Now here’s a good question.
You’re looking at your 401k plan and you’ve got all these funds listed. They show expense ratios, past performance, and list all kinds of other statistics. The funds have names that maybe you can understand and maybe you can’t. Over here is the “FTSE All-World Ex-US Small Cap” fund and over there is the “Oakmark” fund.
I mean, who chooses these names? Are they just randomly generated by robotic gerbils?
So let’s start with the basics. A mutual fund is, actually, what it sounds like it is. It’s a fund, and people get together to start it, making it “mutual”.
Let’s say you want to own a diversified stock portfolio. But you are only a small investor starting out, and you really can’t afford to buy hundreds of different stocks to set up your portfolio in a rational way. On top of that, you really don’t want to actively manage your portfolio of stocks on a day-to-day basis. What do you do?
Well, you could pool your money with other investors so that you you have enough of a fund to buy that diversified portfolio. Then, you could hire somebody to manage that pool of money so that you don’t have to manage it. Finally, you could call your share of the pool of money a…”share” and then you could trade that share. This would allow you to purchase this diversified portfolio of stocks in even very small increments, by buying shares of to pooled investment fund.
And that’s a mutual fund.
A bunch of people pool their money together so that they can get a better investment portfolio than any of them could achieve on their own.
The key is that the mutual fund company does not own the fund. They really don’t own much of anything, actually. You and the other investors own the fund. The fund company merely runs the fund, advises the fund, does all the paperwork. If the fund company goes out of business that will be annoying, because some other company will take over management of the fund and you might not like them. But you won’t lose a dime if your fund company fails. The worst case scenario is that the fund will just be liquidated and you’ll get cash in exchange for your shares.
Also, mutual funds are tightly regulated. I made fun of the names earlier, but if a fund calls itself a “stock fund” then it has to be that. Funds which have names like “Wellington” have more leeway to do what they’d like. But particularly with index funds, the name is what the fund is. If a fund calls itself the “Total US Stock Market Index Fund” then that is what it has to be.
Mutual funds are also required to report exactly what they own to the SEC, and they must mark their portfolios to market every single day. “Mark to market” means they are not allowed to “estimate” what their fund is worth. They have to be exact.
This is different from hedge funds, which are not required to report what they own, and which are allowed to “estimate” what they hold. This is why you hear about fraudulent hedge funds but not fraudulent mutual funds.
Alright, now you know what a mutual fund is. So that’s no longer an excuse. Time to start investing!