Mutual funds are companies that create investment pools made up of thousands of different securities such as stocks and bonds. Both institutional and private investors can buy shares in mutual funds. Market volatility affects mutual fund shares in the same way that it impacts the market value of stocks, bonds and other securities.
While many types of securities are subject to price volatility throughout the day, mutual fund share prices only change once daily. The overall worth of a mutual fund is calculated by adding together the market value of the underlying securities as of the close of the business day. Share prices are calculated by subtracting the fund's operating costs from the net asset value of the underlying securities and dividing the remaining sum between the fund's outstanding shares. When you buy a share in the fund, you pay the net-asset-value per share price as well as any applicable fees or sales commissions.
A stock represents an ownership stake in a particular company, and stock prices increase or decrease in value in line with the issuing company's financial performance. Stock prices across particular sectors may also rise or fall in unison if economic or technological developments occur that are likely to help or hinder the future performance of those sectors. Aggressive mutual funds usually contain mostly stocks, and some funds contain only stocks from one sector of the economy, such as financial firms or technology companies. The performance of the underlying stocks has a direct impact on fund's performance and its net asset value.
Generally, bond prices are subject to less volatility than stocks, because the claims of bondholders take precedence over the claims of stockholders if a particular company goes bankrupt. If a mutual fund contains bonds, the bond issuers make regular interest payments to the fund. The mutual fund passes on these interest payments to investors in the form of dividend payments. Dividend payments affect an investor's overall returns but do not directly impact the fund's actual share price. Bonds fall in value when interest rates rise, because newly issued bonds are available that pay higher rates of return. The opposite occurs when interest rates are falling. Therefore, the share prices of mutual funds containing bonds tend to experience more volatility when interest rates are on the move.
Managed Versus Non-Managed
Many mutual funds are managed by investment professionals who attempt to combat negative market movements by replacing poorly performing securities with better ones. Even if two funds contain largely the same types of securities, one may experience more price volatility than the other due to the trading activity of the fund manager. In contrast, non-managed funds are tied to indexes such as the Standard and Poor's 500. Securities are only bought or sold from these funds if the S&P or other index changes its makeup. Therefore, a fund tied to a particular index should rise or fall in value in unison with that index.
Diversified or balanced mutual funds contain a mixture of bonds, stocks and cash equivalents such as commercial paper. When stock prices rise, the stocks within the fund gain value, but the prices of cash equivalents and bonds remain steadier, meaning the fund does not grow as much as an actual stock fund. When stocks fall in value, a balanced fund does not experience as much volatility as a stock fund due to the stability brought to the fund by the cash and bonds. Consequently, balanced funds are designed for investors who are willing to give up some of the market highs in order to avoid some of the market's low points.