By putting your money into a mutual fund, you are pooling your money with that of other investors. Mutual funds are typically professionally managed. The investors don’t sit down and make investment decisions together; they leave that to the professional fund managers.
The mutual fund will make investments and you will not have any direct ownership of those assets. You will only own a certain number of shares/units of the fund.
Example: 50 investors put $10,000 each into a mutual fund. The fund purchases 1,200 shares in various companies. None of the 50 investors have any direct ownership in the shares. None of the investors are allowed to attend and vote at shareholder meetings. If you are one of the 50 investors, you have no right to have 24 of the shares registered in your name.
Since the legislation concerning mutual funds vary from one jurisdiction to the other, it is important to obtain information that is pertinent to your specific situation before putting any money into an investment fund. It is also important to keep in mind that there can be different types of mutual funds available to investors.
One of the reasons why people put money into a mutual fund instead of just buying assets in their own name is that they desire a higher degree of diversification. Let’s say for instance that you have $1,000 to invest and you wish to stick to blue chip companies included in the Dow Jones Industrial Average (DJIA). This is not penny stocks and you will not be able to spread your purchases over many different companies before you have invested all of your $1,000.
If you instead seek out a mutual fund focused on DJIA companies, the situation will be different because you will be pooling your money with money from other investors. Let’s for instance assume that together, you have $100,000 to invest through the fund. That will allow for a much more complex diversification strategy.
If a high degree of diversification is important to you, always check out the specifics of the investment fund to learn about the details before you commit any money. There are for instance funds that invest in a lot of different companies, but only companies within a certain industry. Geographical diversification can also be lacking. Also keep in mind that you might prefer a mutual fund that invests not just in stocks but in a lot of other assets.
When you buy stocks, derivatives, etc through a broker, knowing the transaction costs – such as courtage – is usually very easy. You can even tailor your trading decisions to avoid exorbitant transaction costs.
When you invest in a mutual fund, it becomes more complicated. Money from the investors will be used to pay for the fund’s costs and this will erode the bankroll. It’s not just about paying a fund manager $1 today – it is also about losing what that dollar would have yielded you if you had been able to invest it instead. On the one hand, funds can typically get the transaction costs down a lot compared to what it would have cost you to purchase shares in 25 different companies, a few stock options, some warrants, some governmental bonds, etc through a broker. On the other hand, you are paying to have one or more professionals make the decisions for you. The fund will also have costs associated with the overall running of the business.
Before investing in any mutual fund, it is a good idea to take a look at their historical costs. Are they running a tight ship or are they spending widely? Is that high-spending fund brining in a better return than the low-spending fund? How are the managers paid; a fixed amount each year, a fixed percentage of fund capital each year or variable amounts based on the fund’s performance?
Open-ended investment funds
Open-ended investment funds are continuously open for new investments. Existing investors can put more money into the fund and new investors can join the fund. Each time someone wants to buy into the fund, new shares/units are created and sold to that person. The price of a share/unit is based on the net asset value of the fund.
Close-ended investment funds
The basic idea of a close-ended investment fund is to create a certain number of units when the fund is formed and then not add any more units throughout the lifetime of the fund. If anyone wants to buy into the fund later, that investor must find a unit owner that is willing to sell. This can bring the unit price up well above what is warranted by the current net asset value of the fund. If investors believe that this is a fund that will do well in the future, they will be willing to pay extra to obtain units. The market price of units will depend on supply and demand.
With that said, it is quite common for close-ended investment funds to not stick very rigidly to the idea of not creating any more units. In many jurisdictions, they are permitted to create more units. However, a close-ended investment fund is not likely to create new units every time someone wants to invest in the fund. Instead, they will wait until the fund has become very popular (high demand / low supply of units on the market) and create a certain number of new units. When new units are created by a close-ended investment fund, it will typically cause the market price of fund units to drop down significantly since that price was boosted by scarcity.