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Mutual Fund Securities: Definition & Examples

Instructor: LEROY (Bill) RANDS

Bill has taught college undergraduate and MBA classes in finance, economics & management, 40 years of finance experience and has a MBA degree.

Mutual funds are an investment vehicle for smaller investors, and provide investment diversity, albeit at a higher fee. This lesson discusses mutual funds generally and different types of funds.

Mutual Funds

Bob has some money to invest, so he decides to diversify his investments by investing in mutual funds rather than investing in individual stocks and bonds.

Mutual funds are investment portfolios in diversified securities based on the objective of the fund. A mutual fund is often organized into its own separate company. Mutual funds sell shares in their funds to investors, and an investor participates in the growth or income from the securities portfolio based on his shareholding in the fund.

Bob likes that he can buy mutual funds that meet his investment strategy. He decides to put $20,000 into a mutual fund that contains mostly growth stocks providing a high return. At the same time, he puts $15,000 into a mutual fund that focuses on dividend-paying blue chip stocks to provide a steady income.

Examples

Most investment firms like Fidelity, Vanguard, T. Rowe Price and others have developed multiple in-house mutual funds to attract investor capital. The portfolios in these mutual funds are developed with specific investing strategies in mind.

Mutual funds are developed to provide varying levels of diversification of risk and income performance. The higher the risk of the mutual fund, the higher the income potential, but with greater variance in returns. Some of the types of mutual funds are:

  • Stock funds focusing on growth stocks and higher returns, which come with more risk
  • Stock funds focusing on blue chip and dividend-paying stock, which provide lower but more predictable returns
  • Bond funds providing interest income
  • Asset allocation funds, which have a variety of securities to provide a reliable return
  • Money market funds
  • Target date funds based on how close one is to retirement

Helen is investing in retirement through the 401(k) plan at ABC Corp. She has 30 years until she turns 65 and wants to build a big retirement balance. She picks mutual funds from the ones ABC offers that are focused on maximizing return on her investment. She generally likes funds that have predominantly growth stocks.

Advantages and Disadvantages

Mutual funds have some significant advantages to the small investor over an individual picking their own investments. These advantages include:

  • Diversification - Mutual fund portfolios include hundreds of stocks, bonds or securities providing a diversification of investments.
  • Professional management - All mutual funds are managed by a professional fund manager whose primary aim is to provide the best return to investors.
  • Variety and freedom of choice - There are hundreds of mutual funds with varying investment strategies to choose from.
  • Fees - It is cheaper to invest in mutual funds than the fees incurred by picking individual investments oneself.
  • Transparency - Mutual funds are registered with and regulated by the SEC, providing fairness and accountability.

However, mutual funds do have some disadvantages, including:

  • Returns - There are no guarantees of returns and returns are mitigated for risk, so higher returns can be made by investing in the right individual securities.
  • Fees - Fees may be higher because of having professional management.
  • Cash drag - There are many investors selling or buying each day, so a mutual fund has to keep a proportion of the fund in cash to stay liquid.
  • Dilution - An investor can be in so many funds that the funds counteract each other and defeat the investor's goals.

Mutual fund selection by an investor or someone in a retirement plan requires a careful selection based on the priorities and goals of the investor.

Tax Treatment and Restrictions

Upon creation, mutual funds have to go through the same registration process with the Securities & Exchange Commission as individual offerings. They are also regulated by the SEC and have to submit regular financial statements. Mutual funds, because of the regulation, usually only pick registered stocks and bonds.

Mutual funds based receive dividends and interest payments based on the stocks and bonds in the fund. These distributions are passed on to the shareholders of the mutual fund and are taxed as ordinary income to the investors. A mutual fund shareholder can choose to have the earnings stay in the account but must still pay income taxes.

A participant in a 401(k) chooses among various mutual fund options provided by the administrator of the 401(k). Dividends and interest payments are not distributed but show as earnings in the account, and the participant does not have to pay income taxes until they retire.

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