A mutual fund is a form of group investment that pools money from many investors who have bought shares in the fund, and invests their money in stocks, bonds, short-term money market instruments, and/or other securities. Shareholders receive an equity position in the fund in return for the money they give when they buy fund shares.

Legally known as an "open-end company", a mutual fund is one of three basic types of investment companies available in the United States (along with closed-end funds and UITs - unit investment trusts). They are classed as open-end funds as there is no limit to the number of new shares that they can issue, and shareholders may simply add as much money to the fund as they want.

Fund Management

A mutual fund may be either actively managed or indexed. Actively managed funds are changed on a regular basis by a fund manager in order to maximize their profitability. The fund manager trades the fund's underlying securities, realizing capital gains or losses, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. An indexed fund simply uses one of the major indexes and buys according to that index. Actively managed funds change more frequently than indexed funds, but have more potential for profit.

Share Values

The value of a share of the mutual fund is known as the net asset value per share (NAV). NAV is calculated by adding up the market value of all the fund's underlying securities, subtracting all of the fund's liabilities, and then dividing by the number of outstanding shares in the fund. Mutual funds calculate their NAVs once per trading day, at the close of the trading session. The resulting NAV per share is the price at which shares in the fund are bought and sold (plus or minus any sales fees).

Shareholders buy and sell shares in open-end mutual funds from the mutual fund itself or one of its agents; they are not traded on exchanges.

Advantages

A mutual fund can offer an easy way to invest in something with a higher return than, say, interest earned at the bank, while keeping funds fairly liquid. It also eliminates the need to track the market oneself. Most mutual funds will allow you to buy into the fund with as little $1,000, while some funds may allow a 'no minimum' initial investment, if the shareholder agrees to make regular monthly contributions of say $50 or $100.

There is also a huge choice of mutual funds each with its own objectives and focus. This enables investors to choose a mutual fund that most closely matches their own particular investment objectives, or allows them to invest in funds that have specific social agendas, political slants and religious inclinations. However, the flipside of this is that as mutual funds are available for virtually every investment strategy, every sector and every country of the world, the process of selecting a fund can be daunting for some.

Disadvantages

Critics of this type of investment point out that barely 25% of mutual funds outperform the Standard and Poor's 500 Index, which means that around 75% of the time, more profit would have been made if the investor had simply bought equal shares in all 500 of the companies currently on the S&P 500.

In addition, although this type of investment is regulated by the government, mutual funds are not insured against losses. This means that despite the risk-reducing diversification benefits provided by mutual funds, it is possible (although very unlikely) that you could lose your entire investment.