Mutual Funds

Mutual Funds

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A mutual fund is an open-end investment company that invests money of its shareholders in a usually diversified group of securities of other corporations, as defined in the Merriam-Webster dictionary. Mutual funds help with financing and investing opportunities. They give the small investors a chance to invest their money in other areas besides stocks and bonds. There is multiple mutual funds to choose from and different reasons why shareholders should choose them. As popular as mutual funds have become, there is downfalls to them like most investment opportunities. In 2003, mutual funds were giving a bad name when a scandal was brought public. These opportunities and issues will be discussed.

Becoming major suppliers of funds in the financial market, mutual funds have become a very popular investment in recent years. Because of the diversity of investments, portfolio management’s expertise, and liquidity, mutual funds have grown rapidly over the past few years. One of the most popular group’s investing in mutual funds is people with self-driven retirement plans. This provides professionally handled money and pooled risk. There are more than 8,000 different mutual funds, with more than 88 million households owning shares of one or more.

Mutual funds pool investments by individual investors and use the funds to accommodate financing needs of governments and corporations in the primary markets. Investments in securities in the secondary markets are made as well. Mutual funds are used both by governments and corporations that need funding, which gives small investors a place to invest their money.

Small investors have limited funds to invest, so mutual funds provide an easier way for them to diversify their investments. Mutual funds pay out higher dividends then money markets or savings accounts, and the dividends are paid out faster with mutual funds then with individual bonds. Small investors can’t afford to diversify with such small amounts of money, so mutual funds allow them to invest in holdings of 50 or more securities. The minimum investments for some of these securities may be only $250 to $2,500. Mutual funds are a very low-risk investment, but still have credit and interest rate risks attached. Since the investments are spread out among a number of bonds the risk is lowered, more so then if it was invested all in one bond. Mutual funds are also more liquid then regular bonds; they can be bought and sold more easily. Mutual funds are also managed by experienced portfolio managers, so the investors don’t have to worry about managing the portfolio themselves.

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The portfolio managers are hired based on their expertise in analyzing economic and industry forecasts and how well they assess the potential impact of certain conditions that companies may have. The portfolio managers also have to make purchases based on what satisfies the wants of the small investors. The managers have to be able to change the structure of their folders in response to the changing economy.

There are three different kinds of bond mutual funds; they are U.S. bond funds, municipal bonds, and corporate bonds. U.S. bond funds invest in debt securities that are issued by the United States government and its agencies. These funds are said to be the safest of the three since it is backed by the U.S. government. These funds invest in such things as Treasury bills, Treasury notes, Treasury bonds, and mortgage-backed securities. The largest risk with U.S. bond funds is in relation to the fluctuation of interest rates and inflation.

Municipal bond funds invest in debt securities issued by state and local governments to pay for things like local projects such as schools and highways. Investors with high incomes are more interested in these funds than any other group because they are exempt from federal taxes and sometimes state taxes. Municipal bonds have a high credit rating due to the government backing. Municipal bond funds are more risky then the others, because the municipalities have been known to go bankrupt.

Corporate bond funds are just like they sound, bonds issued by corporations. The downfall to corporate bonds is that they are not backed by government organizations. If the corporation falls into financial trouble the bonds will likely default. The up side to corporate bonds is the pay out is greater then with municipal or U.S. bond funds.

The different classifications of mutual funds are also important; they are open-end, closed-end, exchange traded, and hedge funds. Open-end funds are open to invest at any time. Investors can purchase shares from the open-end fund anytime they want. Therefore, investors can sell the shares from the fund just as easy as they can purchase them. The number of shares in an open-end fund is always changing for this reason. There are numerous different categories of open-end funds, allowing investors to purchase shares that fit their managed portfolios. When mutual funds are mentioned in general it is assumed they are open-end funds, seeing that they are the most common type.

Closed-end funds sell a fixed amount of shares at one time and then have to resell them in the secondary market. Once the shares are bought they can not be sold back, they must be sold in the stock exchange. The number of outstanding shares sold usually remains constant and equal to the number of shares originally issued. 75% of closed-end funds are sold to bonds or debt securities the rest are sold to stocks. There are approximately 500 closed-end funds and a significant amount more of open-end are sold compared to closed-end funds.

Exchange traded funds are traded on the stock exchange just like stocks. They are traded on the exchange and their share prices change throughout the day. Exchange traded funds have a fixed number of shares and differ from the other to funds in that they are not actively managed. Since they are not actively managed they normally don't have capital gains and losses that must be distributed to shareholders. Although exchange traded funds are becoming more and more popular they have a disadvantage in which each purchase of additional shares must be done through the stock exchange, therefore there is a brokerage fee.

