A mutual fund is an investment product that allows investors to participate in a portfolio of financial securities such as stocks, fixed income instruments, and other assets. Mutual funds are managed by professional financial managers and allow investors to invest in well-diversified portfolios with risk-return characteristics that are difficult to obtain by individual investors.
Mutual funds sell shares to investors to collect money and invest this pool of money on their behalf. These shares represent proportional ownership in the portfolio, and their price is equal to the per-share net asset value of the mutual fund. Mutual fund companies calculate and announce the portfolio's net asset value each day, generally after the markets are closed. The net asset value of the fund is equal to the fund portfolio value calculated using the market prices on the valuation day minus the fund's liabilities. The unit share price is obtained by dividing the total fund value by the number of shares outstanding. If the price of the securities that the portfolio holds increases, the price of the participation shares would increase. The net asset value also includes the dividends and interest payments from the assets in the portfolio. Therefore, investors who sell their shares and redeem their money on a specific date receive their share of the fund's total profit (loss) until that day.
Since the price of a mutual fund share is determined and announced once a day, the transactions are conducted based on the forward pricing principle. When an investor places an order to buy or sell a share during the day, the order is carried out at the first price determined after placing the order.
Although the term “mutual fund” typically denotes open-end funds, in practice, it is used for closed-end funds as well. In open-end funds, the number of shares that can be issued is unlimited. When there is a new demand, the mutual fund investment company can issue new shares and sell them to these new investors. All buy and sell orders are carried out by the mutual fund investment company. There is no trading between investors. On the other hand, closed-end funds have limited shares offered in the initial public offering, and these shares are traded in an exchange. Therefore, a closed-end fund investment company does not need to be concerned about the unexpected cash outflows redeemed shares.
Individual investors prefer mutual funds for various reasons:
Diversification: Diversification is one of the essential principles of sound investment strategy. Individual investors might not diversify their risks, especially if they have a small investment budget.
Portfolio management: Mutual funds provide investors with professional portfolio management services.
Convenience: Mutual funds make investment easier by offering various functions such as record keeping, payment collection, and tracking. Mutual funds also allow investors to invest in securities that are hard to access. For instance, international financial securities and some derivatives require a sizable investment budget and cost more than individual investors can afford.
Mutual funds have become more popular since they provide an easier way to invest for investors, especially those who don’t have financial literacy and capabilities.
Prof. Dr. Cenktan Özyıldırım
References:
Randy Billingsley, Lawrence Gitman, Michael Joehnk (2021) Personal Financial Planning, 14th Edition, Cengage
Securities Exchange Commission, MUTUAL FUNDS and ETFs: A Guide for Investors https://www.investor.gov/sites/investorgov/files/2020-04/mutual-funds-ETFs_2_0.pdf