Definition: A mutual fund is an entity (either a trust or corporation) which actively manages your investment in a specific asset class (stocks, bonds etc.) or mixture of asset classes with the belief that the active management (asset selection) will outperform the market in general. Income and capital gains from mutual funds are typically taxed as long-term capital gains at 15%. There are mutual funds who focus on different assets, i.e. stock funds, or income funds (i.e. with bonds and other credit instruments), combination funds (bonds and stocks) and funds that specialize in certain sectors—i.e. energy, or health care, or retail, or gold etc.
Fancy/Alternative Names: Open-End Investment Companies, Management Investment Companies.
Advantages: Mutual Funds offer diversification and active management—which can be seen as positive if the mutual fund’s management has consistently done well—and not just due to the tailwinds of a bullish trending market. There are rules imposed on mutual funds to ensure minimum diversification levels as well as rules avoiding too much concentration in any single stock/position. Also, mutual funds are very liquid—at least in good times—which means you can get in and out fairly easily.
Risks/Disadvantages: Mutual Funds are a bit more expensive than other market vehicles, like ETF vehicles. In addition to its public price or “NAV,” there are typically a range of sales charges (which cannot exceed 8.5% of the NAV) associated with mutual funds. Be sure to know what they are (“front-end loads,” “back-end loads” and “12b-1” fees are often associated/charged based on whether you are Class A, Class B or Class C shareholder of the mutual fund.) It can get pretty confusing. The key is to ask your mutual fund representative or advisor to give you the bottom line on all the fees associated with a given mutual fund.
Further Reading: The performance of active managers (i.e. mutual fund managers) vs passively managed vehicles (i.e. ETF’s) is compared in Section 5 of “The Six Portfolio Secrets.”