The Mutual Fund as an Investment Diversification - Essay Example

? Mutual Funds Introduction With the increasing risk of the financial markets brought on by the American recession and the European Sovereign Debt Crisis investors have increasingly looked to safe havens for their money. One of the most prominent and conservative means of investment diversification has been the mutual fund. Mutual funds are securities that are registered with the Securities and Exchange Commission (SEC). Broadly speaking, they are composed of stocks, bonds, short-term money market instruments, and other securities that function as a means of hedging against possible declines in a security or investment sector. The main understanding is that this diversified approach will provide the investor an option that protects them against market fluctuations, as when one security drops in value, another will increase. A manager or board of directors oversees these funds. The board hires a fund manager and works to ensure that the mutual fund is managed in the intended interest of the shareholders. This essay examines the advantages, disadvantages, and different types of mutual funds. Advantages There are a great variety of advantages to investing in mutual funds. One of the most prominent such aspects is the increased amount of diversification. In terms of portfolio theory, diversification constitutes perhaps the most overarching concept. Essentially diversification is the gathering together of diverse investment securities as a means of guarding against the failure of one specific sector. While it is possible for investors to diversify their portfolio through a widespread purchase of stocks, such a process is both extensive and also contains liquidity issues. In terms of liquidity, most brokerage firms attach a fee to individual trades, such that an individual attempting to withdraw money from a portfolio of diversified stocks would be required to pay a series of fees; mutual funds offer liquidity in terms of one direct and easily accomplished sale (Pozen, Hamacher, 2011). Another prominent advantage of mutual funds is that they operate in terms of economies of scale. Essentially the equivalent of economies of scale is volume discounts in department stores. In the context of mutual funds, a wide variety of investment funds are collated allowing the fund manager to gain greater value per purchase (Pozen, Hamacher, 2011). Divisibility is another prominent advantage to investing in mutual funds. Divisibility can be understood in terms of the purchase of a wide variety of stocks. It’s noted that, “Smaller denominations of mutual funds provide mutual fund investors the ability to make periodic investments through monthly purchase plans while taking advantage of dollar-cost averaging” ("Advantages of mutual," 2009). Essentially this indicates that through a mutual fund, an individual with modest means is able to invest in a great amount more stocks than they would if they only purchased the securities on their own. This allows for considerably greater amounts of diversification. Another prominent benefit of investing in mutual funds is that they are under professional management. The obvious implications of this are that an experienced and knowledgeable professional will be overseeing the securities and investment strategy. Ultimately, the cumulative advantage of these benefits makes mutual funds an attractive option for conservative or inexperienced investors. Disadvantages While there are a great variety of advantages to investing in mutual funds, there are also a number of prominent disadvantages. Even as mutual funds offer a generally conservative investment option as compared to stocks, precious metals, or derivatives, there is nonetheless a degree of risk associated. The main understanding in these regards is that even with extensive levels of diversification, macroeconomic elements oftentimes contribute to a large-scale market decline. In these regards, individuals that do not have the financial wealth or patience to out-wait market downturns might find mutual funds an unattractive option (Pozen, Hamacher, 2011). Instead, the more conservative approach of investing in United States Treasury bills or fixed-income bonds provides more stable investment solutions. Another frequently occurring disadvantage of mutual funds is the problem of overdiversification. One considers, “overdiversification (also known as diworsification) occurs when investors acquire many funds that are highly related and, as a result, don't get the risk reducing benefits of diversification” ("Disadvantages of mutual," 2009). Within this context of understanding the investor in the mutual fund runs the risk of the investment manager placing too high an emphasis on a single sector, that in-turn affects the entire portfolio; one understands the potential of such an occurrence, as oftentimes money managers will possess a disproportionate amount of knowledge in one sector over another, creating a greater potential for an overdiversified mutual fund. Another disadvantage is the heavy reliance mutual funds have on cash funds. While one of the primary benefits of mutual funds is their great degree of liquidity, as a means of offering this liquidity through easy withdrawal options, it’s necessary for the fund manager to retain a considerable amount of investment capital in cash. From an investment perspective, having such a high proportion of the capital in cash is counter-productive to investment gains. Still another prominent concern is the loss of control the investor gains over their investments. Not only does investing in mutual funds necessitate that the investor pay high fees to the fund manager, it also eliminates the opportunity for the investor to keep tabs on their investment. With the great amount of securities contained in a mutual fund, security analysis through financial ratios or similar market indicators is made all but useless. Such lack of control reduces the checks and balances on the fund manager. Different Types of Mutual Funds While all mutual funds function through diversification, there are a variety of types of mutual funds. The two main types of mutual funds are open-end funds and closed-end funds. Open-end funds provide a great amount of liquidity, as they are willing to buy back their shares from investors at the end of the business day. These funds may have greater degrees of fluctuation, as the investments are determined on the investment pool, which fluctuates daily (Fink 2008). Closed-end mutual funds are the exact opposite of open-end. Rather than the investor having the option of selling their mutual fund back to the management firm, they must sell the fund on the stock exchange. These mutual funds are then subject market valuations (Fink 2008). Two other forms of mutual fund are unit investment trusts and exchange traded funds (Fink 2008). Unit investment trusts are a hybrid form of closed and open-end funds. In these regards, these funds are offered on the market through an initial public offering, however the investor has the option of either selling the fund to the creator or selling it on the open market. Notably, these funds do not have a professional investment manager (Fink 2008). Exchange-traded funds offer are a relatively new form of mutual fund (Fink 2008). Similar to unit investment trusts, exchange-traded funds are a hybrid form of open and closed-funds. The exchange-traded fund are sold daily on the stock exchange, as well as being bought by the original investment company; they are differentiated from unit-investment funds as the investment firm regularly purchases large blocks of these funds to ensure their market price is closely aligned with the price the firm is willing to pay the investor for them. Conclusion In conclusion, this essay has examined mutual funds. In this context of understanding, mutual funds have been considered in terms of their advantages and disadvantages, as well as the various types of mutual funds. It’s demonstrated that mutual funds offer great diversification levels. Still, aggressive investors may not be happy with the lack of control they have over this investment and the mutual fund’s relatively conservative approach. References Advantages of mutual funds. (2009). Retrieved from http://www.investopedia.com/articles/basics/03/040403.asp Disadvantages of mutual funds. (2009). Retrieved from http://www.investopedia.com/articles/basics/03/041103.asp Fink, M. (2008). The Rise of Mutual Funds. Oxford University Press. Pozen, R.; Hamacher, T. (2011). The Fund Industry: How Your Money is Managed. John Wiley & Sons. Read More