Advantages of Mutual Funds

Advantages of investing through mutual funds vs. buying stocks and bonds directly include:
  • Investment decisions made by a professional portfolio manager
  • Ease of diversification
  • Ability to liquidate a portion of the investment without losing diversification
  • Simplified tax information
  • Simplified record keeping
  • Automatic reinvestment of capital gains and income distributions at net asset value
  • Safekeeping of portfolio securities
  • Ease of account inquiry
 
The first point is probably the main reason people buy mutual funds they have no knowledge of stocks, bonds, taxation, etc., and they have even less interest in learning. Let a professional portfolio manager often an entire team of portfolio managers decide what to buy and when to buy or sell it. As we mentioned, it's tough to have your own diversified portfolio in individual stocks and bonds because a few hundred or thousand dollars will only buy a few shares of stock or a few bonds issued by just a few companies.

On the other hand, a mutual fund would usually hold stock in, say, 100 or more companies, and their bond portfolios are also diversified. Therefore, even with the smallest amount of money accepted by the fund, the investor is diversified. This is called the "undivided interest concept," which means that $50 from a small investor owns a piece of all the securities in the portfolio, just as $1 million from a larger investor does.

Another bullet said, "Ability to liquidate a portion of the investment without losing diversification." That means if an investor owns 100 shares of IBM, MSFT, and GM, what is he going to do when he needs $5,000 to cover an emergency? If he sells a few shares of each, he'll pay three separate commissions. If he sells 100 shares of any one stock, his diversification is reduced. With a mutual fund, investors redeem a certain number of shares and remain just as diversified as they were before the sale. And, they can usually redeem shares without paying fees. Mutual funds can diversify their holdings by:

•    Industries
•    Types of investment instruments
•    Variety of securities issuers
•    Geographic areas

If it's a stock fund, it is typically a growth fund, a value fund, an income fund, or some combination thereof. No matter what the objective, the fund usually buys stocks from issuers across many different industries. In a mutual fund prospectus, there is typically a pie chart that shows what percentage of assets is devoted to an industry group. Maybe it's 3% in telecommunications, 10% retail, and 1.7% healthcare, etc. That way if it's a bad year for telecommunications or retail, the fund won't get hurt like a small investor who owns shares of only one telecom company and one retail company.

A bond fund can be diversified among investment interests. That means they buy debentures, secured bonds, convertible bonds, zero coupons, mortgage-backed securities, and even a few money market instruments to be on the safe side.

Even if the fund did not spread their investments across many different industries, they would purchase securities from a variety of issuers. If they focus on the retail sector, they can buy stock in a variety of companies Walmart, Target, Sears, Nordstrom, Home Depot, etc. And, since any geographic area could be hit by an economic slump, a tropical storm, or both, most funds spread their holdings among different geographic areas.

The Investment Company Act of 1940 defines a diversified company as:
"Diversified company" means a management company which meets the following requirements: At least 75 per centum of the value of its total assets is represented by cash and cash items (including receivables), Government securities, securities of other investment companies, and other securities for the purposes of this calcula-tion limited in respect of any one issuer to an amount not greater in value than 5 per centum of the value of the total assets of such management company and to not more than 10 per centum of the outstanding voting securities of such issuer.

So, how does the "Act of 1940" then define a non-diversified company?
"Non-diversified company" means any management company other than a diversified company.
If the fund wants to promote itself as being diversified, it must meet the definition above. For 75% of the fund's assets, no more than 5% of its assets are in any one company, and it doesn't own more than 10% of any company's outstanding shares.

If it doesn't want to abide by the definition, it must refer to itself as a "non-diversified fund." The term "management company" includes both open-end and closed-end funds. From there, each could be either diversified or non-diversified, leaving us with the following four types of Management Company:
•    Diversified Open-End Fund
•    Non-Diversified Open-End Fund
•    Diversified Closed-End Fund
•    Non-Diversified Closed-End Fund
Because closed-end funds use leverage, the most aggressive type above is the non-diversified closed-end fund.

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