Continuing with our series, this blog describes [highlight]what is a mutual fund[/highlight]. And while my teachers at Chaminade High School in Mineola, told me I should not describe something by stating what it is not – that is where we will begin.
There are different types of financial assets. We have written two posts describing what a stock is and what a bond is. As a reminder, a stock represents fractional ownership in a company and a bond is when you lend money to a company or government. A mutual fund is not – on its own – a financial asset class.
Rather, mutual funds are designed to either own one, two or many different financial asset classes. We often meet with prospects or answer questions directed to the blog where people described their investments as some money in stocks, some money in bonds and some money in mutual funds.
So let’s now describe what a mutual fund is. Mutual funds were started to allow individuals to combine assets with other individuals to invest in various financial asset classes. The combining of these assets allows for the benefit of hiring a professional money manager who would manage the assets as directed by the owners.
For example, people invest in vacation home timeshares. By pooling their money, they able to purchase nicer properties then the individuals could purchase on their own. In addition, they can hire management to upkeep the properties while the owner is not present.
While I would not recommend buying vacation timeshares, the concept of pooling money to be able to hire professional managers and invest the money is similar. Because while it would be difficult to hire an experienced money manager if you were only investing a half million dollars, you could pool your money along with several thousand other people to be able to afford the compensation for a top-flight money manager.
The owners of the mutual fund (the financial contributors) would decide how they would like this pool of money to be invested or managed. The mutual fund manager would then be limited to invest the money in ownership of companies (stocks) targeted to a specific sector or specific country. While we do not use mutual funds that seek to achieve this, there are mutual funds that give the manager the ability to select whatever stocks that they believe would outperform the market. (Good luck with that one!)
A mutual fund could also be established to only purchase US government debt. Many of the 8000+ mutual funds are combination of stocks and bonds usually based on some time horizon. But as you can see mutual funds are not by themselves a separate asset class. You have to know what the mutual fund has invested in to determine the percent of money invested in each asset class such a stocks or bonds.
We are strong believer in institutional mutual funds which allows the investor to focus very specifically on the asset class that will be owned inside of each mutual fund. This allows for us as advisor to create an overall portfolio knowing at any moment what the mix of investments are for each of our clients. Knowing this breakdown – which is known as an asset allocation – is critical to both understanding the risk being taken as well as the expected performance over the long-term.
So now you know. It’s not enough to know that you own mutual funds. You have to dig into the prospectus in order to determine what instructions have been given to the manager as far as allocating the money currently invested in the fund.