Important Terminology for Mutual Funds
Just about every investor with actively open and operating brokerage or retirement accounts is invested in at least one mutual fund. They are one of the greatest investment creations ever, primarily due to their ability to maximize growth by minimizing risk as much as possible. I enjoy talking about mutual funds with investors and clients; mostly because they serve as a safe and easy way to ensure your money grows over time.
There are a few terms that savvy mutual fund investors should know, and since I am currently the lead instructor on the College for Financial Planning's mutual funds designation, I thought I would share with my readers are few of the important terms used when discussing mutual funds:
Professional Management Star" System or Team System" : All mutual funds have a designated manager or team who are responsible for the daily decisions and trading actions of the fund. This way, someone specific is held accountable for the fund's performance, or underperformance as the case may be. Some implement what is called a "star" system, where one very famous and popular fund manager is hired to run a portfolio and are included in the marketing material since their reputation precedes them. For example, Bill Gross is a "star" manager at Janus Capital after he was a stellar portfolio manager for PIMCO.
Diversification: Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. It strives to smooth out unsystematic risk events in a portfolio so the positive performance of some investments neutralizes the negative performance of others. Therefore, the benefits of diversification hold only if the securities in the portfolio are not perfectly correlated. Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Investing in more securities yields further diversification benefits, albeit at a drastically smaller rate.Further diversification benefits can be gained by investing in foreign securities because they tend to be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments gives an investor a small cushion of protection against losses due to an American economic downturn.Most noninstitutional investors have a limited investment budget and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with an inexpensive source of diversification. To learn more on diversification for mutual funds, check out this entry on Investopedia.
Organizational Structure of a Mutual Fund: Mutual funds are made successful thanks to the efforts of a wide variety of individuals at various levels within their own unique hierarchy. Here is an example of what a typical mutual fund corporate structure looks like: