A mutual fund is a professionally managed company that collects money from many investors and invests it in securities such as stocks, bonds and short-term debt, equity or bond funds and money market funds.
Mutual funds are a good investment for investors looking to diversify their portfolio. Instead of betting everything on one company or sector, a mutual fund invests in different stocks to try to minimize portfolio risk.
The term is typically used in the US, Canada and India, while similar structures around the world include the SICAV in Europe and the open-ended investment firm in the UK.
What are indexes?
Index funds are passive mutual funds that mimic popular market indices. The Fund Manager does not play an active role in selecting sectors and stocks to build the fund’s portfolio, but simply invests in all the stocks that make up the index to follow. The weighting of the shares in the fund closely corresponds to the weighting of each of the shares in the index. This is a passive investment, i.e. the fund manager simply copies the index while building the fund’s portfolio and trying to keep the portfolio in sync with its index at all times.
If the weight
of a security within the index changes, the fund manager must buy or sell shares of the security to have its weight in the portfolio aligned with that of the index. While passive management is easier to follow, the fund does not always produce the same returns as the index due to a tracking error.
The tracking error occurs because it is not always easy to hold index stocks in the same proportion and transaction costs are borne by the fund in doing so. Despite the tracking error, index funds are ideal for those who do not want to take the risk of investing in mutual funds or individual stocks, but would like to take advantage of exposure to the broader market.