Mutual funds sell shares to individuals, pool these funds, and use them to invest in securities.
Mutual funds are classified into three broad types. Money market mutual funds pool the proceeds received from individual investors to invest in money
Financial institutions that sell shares to individuals, pool these funds, and use the proceeds to invest in securities.
market (short-term) securities issued by firms and other financial institutions. Bond mutual funds pool the proceeds received from individual investors to invest in bonds, and stock mutual funds pool the proceeds received from investors to invest in stocks. Mutual funds are owned by investment companies. Many of these companies (such as Fidelity) have created several types of money market mutual funds, bond mutual funds, and stock mutual funds so that they can satisfy many different preferences of investors.
Role of Mutual Funds as Financial Intermediaries
When mutual funds use money from investors to invest in newly issued debt or equity securities, they finance new investment by firms. Conversely, when they invest in debt or equity securities already held by investors, they are transferring ownership of the securities among investors.
By pooling individual investors' small investments, mutual funds enable them to hold diversified portfolios (combinations) of debt securities and equity securities. They are also beneficial to individuals who prefer to let mutual funds make their investment decisions for them. The returns to investors who invest in mutual funds are tied to the returns earned by the mutual funds on their investments. Money market mutual funds and bond mutual funds determine which debt securities to purchase after conducting a credit analysis of the firms that have issued or will be issuing debt securities. Stock mutual funds invest in stocks that satisfy their specific investment objective (such as growth in value or high dividend income) and have potential for a high return, given the stock's level of risk.
Because mutual funds typically have billions of dollars to invest in securities, they use substantial resources to make their investment decisions. In particular, each mutual fund is managed by one or more portfolio managers, who purchase and sell securities in the fund's portfolio. These managers are armed with information about the firms that issue the securities in which they can invest.
After making an investment decision, mutual funds can always sell any securities that are not expected to perform well. However, if a mutual fund has made a large investment in a particular security, its portfolio managers may try to improve the performance of the security rather than sell it. For example, a given mutual fund may hold more than a million shares of a particular stock that has performed poorly. Rather than sell the stock, the mutual fund may attempt to influence the management of the firm that issued the security in order to boost the performance of the firm. These efforts should have a favorable effect on the firm's stock price.