Mutual funds are simply a collection of stocks and/or bonds. A mutual fund can be a company that contains a group of investors where each investor owns a fund.
You can make money from a mutual fund in three ways:
1) Income is earned from dividends on stocks and interests on bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution.
2) If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
3) If fund holdings increase in price but are not sold by the fund manager, the fund’s shares increase in price. You can then sell your mutual fund shares for a profit.
(The 3 steps are directly from Investopedia)
The advantages of mutual funds are:
- Professionalism – it is a relatively cheap way of having a fund specialist managing your portfolio, especially if you don’t have the time or knowledge of stocks and/or bonds. This can also be seen as a disadvantage.
- Risk Mitigation – The risk of a significant loss is spread-out across a series of funds which also increases the diversity of the fund. This means that the larger the fund, the less risk there is for a significant loss and vice versa. However the risk of a minimal loss increases with the size of a fund. Another factor that has to be considered is the amount invested into each stock and/or bond.
- Scale – Usually mutual funds are traded in large volumes which allows for a decreased transaction cost per share. This is described as the “Economies of Scale”.
- Liquidity – Mutual funds are able to be converted into cash at any time.
However the costs of owning a mutual fund can be quite high as there are professionals involved. This can be seen as a significant disadvantage and is quite often the main reason why here aren’t more mutual funds.
Also, mutual funds can reduce market competition as your fund doesn’t have any connection to other funds on a competitive level. This could also cause an increased price for the customers.
Mutual funds can be costly to set-up however if there is knowledge of investments then significant gains can be made.