How Money Really Works, Part 9: How Funds Spread Your Money

7. What is a fund, really

One fund can own pieces of thousands of companies. Here is how funds spread your money, in seven parts. Number seven: what is a fund, really? A fund pools money from many investors, a market regulator's investor guide says.

It invests that money in stocks, bonds, other assets, or a mix of these. Those combined holdings are called its portfolio, managed by a registered investment adviser. Each fund share is part ownership of that portfolio, with its gains and losses. Many funds set a relatively low amount for a first purchase and for later ones, the guide adds.

That regulator's guide to diversification says funds make it easy to own a small portion of many investments. Its example is a total stock market index fund, which owns stock in thousands of companies. That's a lot of diversification for one investment, the guide says. Which funds you can buy depends on the rules where you live.

Spreading money that way has a reason, and number six shows it. Subscribe for the next parts of this series: every source here is an official investor guide, linked below.

6. Why not just buy a few shares yourself

Number six: why not just buy a few shares yourself? Spreading money among different investments to reduce risk is called diversification, a market regulator's guide says. With only four or five individual stocks, the stock part of a portfolio won't be diversified, it says. You'll need at least a dozen carefully selected individual stocks to be truly diversified, the guide adds.

Because that can be so challenging, some investors may find it easier to diversify through funds. Funds may invest in a range of companies and industries rather than in one stock or bond. That helps lower your risk if one company fails, the guide says. Many investors also find it less expensive to diversify through certain funds than through individual stocks or bonds.

Still, a fund doesn't necessarily give instant diversification, especially if it focuses on one industry. Some exchange-traded funds have fewer investments, or may even track a single stock, the same regulator says. With narrowly focused funds, you may need more than one fund to get the spread you want, the guide says. Funds that invest in other funds can spread much further than any single fund, an industry regulator's guide says.

But their returns carry the fees of both layers, it adds. And as you add more investments, you'll likely pay more fees, which lower your returns, the market regulator's guide says. Fund choices and rules differ where you live. Funds come in a few main kinds, and number five shows them.

5. What kinds of funds are there

Number five: what kinds of funds are there? An industry regulator's guide says mutual funds fall into only a handful of major categories. Owning a bond fund is not the same as owning a bond, the industry guide adds. When you buy a single bond, you're promised a specific rate of interest and the return of your principal, the guide says.

A bond fund holds many bonds with different rates and end dates, so it makes no such promise. Stock funds invest in stocks, bond funds in bonds, and balanced funds in a mix of both. Because stocks and bonds tend to do well at different times, balanced funds may swing less than pure stock or bond funds. Money market funds invest in very short-term investments, sometimes described as cash equivalents.

Many investors use them to store cash, the market regulator's guide says. Equity income funds invest in stocks that regularly pay dividends. Global funds may invest in companies all over the world, the industry guide says. Target date funds typically hold a mix of funds and change that mix as a chosen date gets closer.

The farther away that date is, the more risk such a fund usually takes, the industry guide says. Which kinds you can buy differs where you live. Some funds simply follow a market index, and number four explains that choice.

4. Does a fund try to beat the market

Number four: does a fund try to beat the market, or just match it? Index funds follow a passive strategy, aiming for about the same return as an index before fees, a market regulator's guide says. In an industry regulator's example, a fund that tracks an index typically holds all of that index's stocks, in the same proportions. When the index adds a company, the fund buys it, and when the index drops one, the fund sells.

Passive management usually means less trading, more favorable taxes and lower fees than actively managed funds. Actively managed funds are not based on an index, and an adviser may buy or sell investments daily. They have the potential to outperform the market, but results depend heavily on the manager's skill. Each fund is measured against a benchmark, an index that fits its strategy, the industry guide says.

In the guide's example, an active fund's fees are 1.5% of its total assets. If its benchmark returns 9%, the manager needs better than 10.5% to beat it. In any given year, most actively managed funds don't beat the market, that guide says. Many people choose funds that don't try to beat the market at all, called index funds, that guide says.

