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Mutual funds are also sometimes known as open-end funds. These are portfolios of securities, mainly stocks, bonds and money market instruments. There are several important aspects of mutual funds. First, investors in mutual funds own a pro rata share of the overall portfolio. Second, the investment manager of the mutual fund actively manages the portfolio, that is, buys some securities and sells others. Third, the value or price of each share of the portfolio, called the net asset value (NAV), equals the market value of the portfolio minus the liabilities of the mutual fund divided by the number of shares owned by the mutual fund investors. Fourth, the NAV or price of the fund is determined only once each day, at the close of the day. For example, the NAV for a stock mutual fund is determines from the closing stock prices for the day. Fifth, and very importantly, all new investments into the fund and withdrawals from the fund during a day are priced at the closing NAV (investments after the end of the day or on a non-business day are priced at the next day’s closing NAV).

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The number of and assets in mutual funds grew significantly during the 1990s. At this time, there was a significant shift by individual investors from real estate and other tangible assets to financial assets. Discretionary financial assets increased from 34% in 1989 to 44%. Households increased their preference for indirect ownership through mutual funds over direct ownership of stocks and bonds. By the end of 1999, mutual funds accounted for 28% of household discretionary assets, up from 12% at the end of 1989. In addition, 85% of equity-owning households held a portion of their stocks in mutual funds in 1999, up from 50% in 1992 (Fabozzi, Modigliani, Jones & Ferri, 2002). From 1990 to 1999, the number of mutual funds also rose, from approximately 2,900 to 8,000. According to the Investment Company Institute, the assets invested in mutual funds have increased significantly, from $134 billion to $6,846 billion in 1999 (Reid, 2000). Mutual funds must have a few advantages to which this significant growth can be attributed. They are:

Advantages of Mutual Funds:

Diversification:

This is one of the primary advantages of a mutual fund and is one rule of investing that both large and small investors should follow. An effective risk management technique, investors can mix investments within a portfolio. For example, if an investor buys stocks in the retail sector and then offsets them with stocks in the industrial sector, he has reduced the impact of the performance of any one security on his entire portfolio. A truly diversified portfolio is one which contains stocks with varying capitalizations and from different industries and bonds with different maturities and different issuers.

While this may be a tall order for an individual investor, a mutual fund facilitates this. When an investor purchases mutual funds, he is given the immediate benefit of instant asset diversification and allocation without spending a lot of money on creating an individual portfolio. Hence, the investor has readily diversified with minimum investment. As a stock mutual fund invests in many stocks, if a few securities in the mutual fund lose value or become worthless, the loss maybe offset by other securities that appreciate in value. The opportunities are endless: an investor can engage in even further diversification by investing in multiple funds which invest in different sectors or categories. This helps to reduce the risk associated with a specific industry or category (Mutual Fund Fact Book).

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Economies of Scale:

Economies of scale is a concept which perhaps can be best understood by an example. It is denoted by the way volume discounts work: a lot of stores have this offer that the more of one product that a customer buys, the cheaper that product becomes. Like the price per doughnut is usually lesser for a dozen doughnuts than for a single one. This concept also holds true for the purchase and sale of securities. If an investor buys only one security at a time, the transaction fees will be comparatively higher.

Mutual funds enjoy this advantage due to their buying and selling size and in this way; they reduce transaction costs for investors. When an investor buys a mutual fund, he can diversify without the various commission charges associated with the transaction. If he would have to buy 10-20 stocks needed for diversification, the commission charges he would have to pay would be huge and also, every time he would want to modify his portfolio, he would have to pay additional transaction fees. Hence, with mutual funds, he is able to make transactions on a much larger and cheaper scale (Mutual Fund Fact Book).

Divisibility:

This is another advantage that mutual funds offer. Often, a lot of investors don’t have the exact sums of money to buy lots of securities. At most times, a mere $100 or $200 is not enough to buy a round lot of a stock, especially after paying commissions as well. With mutual funds, investors can purchase securities in smaller denominations, ranging from $100 to $1000 minimums. Investors no longer have to wait until they have enough money to buy high-priced investments. This factor is related to the next advantage on our list (Fabozzi, Modigliani, Jones & Ferri, 2002).

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Liquidity:

Mutual fund shares are highly liquid and orders to buy or sell are placed during market hours. But, it should be remembered that orders can not be executed until the close of business when the NAV of the fund can be determined.

Professional Management:

The professional management that a mutual fund offers is definitely an important advantage. The investment professionals, who manage and supervise the mutual funds, decide when to buy or sell securities according to the stated objectives