Mutual Funds Essay, Research Paper

Mutual funds are an easy, convenient way to invest, without having to worry about choosing individual stocks. A mutual fund can be defined as a single portfolio of stocks, bonds, and/or cash managed by an investment company on behalf of many investors. The investment company manages the fund, and sells shares in the fund to individual investors. When one invests in a mutual fund, they become a part owner of a large investment portfolio, along with all the other shareholders of the fund. The fund manager invests the contributions when shares are purchased, along with money from the other shareholders. Every day, the fund manager counts up the value of all the fund’s holdings, figures out how many shares have been purchased by shareholders, and then calculates the net asset value (NAV) of the mutual fund, which is the price of a single share of the fund on that day. If the fund manager is doing a good job, the NAV of the fund will usually get bigger and the shares will be worth more.

There are a couple of ways that a mutual fund can make money in its portfolio. A fund can receive dividends from the stocks that it owns. Also, the fund might have money in the bank that earns interest, or it might receive interest payments from bonds that it owns. At the end of the year, a fund makes another kind of distribution, this time from the profits they might make by selling stocks or bonds that have gone up in price. Unfortunately, funds don’t always make money. For example, the fund manager could have made some investments that didn’t work out, sold some investments for less than the original purchase price, and there may be some capital losses.

Most mutual funds invest in stocks, and these are called “equity funds.” Some funds specialize in investing in large-cap stocks, others in small-cap stocks, and mid-cap stocks. Large-cap stocks have market caps of billions of dollars, and are the best-known companies in the U.S. Small-cap stocks are worth several hundred million dollars, and are newer, up-and-coming firms. Mid-caps are somewhere in between. There are also bond funds that purchase bonds issued by corporations, municipal governments, or the federal government agencies. You can invest in tax-free bond funds, just as you can buy tax-free bonds, and the interest you earn is exempt from federal and perhaps state and local income taxes. Mutual funds that specialize in securities outside the U.S are known as international funds or global funds. These funds can also specialize in bonds, stocks, or some mix of the two. An international fund can also specialize in a particular country or region of the world, such as the Pacific Rim, Latin America, or Germany.

Equity-fund managers usually use one of three particular styles of stock picking when they make investment decisions for their portfolios. First there is value, where a fund manager uses a value approach search for stocks that are undervalued when compared to other similar companies. Next, there is growth and those funds try to find stocks that are growing faster than their competitors, or the market as a whole. These are often the stocks of well-known established corporations. There is blend where managers buy both kinds of stocks, building a portfolio of both growth and value stocks.

Only 25 years ago, there were fewer than 500 funds available. Today, there are over 7,000, with more added every year. There are many advantages to buying mutual funds, but there are disadvantages as well. Mutual funds can offer instant diversification, and diversification reduces risk. For example, funds can reduce risk by spreading it among a large number of investments, if one stock performs badly, its impact on the overall portfolio is lessened. Funds can also reduce risk by investing in different asset classes: stocks (which can include international as well as U.S. stocks), bonds, cash and other securities. Many mutual funds can be purchased commission-free, reducing the overall impact of commissions and expenses on a portfolio. Also, by pooling money accepted from many investors, mutual funds can reduce the percentage that expenses eat up in a portfolio. Many investors strive to keep commissions as low as possible, but they can still take 3 to 5 percent of an investor’s portfolio. Funds typically have expenses of about 1 to 2 percent. Of course, if a fund is bought through a broker who charges a commission, or if the fund charges a load, then these savings may be lost. Another advantage is that, mutual funds are a very liquid investment. Funds can usually be sold immediately and there’s no need to worry about finding a buyer or at what price the shares might sell. Mutual-fund companies often offer a lot of attractive free services for shareholders, such as reinvestment of dividends and distributions, the ability to transfer between funds in a family, systematic investment or withdrawal plans to allow you to invest or sell on a monthly basis, and detailed record-keeping and tax reports.

Probably the biggest reason not to invest in mutual fund is, each year 80 percent of all mutual funds perform worse than average. One of the reasons for these low returns is that all funds have a variety of fees and expenses, which directly reduce the return. Some funds also charge a sales fee of up to 8 1/2 percent. There are marketing and advertising costs that are passed right along to the fund holders. Also, to be prepared for withdrawals and provide for the liquidity that investors seek, funds typically have to maintain a large cash position. To our disadvantage, this is money that’s not working to the best value for the investors. It’s nearly impossible to tell if a fund is a good value at any particular point in time. Unlike stocks, where it is possible to tell if a stock is undervalued according to several different measures, it is much harder to determine if a mutual fund’s Net Asset Value represents a good value or not. A fund could have shown a solid rate of return for a particular period, but that could be a result of its holdings having reached peaks from which they might then plateau or decline. Finally, a fund is only as good as its management, and fund managers can change. The famous Magellan Fund survived Peter Lynch’s departure, but other funds have not done so well when a dynamic and talented manager has left.

In the process of doing this paper mutual funds seemed to be a very convenient and faily easy investment tool. Using the internet and some of the advantages and disadvantages mentioned earlier I found a fund that was interesting. The Domini fund only invests in companies that are part of the Domini Social Index. The index excludes companies that derive more than 2% of sales from military weapons, sell any alcohol or tobacco or own interest in nuclear power plants. The remaining large-cap stocks are then evaluated according to other social criteria: diversity, employee relations, the environment and the product. For example, a company may give a lot of money to community organizations but may be rabidly polluting the environment. In a situation like this, the analyst will carefully consider the pros and cons before including the company in the index and in the fund. Investment requirements were also a factor for considering this fund and the Domini fund requires a minimum initial investment of $2,000. However, the company can waive the minimum investment to a mere $25 each month. The fund has been around since 1991 and has had an average annual return of 20.61% for the last 8 years. It returned 32.99% in 1998 (while the S&P500 returned 28.58%). It invests 25.85% of its assets in technology and is no load.