Definition: A corporation that does not produce goods or services of its own, but instead carefully invests its shareholders’ money in the stocks and/or bonds of corporations that do.

Example: 100,000 people each buy 200 shares of Prudent Stock Mutual Fund, paying $50 per share, as follows:

200 shares * $50 per share = $10,000 per person

Now, let’s extend this out to the 100,000 investors around the U.S. who Prudent convinced to invest:

$10,000 per investor * 100,000 investors equals = $1,000,000,000, or $1 billion

Prudent received a total of $1 billion of new investors’ money. It takes this money and buys shares of 100 corporations it believes are going to do well in the future. The group of investments is known as its holdings. A year later, the value of the holdings as a group has risen to $1.1 billion.  The $100 million gain is 1/10th, or 10% of the $1 billion invested. While not offering a unique product or service of its own, over the course of a year Prudent has earned its shareholders 10%.

Investeach explains: You may have noted that Prudent actually does have a unique service to offer: skill in selecting the right corporations at the right time. In fact, Prudent is formally known as an Investment Company. Having skilled financial professionals investing your money is one of the supposed advantages of mutual funds.

The reason we say supposed is that over extended periods of time like a decade or more, the majority of fund managers do not beat the performance of the overall stock market. While the 10% rate of return Prudent achieved in our above example appears solid, would you feel the same way if you learned that the value of stocks overall rose 12% over the same year?

Another point to keep in mind is that professional managers don’t work for free. They charge a management fee for their services, and the fee is subtracted each year from the fund’s holdings. In our above example, if it cost $10 million to “run” (ie, manage) the fund, that is 1% of the $1 billion managed. So, the actual rate of return fund shareholders receive is 10% minus the 1% management fee, or 9%.

A second reason why mutual funds are popular with investors is that they achieve diversification. One mutual fund can hold up to 100 or more corporations. In these days of 0% commission trades, an individual can assemble a large portfolio at no cost, but to stay on top of what is happening with every one of the holdings is a serious responsibility that will consume a substantial amount of time to do properly.

There are thousands of mutual funds available to meet different investing objectives. For example, retirees may want to invest in income funds, those whose holdings pay significant dividends that they can live on. Younger investors may want to boost their wealth by investing in growth funds which hold the shares of rapidly expanding business and which may achieve significant share price appreciation going forward. 

Finally, in order to achieve the different objectives investors may have, some funds invest only in stocks (known as stock funds or equity funds), some only in bonds (known as bond funds or fixed-income funds), and some a combination of both (known as blend funds or hybrid funds).

Riddle me this:

1. While mutual funds appear to piggyback off the success of other corporations, there is a unique skill/service that they offer. What is it?
2. Why are many people not impressed by the skill/service you just identified?
3. What name do we give to the stocks and/or bonds a fund currently owns?
4. What name do we give to the amount of money the professionals managing the fund charge each year for their services?
5. Who pays this fee?
6. Identify a second advantage that mutual funds offer which cannot be easily managed by individual investors.
7. Identify which type of fund makes regular payments to its shareholders, which they may be relying on to live.
8. Identify the type of fund that is more suitable for a young person who can invest more aggressively with the hope of owning some corporations that soar over the coming years.
9. What two names do we give to funds which invest in both stocks and bonds?