What is a Mutual Fund?
A mutual fund is a pool of investments used to buy a large portfolio of securities that will be managed by a professional advisor. When you buy a share in a mutual fund, you effectively buy a bit of each security held in the fund's portfolio. Mutual funds are sometimes referred to as "investment companies." These investment companies should not be confused with investment banking companies, which raise capital for corporations and municipalities. Mutual funds, on the other hand, are "investment companies" whose shares are sold to the public and which invest the proceeds of these sales in other public companies.
Mutual funds are not risk free investments. Even investing in mutual funds whose portfolios consist only of guaranteed U.S. government bonds contains an element of risk. Before you invest in a mutual fund, be sure you completely understand the risk. When you invest in a fund, the risk of total loss is lessened due to the diversity in the portfolio, but anyone who tells you that there is no risk involved in this investment is lying.
Debt Security. This is a security such as a bond or debenture, in which a specific amount is owed to the purchaser of the security. These are sometimes referred to as fixed-income assets.
Equity Security. This is a security such as a common or preferred stock in which the purchaser of the security actually purchases a piece of the company and is an owner of the company.
Issuer. The issuer is the entity from which the security is derived. AT&T is the issuer of its common stock, for example. Mutual funds are the issuers of their shares or units.
Government Backed or Guaranteed. The U.S. government guarantees that if you buy its bonds, it will pay the amount shown on the face of that bond. This does not guarantee that the market price will remain constant, and for that reason, a fund fully invested in government securities may still fluctuate in value. This is because interest rates and the prices of existing bonds move in opposite directions.
Call feature. Most debt instruments issued today allow the issuer to "call" the bonds. Call features pay back the bond's face value to the investor prior to the maturity date. The issuer will do this if interest rates drop, so it can refinance at a lower rate.
Option. An option is a right to buy or sell a security at a later time at a specific price. A fund that uses options to hedge its existing portfolio may be generally conservative, but other uses of options can range from moderate risk to outright speculation.
Interest/principal. It is important to understand that the principal is the amount you invest. Interest represents your earnings. Be sure to find out whether the periodic payments you receive represent only your earnings or whether you are receiving back principal (which reduces your investment).