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The Definition of a Mutual Fund Revealed

Richard Beardsworth Pension Expert

By Richard Beardsworth.

Independent Financial Advisor

More Reading on Personal Pensions...

A mutual fund is an investment tool utilised by a majority of pension operators to provide a relatively low-risk option to members. It is also a tool used by independent investors operating outside the confines of a typical pension. Mutual funds offer quite a bit of flexibility as well as a comfortable risk-reward ratio.

If you are considering investing in one of these opportunities, you should first know the definition of a mutual fund as well as its fundamental principles. This guide will explain everything you need to know. Please understand that while mutual funds tend to be low risk as compared to other, more volatile alternatives, no investment is 100% without risk. You can still lose with mutual funds if those funds do not perform well.

Definition of a Mutual Fund

A mutual fund is simply a fund that combines the investments of many investors, usually hundreds or thousands, in order to create a large amount of capital that can then be invested in opportunities like stocks and shares. Investopedia, the popular investment encyclopaedia and dictionary, defines the mutual fund as follows:

“An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.”

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Mutual funds are also known in the UK as either unit trusts or open-ended investment companies. The differences between the two are rather subtle. With a unit trust, money is invested with the understanding that all profit is returned directly to investors rather than redirected back into the fund to generate further growth. The open-ended investment company is similar in operation, but there is one significant difference: operators can adjust the size of the fund at any time by either eliminating or issuing new shares.

Funds are always controlled by fund managers consisting of either an individual or a team of managers with expertise in securities. Such knowledge is critical, given the fact that the average mutual fund invests in stocks and shares along with other opportunities. A fund manager without significant securities expertise presents too much of a risk.

Mutual Fund Investment Basics

When you invest in a mutual fund, you are giving your money to fund managers who have the fiduciary responsibility to earn as high a return as possible. You may only invest a few thousand pounds that, by itself, may not do much for you if you were to invest in stocks and shares individually. Combining your money with that of other investors increases everyone's earning power exponentially. In theory, the earnings are greater as a result.

There are four terms you need to know in order to understand how mutual fund investing works:

  • Passive Fund – In a passive mutual fund, the fund manager does not explicitly choose stocks to purchase. Rather, the fund is spread out across a given market and is linked to a particular exchange or track. For example, you may invest in a fund that is linked to the FTSE 100.
  • Active Fund – With an active fund, the fund manager picks and chooses investments on a regular basis. The idea is to buy and sell in order to take maximum advantage of the market on any given day. In essence, the manager of an active fund plays the role of a stockbroker whose goal is to make you as much money as possible.
  • Accumulated Class – An accumulated class fund is a fund in which all dividends are returned to the fund to increase its earning power. The final value of your investment is determined by applying dividends across your entire investment term to the amount you invested. A unit trust is typically established as an accumulated class fund.
  • Income Class – An income class fund returns dividends directly to investors as cash. Those dividends can accumulate in the investor's account or be reinvested in the fund for greater earnings. An open-ended investment company will often be set up as an income class fund.

It pays to know these terms if you are offered the opportunity to invest in mutual funds through your pension. If you have multiple options, a mutual fund may or may not be appropriate to your investment strategy. But you may not have an option. Some pensions invest solely in mutual funds due to their relatively low risk. Keep reading to learn more.

Finer Points of Mutual Fund Investing

Now that you know the definition of a mutual fund, it is time to talk about some of the finer points of investing in these vehicles. As previously mentioned, mutual funds are a favourite among pension operators because of their low-risk profile. Why are mutual funds low risk?

Mutual funds utilise two components to reduce risk. The first component is the one we have already talked about: combining investment monies from multiple investors to increase earning power. This strategy spreads losses across every investor in the plan, minimising how much each person loses should the fund not perform well.

The second component used by fund managers is the opportunity to invest in multiple stocks and shares. Whether you are talking about a passive or active fund, all of the money in a mutual fund is spread out across a vast array of opportunities. For example, let us just assume a passive fund invested in 100 different stocks and shares. We have chosen this number randomly, so do not assume we are speaking about a particular fund here.

By investing in 100 different stocks, fund managers are spreading out their risk considerably. It's unlikely that all 100 – or even a majority of them – will suffer significant losses over an extended amount of time. The odds say that such funds will at least break even although they historically do make a fair return over time.

A few other finer points you need to know are as follows:

  • Charges – Mutual fund managers have to earn a profit in order to stay in business. Therefore, there are always charges associated with investing in a mutual fund. Those charges can be based on a flat rate fee, a percentage of the fund's total value at any given time, or a combination of both. Charges will be critical to your investment decisions.
  • Minimum Contributions – Some mutual funds require minimum contributions. One fund might require a minimum of £500 while another sets the minimum and £1,000. A mutual funds offer through your pension will likely not apply minimums to individual savers.
  • Diversification – A primary benefit of mutual funds is the opportunity to diversify. Diversification lets you spread your investment widely in order to increase returns and reduce risk.
  • Liquidity – Mutual funds also offer a fair amount of liquidity. In other words, you can get out of a mutual fund at any time with little or no penalties involved. For the pension saver, that is important should one want to access some of the money saved prior to reaching retirement age.
  • Flexibility – Lastly, mutual funds sometimes offer the flexibility to transfer your money from one set of investments to another. In other words, you may invest in a mutual fund that is marketed as a family of funds. You can move your money between every member of the family indiscriminately.

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As you can see, there is more to mutual fund investing than merely knowing the definition of a mutual fund. Now you know at least the basics, you might want to consider mutual funds as part of your pension investing or as a separate opportunity altogether. Mutual funds that perform well can pay excellent returns while mitigating your financial risk significantly. Given all they have going for them, it's surprising that more people do not take advantage of them.

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