shareholders of the fund. When you purchase shares, the fund manager invests your money, as well as the money contributed by the other shareholders.
The fund manager counts up the value of all the fund's holdings daily, figures out how many shares have been purchased by shareholders, and then calculates the Net Asset Value (NAV) of the mutual fund, the price of a single share of the fund on that given day. If you decide to buy shares, you just send the mutual fund manager your money, and they will issue new shares for you at the most recent price. This routine is repeated every day on an ongoing basis, which is why mutual funds are sometimes called "open-end funds." If the fund manager is doing a competent job, the NAV of the fund will usually get bigger, hence your shares will be worth more.
But exactly how does a mutual fund's NAV increase in worth? There are a couple of ways that a mutual fund can make money in its portfolio. Simply, a mutual fund makes money in its the same ways that your own portfolio of stocks, bonds, and cash would make money. A mutual fund receives dividends from the stocks that it owns. Dividends are shares of corporate profits paid to the stockholders of publicly traded companies. The fund may have cash in the bank that earns interest, or it might receive interest payments from owned bonds. Mutual funds are required to distribute the income they aquire through these venues to mutual fund shareholders. Most mutual funds do this twice a year, in a process termed an income distribution.
At the end of the fiscal year, a mutual fund makes another kind of distribution from the profits it may have made by selling stocks or bonds that have gone up in price. These profits are called capital gains, and the act of handing them out is called a capital gains distribution. Unfortunately, mutual funds don't always make money. If the mutual fund managers committed to some investments that didn't work out, for example selling some investments for less than the original purchase price, the fund manager may have report capital losses.
Losses are not pleasant in any investment venture, and funds are no different. Fortunately, these losses are subtracted from the mutual fund's capital gains before the money is distributed to the shareholders. If the losses exceed the gains, a mutual fund manager can compile these losses and use them to offset future gains in the fund's portfolio. This means that the mutual fund won't distrubute capital gains to shareholders until the fund had at least earned more in profits than it had lost (however, it may be wise to reconsider your decision to remain invested in a fund that's losing money if the rest of the market shows growth).
Pros and Cons of Mutual funds
Pros:
Diversification. A single mutual fund can hold securities from hundreds or even thousands of issuers, far more than most investors could afford on their own. This diversification sharply reduces the risk of a serious loss due to problems in a particular company or industry.
Professional management. Few investors have the time or expertise to manage their personal investments every day, to efficiently reinvest interest or dividend income, or to investigate the thousands of securities available in the financial markets. They prefer to rely on a mutual fund's investment adviser. With access to extensive research, market information, and skilled securities traders, the adviser decides which securities to buy and sell for the fund.
Liquidity. Shares in a mutual fund can be bought and sold any business day, so investors have easy access to their money. While many individual securities can also be bought and sold readily, others aren't widely traded. In those situations, it could take several days or even longer to build or sell a position.
Convenience. Mutual funds offer services that make investing easier. Fund shares can be bought or sold by mail, telephone, or the Internet, so you can easily move your money from one fund to another as your financial needs change. You can even schedule automatic investments into a fund from your bank account, or you can arrange automatic transfers from a fund to your bank account to meet expenses. Most major fund companies offer extensive recordkeeping services to help you track your transactions, complete your tax returns, and follow your funds' performance.
Cons:
As with any investment, mutual funds come with some cons, and you should understand those before making the commitment to invest.
No guarantees. Mutual funds are regulated by the U.S. Securities and Exchange Commission (SEC), which requires funds to disclose the information an investor needs to make sound decisions. Unlike bank deposits, mutual fund shares are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other agency of the U.S. government. In fact, the value of a mutual fund may fluctuate, even if the fund invests in U.S. government securities.
Diversification "penalty." While diversification eliminates the risk of catastrophic loss that would occur if you own a single security whose value plummets, it also limits the potential for making a killing in the market if that security's value shoots up. It's important to note that diversification does not protect you from a loss caused by an overall decline in financial markets.
Potentially high costs. Mutual funds can be a lower-cost way to invest when compared with buying individual securities through a broker. However, a combination of sales commissions and high operating expenses at some fund companies will reduce your investment returns. Compare the costs of mutual funds. High costs can badly damage the returns you receive as a shareholder. Use Vanguard's Compare Fund Costs tool to view the effect of mutual fund loads, sales charges, fees, and other expenses on the returns for Vanguard funds and funds from other fund families offered through Vanguard's FundAccess program.
Tax impact. The profits on a mutual fund investment are typically subject to federal (and often, state and local) income tax unless you're investing through a tax-free retirement or education account. If you invest in a regular taxable account, then dividend and taxable interest distributions you receive are taxed as ordinary income each year. A mutual fund also is required to distribute its net realized capital gains each year, and those distributions are taxed as either short-term gains (the same tax rate as ordinary income) or long-term gains (taxed at a lower rate), depending on how long the fund held the securities. A fund that buys and sells securities frequently may add to your tax bill with hefty capital gains distributions. You would also incur taxes on your capital gains-and pay taxes at short-or long-term rates depending on how long you had held the shares-if you redeem shares in a fund at a price higher than you paid for them.
