What are Mutual Funds?
Mutual Funds Defined

So, just what are mutual funds? Mutual funds are large, diversified portfolios of securities selected by skilled securities analysts and managed by highly qualified investment professionals. Here, the term "security" refers to any transferable claim on assets and includes derivative securities which derive their value from the underlying assets. Mutual fund shares are securities, too.

Every mutual fund has a book of rules called a prospectus that is specific to that fund. Mutual funds are managed in accordance with the objectives, strategies and other criteria stated in the their prospectuses. The prospectus, which is described in detail in the subsection entitled "The Mutual Fund Prospectus", provides you with all the details about any particular mutual fund.

Mutual funds cover the full spectrums of asset classes, investing styles and financial markets, all of which can be determined by reading a fund's prospectus. These three factors, asset class, style and geography, define the various fund types, which are described in the section entitled "Types of Mutual Funds."

When a mutual fund is formed, there are significant upfront costs that must be borne by the fund's sponsor. After the preliminaries have been dispensed with and an initial investment of at least $100,000 has been made by the fund's advisor and/or sponsor, shares can be offered to the public.

The fund's objective, strategy, the types of securities it will invest in and the fees the fund manager will charge shareholders are presented to investors in the fund's prospectus. The fund's assets are then sold to investors in the form of mutual fund shares and the fund's managers proceed to purchase securities that conform with the prospectus.

The price of these initial shares is determined by dividing the fund's net assets, which at the time of the offering would be the $100,000+ initial investment, by the number of shares the sponsor chooses to offer. The choice of the initial number of shares is usually determined on a subjective basis by the fund's sponsor to arrive at a per share price that is on a par with the price of similar funds and deemed to be appealing to investors, i.e., there's no rationale for this other than marketing strategy and investor psychology. As this price is arrived at by dividing the fund's net assets by the number of shares, the price of the shares is their net asset value (NAV). The NAV will vary as soon as the initial investment has been made, even if it is parked in an interest-bearing account, and from that point on the NAV will be recomputed at the end of each trading day.

Once the initial shares have been sold to investors, new shares are created at the current NAV whenever new money flows into the fund and that money is invested in accordance with the prospectus. Whenever shares are sold (redeemed) by investors, those shares are taken out of play, securities are sold from the portfolio to cover the cost of the redemptions and the NAV is computed by dividing the remaining assets by the remaining shares outstanding. Thus sales and redemptions should have no effect on NAV.

In reality, most mutual funds keep a portion of their assets in cash and this cash can be used to handle the ordinary net volume of redemptions, which avoids the need to sell securities immediately to buy back shares redeemed by investors. Handling redemptions in this manner gives the fund manager some latitude in the timing of the sale of securities, which is a benefit to the remaining shareholders.

Purchasing shares of mutual funds is the most cost effective way for individual investors to assemble a broadly diversified portfolio of professionally managed assets. If you've been working your way through this site from the beginning, you already knew that. Now you also know what mutual funds are, how they are formed and how their shares are priced.

Return to the top of What are mutual funds?

Return to the introduction to mutual fund investing.

Move on to the next subsection, "Mutual Fund Prices."