Mutual Funds
Definition:
- Are portfolios that invest into a variety of chosen shares or bonds by using the fund gathered from a number of investors (Dass & Massa, 2014).
Benefits:
- Professional management: Mutual funds are usually managed by a funds’ management team that consists of few financial experts with professional skills (Ericsson, et al., 2005).
- Risk Reduction: A reduced portfolio risk is achieved through the use of diversification (Valley Vista Enterprises, 2014). It is easier to maximize the benefits of diversification by owning mutual funds as most mutual funds will invest in anywhere from 50 to 200 different securities. Stockholders might not able to purchase and hold too many stocks at the same time. For example, investor A owns 100 stocks in market through the ownership of one mutual fund that costs him $100,000. However, with the same amount of the money, he only can invest into 10 to 50 stocks.
- Accessibility: Mutual funds are common and easy to buy (U.S. Securities and Exchange Commission, 2014). They typically have low minimum investments as compare to ETFs and direct equities which require investors to purchase a minimum number of stocks or units.
- Arbitrage: There is no price fluctuation throughout the day as mutual funds only traded at the closing net asset value (NAV) (Wilmington Trust, 2014). Therefore, it can eliminate the arbitrage practices where the investor makes profit from the price differences in that asset by continuously selling and buying it.
Risks:
- Low transparency: Mutual fund holders are not free to invest in what stocks or bonds that they preferred and fund manager is not required to report to them on what stocks or bonds that have invested. Moreover, the mutual fund holders m...
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...a low correlation through diversification. In addition, overlapping can be eliminated by constructing a portfolio with bond and equity funds that are not perfectly correlated.
Diversification in different mutual funds sometimes might not be as effective as portfolio with individual securities (Fabozzi & Francis, 1979). This is because investors might experience overlapping in mutual funds. Overlap usually occurs when an investor owns more than two mutual funds that hold the similar securities. For example, diversification is no longer effective when an investor owns two equity funds that invested in most of the similar stocks as they will be exposed to the similar area which will increase the market risk. Thus, a well-diversified portfolio should contain different types of mutual funds such as equity funds, bond funds, real estate investment trust funds and etc.
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