But fees still vary from one index fund to another, and so do their returns, the guide adds. Fund rules, fees and taxes differ where you live. Halfway point: a fund pools money, spreads it, comes in a few kinds, and can match an index. Next, how the price of a fund share is set each day.

3. How is the price of a fund share set

Number three: how is the price of a fund share set? A fund's net asset value is its total assets minus its total liabilities, a market regulator's glossary says. In its example, assets of $100 million and liabilities of 10 million leave 90 million. Dividing a net asset value by the number of shares investors own gives the value of one share.

In its next example, a net asset value of $100 million over 10 million shares is $10 a share. Mutual funds calculate that value only once a day, when the investment markets close, an industry regulator's guide says. All purchases and sales for that day are recorded at that value. You can sell shares back to the fund on any business day, at the next calculated value, minus any fees.

Exchange-traded funds work differently: their shares trade like stocks throughout the trading day, at changing prices. Their market price may be above or below the value of what the fund holds, the market regulator's guide says. So you may pay more or less than that value when you buy, and receive more or less when you sell. A fund's value per share is not, on its own, a measure of its success, the industry guide says.

It says total return over time compares funds better, though past returns don't necessarily predict future ones. If you want to see how rising prices affect your money, the video on protecting your money from inflation is linked on screen. Trading hours, fees and taxes differ where you live. In one breath: a fund pools money, spreads it, comes in a few kinds, can match an index, and its value changes daily.

Values go down as well as up, and number two shows what a fund can't promise.

2. Can a fund lose money

Number two: can a fund lose money? According to a market regulator's guide, funds are not guaranteed or insured by a government agency. You may lose some or all of the money you invest, because what a fund holds can go down in value. Dividends or interest payments may also change as market conditions change.

Past performance does not predict future returns, but it can show how steady a fund has been. Generally, the higher the potential return, the higher the risk of loss, the guide says. A stock fund's value can rise and fall quickly over the short term. And how it does depends on whether the companies it holds do well or not.

Fund investors pay their fees and expenses regardless of how the fund performs, the guide notes. And they cannot directly influence which securities the fund holds. Some funds also take a sales charge, called a load, when you buy shares. In the guide's example, a 5% load on $10,000 takes 500, so 9,500 is invested.

An industry regulator's guide says such charges can range between two and 5%. By our count, at 2%, the same $10,000 would leave 9,800 invested. No-load funds don't impose sales charges, but they might have other fees, that guide adds. Investor protections differ where you live.

A fund's yearly expenses are listed in its prospectus fee table, so here is a question before number one. Two funds start with the same $10,000 and differ only in their yearly expenses. After twenty years, how far apart do you think they end up?

1. How can a fund grow your money over time

Number one: how can a fund grow your money over time? In the regulator's example, $10,000 earns 5% a year before expenses, for twenty years. With yearly expenses of 1.5%, the investor could have roughly $19,612. With expenses of only 0.5%, the investor would end up with $24,002.

That is a 23% difference, the guide says. By our count, the lower-cost fund ends roughly $4,390 ahead. Even small differences in fees can mean large differences in returns over time, the guide adds. A market regulator's guide lists three ways investors can make money from funds.

A fund pays out nearly all the income from its holdings, less expenses, as dividends. When it sells holdings that rose in price, it pays out those gains, minus any losses, at the end of the year. And when its portfolio's market value rises, after expenses, the value of each share rises too. You can usually have those payments reinvested to buy more shares, the guide says.

One easy way to compare fund costs is the expense ratio, an industry regulator's guide says. It is the share of a fund's total assets that pays its recurring fees every year. A fund passes its costs on by deducting them from its value, so you pay them indirectly, the market regulator's guide says. Fees, taxes and fund rules differ where you live.

And that is how funds spread your money: one shared pool, many holdings, and a value set each day. So, seven parts: what a fund is, why spreading helps, the main kinds, and matching an index. Then how a fund's price is set, what it can't promise, and how it can grow over time. Today, you can open a market regulator's guide to mutual funds, linked below, and read how it explains fees.

Which of the seven surprised you most? Tell us the number in the comments. Results vary, rules differ where you live, and this is information only, not financial advice. This is Wealth Filings.

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