouldn't.