Investing Classroom: What is a fund?

Buying a fund is a lot like going in on a group gift or joining a co-op--with people you'll never meet. Funds allow a group of investors to combine their cash and invest it. By pooling their money together, fund investors can sample a broader range of stocks or bonds than they could if they were trying to buy the stocks and bonds on their own.

The mechanics

Many people think of funds as "products." But when you buy a fund, you're actually buying an ownership stake in a corporation that in turn hires a money manager to invest its money. The price of a single ownership stake in a fund is called its net asset value, or NAV. Invest £1,000 in a fund with an NAV of £118.74, for example, and you will get 8.42 shares. (£1,000 / £118.74 = 8.42)

The fund manager combines your money with that of other investors. Taken altogether, those investments are called the fund's assets. The fund manager invests the fund's assets, typically by buying stocks, bonds, or a combination of the two. (Some funds buy more complicated security types.) These stocks or bonds are often referred to as a fund's "holdings," and all of a fund's holdings together are its "portfolio." A fund's type depends on the kinds of securities it holds. For example, a stock fund invests in stocks, while a small-company stock fund focuses on the stocks of small companies. What you get as an investor or shareholder is a portion of that portfolio. Regardless of how much or how little you invest, your shares are the portfolio in miniature.

For example, fund Fidelity Special Situations's three largest holdings are Vodafone (4.79% of its portfolio as of August 31, 2009), Royal Bank of Scotland (4.41%), and GlaxoSmithKline (4.35%). A £1,000 investment in that fund means that you own about £47.90 of Vodafone, £44.10 of RBS, and £43.50 of Glaxo. In fact, you own all 115 equities in the fund's portfolio.

The benefits

Funds offer some notable benefits to investors.

1. They don't demand large up-front investments

If you had just £1,000 to invest, it would be difficult for you to assemble a varied basket of stocks or bonds on your own. For example, with £1,000, you could buy one share of stock from the largest UK company, then one from the next largest, and so on, but it’s likely that you’d run out of money sometime before purchasing your 20th stock.

If you bought a fund, though, you would be able to sample many more types of stocks or bonds with that same £1,000.

2. They're easy to buy and sell

Whether you’re buying funds on your own or hiring a broker or financial planner to do it for you, funds are easy to buy. Once a fund company has your money, it often takes just a phone call or mouse click to buy shares in a fund. Of course, there are exceptions: Closed funds, for example, no longer accept money from new shareholders.

By the same token, it's also easy to sell a fund. Unlike many other security types, such as individual stocks, you don’t need to find a buyer when it's time to unload your shares. Instead, the vast majority of funds offer daily redemptions, meaning that the fund company will give you cash whenever you're ready to sell. Investors who own closed funds can also sell at any time.

3. They're regulated

Fund managers can't take your money and head for some remote island somewhere – they are regulated by safeguards put in place to protect investors.

The fact that funds are regulated shouldn’t give investors a false sense of security, however. Funds are not insured or guaranteed. You can lose money in a fund, because a fund's value is based on the value of all of its portfolio holdings. If the holdings lose value, so will the fund. The odds that you will lose all of your money in a fund are very slim, though--all of the stocks or bonds in the portfolio would have to go belly-up for that to happen. And history suggests that such a mass implosion is unlikely in the vast majority of fund types.

4. They're professionally managed

If you plan to buy individual stocks and bonds, you need to know how to read a company's cash-flow statement or assess the likelihood that a given company will fail to meet its debt obligations. Such in-depth financial knowledge is not required to invest in a fund, however. While fund investors should have a basic understanding of how the stock and bond markets work, you pay your fund managers to select individual securities for you.

Still, funds are not fairy-tale investments. As you will learn in later lessons, some funds are expensive and others perform poorly. But overall, funds are good investments for those who don’t have the money, time, or interest necessary to compile a collection of securities on their own.