Hedge funds sell shares to the wealthy and financial institutions; they use the proceeds to invest in securities. They require a larger first investment and they are not as open as open-end funds. Hedge funds provide very little information to investors and are unregulated. They also invest in a wide variety of investments in search of high returns. Hedge funds end up being much more risky then any other fund.

There are many advantages and disadvantages to consider when thinking about investing in mutual funds. It's important to decided whether certain features are or aren't important to you. Professional management of the portfolio is an advantage to most. Some one else is hired to know the secrets of the trade. Professionals managers research, select and monitor the performances of the funds so the investor doesn't have to. Mutual funds come with lots of diversification; this strategy can help spread your investments across different companies and can help lower your risk if one company doesn't do so well. Affordability makes it possible for small investors who don't have a lot of money to invest. Mutual funds are also fairly liquid so investors can collect there share’s at any time.

Like most investments, mutual funds have a down side. No matter how well the investment does the investors still have to pay charges, annual fees, and other expenses. Even if the fund turns out poorly they don't have a choice but to pay the fees. Investors have very limited control over the invested portfolio. They do not always know what securities are being bought and sold or the timing of the trades. Mutual funds have high price uncertainty unlike stocks, which you can check whenever you would like.

As mutual funds continue to become popular ways to invest money, the public did look down on them for a period of time. In 2003, mutual funds went unfavorable and some say had overblown publicity. Some of the funds were allowing their large clients to buy and sell there fund's shares after the stock exchange's 4 p.m. closing. After the closing they continued selling the shares at the 4 p.m. prices. Therefore purchases were being made at prices no longer appropriate. When late trading occurs traders are allowed to purchase funds that lead to an unfair advantage the late traders gains over other traders. Under law monitored by the U.S Securities and Exchange Commission (SEC), mutual funds traded after 4:00 p.m. must be executed at the following day's closing price.

Market timing was also permitted by Janus, Bank One's One Group and Strong Capital. Fund firms allowed some clients to trade more frequently than allowed in their fund documents. Market timing is an investment strategy in which as investor tries to profit from short-term market cycles by buying and selling different markets sectors as they rise and fall in value. Market timing isn’t necessarily illegal; it’s the fact that they did it after the market was closed. This made for easy and also illegal profits for the mutual fund investments. Market timing is usually limited because it increases the cost of administering the mutual fund. The fund gets harder to manage because it needs extra cash to be able to pay out its liquidity.

The SEC launched its own investigation in which front-running was revealed. Certain mutual fund companies had been alerting favored customers when one or more of the company's fund was planning to buy or sell a large stock. The partners were in the position to trade shares in advance. According to the SEC the practice of front-running constitutes insider trading. After the investigation Strong Mutual Funds chairman resigned, in this case he was charged with market timing trading with the funds invested by his own company. Closely after this resignation the chairman of Putman Investments also resigned.

In the end a large number of mutual fund companies and investors, approximately 20, were caught in action. Potentially half of the American public who has invested in mutual funds was affected by this scandal. Most of the charges were civil, so no body went to jail. Authorities have struck deals with the companies for paying the fines and money back. All of the individuals who were involved in the scandal have been fired or resigned and are never allowed to work investments again.

Overall, mutual funds are a good investment to make. Diversifying your money is the surest way to make more of it. Nobody can be certain that the scandals are happening or will happen again, but portfolio managers still say the funds are virtually safe. Mutual funds are a good way for small investors to get their money invested with little maintenance to the portfolio at all. Although mutual funds have there downfalls as does everything, the little risk and high diversification is well worth it.


Sources


Madura, Jeff. Financial Markets and Institutions. Thomeson: South-Western, 2006.

Merriam-Webster Dictionary. “Mutual fund”. 2008. 17 March 2008.



“Mutual Fund Investing: Overview”. Smallcapinvestor.com. 2007.

http://www.smallcapinvestor.com/articles/05092007-mutual_fund_investing_overview



“Investors guide”. Mutual fund basics. 2008.

http://www.investorguide.com/igu-article-482-mutual-fund-basics-bond-mutual-funds.html



“Fortune” Making sense of Mutual fund scandals.

http://money.cnn.com/magazines/fortune/fortune_archive/2003/11/24/353794/index.htm
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