What is a Fund?

Definition:

A fund is a pool of money dedicated to saving, investing, or virtually any other purpose either by an individual, a business, a government, or any other type of entity.

🤔 Understanding a fund

A fund is a pool of money used for a specific purpose. A fund can be established for virtually any type of use — and by an individual or virtually any other type of entity, such as a business, government, or non-profit group. Common types of funds related to investing include mutual funds, pension funds, exchange-traded funds, and hedge funds. The term “fund” is very broad, though, and can apply to many other uses — such as an individual’s retirement fund, a college fund, a trust fund, or an emergency fund.

Example

A common type of fund that we’re probably all familiar with is an emergency fund. An emergency fund is a personal fund, typically kept in a bank savings account or money market fund. The purpose of an emergency fund is to save money for a rainy day. You put a few dollars away with every paycheck for when your radiator blows or you have a medical emergency — and then there’s money to spend when you need it.

Now, let’s say you get an unexpected gift or payout of cash, like a surprise graduation check or a bonus. If you’re already set with an emergency fund, you might want to invest this new money into a mutual fund — a large pool of stocks, bonds, or other securities — with the hopes that your investment grows. That mutual fund is a type of investment fund. You should only invest in funds suitable for your personal financial situation and tolerance for risk.

Takeaway

A fund is like a bucket of water…

What it’s used for depends on who owns it and what he or she wants to do with it. An individual might want to drink from it now or store it for later. An agricultural company might want to use it to water crops. A bucket of water has a million potential uses, as does the concept of a fund of money.

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What are some different types of funds?

There are many different types of funds — and they have many different potential uses.

Emergency Fund: An emergency fund, as the name suggests, is for an emergency. You can save up money today so that if something bad happens tomorrow you have some cash to fall back on.

A Federal Reserve survey found that fewer than half of respondents would be able to cover a $400 emergency without borrowing or selling. This statistic shows that many Americans need to build up an emergency fund so that an unexpected bill doesn’t spiral into a bigger problem.

Financial experts generally agree that an emergency fund should cover three to six months’ worth of living expenses. This would cover you in the event of unforeseen job loss.

College Fund: For decades, parents have been saving up so that they can afford to pay for their kids’ college when they graduate from high school. There are a couple common ways to save for college.

One is with an ESA, or Education Savings Account. Another is with a state 529 plan. A 529 plan is a college savings plan that you can use to pay for higher education expenses, with tax benefits that vary by state.

Retirement Fund: You can create a fund to save up for when you retire. Many people enter into a 401(k) plan through their employer. Your employer can deposit a certain percentage of your paycheck into your 401(k). Your employer may also match your contributions up to a certain percentage.

There are also options for saving for retirement independent of your employer. An IRA is an effective way of saving for retirement.

Both 401(k) plans and IRAs have annual maximum contribution limits.

Mutual Funds: Mutual funds are investment funds directed by professional managers. These funds are typically a collection of various securities like stocks and bonds. Mutual fund shares are often lower-risk than individual stocks and bonds because of their diversification. This is not true in all cases.

Think of mutual funds like a fruit salad. When you buy an individual stock or bond, you’re buying just one type of fruit. With a mutual fund, however, you’re buying a fruit salad. Typically, you’ve got a little bit of many different things in there.

Mutual funds can be appealing and accessible because you don’t have to research every individual stock and bond. However, this convenience does come at a price — you’ll generally pay a management fee, since a professional is working to manage your money.

Money Market Funds: A money market fund is a type of mutual fund. Money market funds are different from traditional mutual funds because they only invest in highly liquid investments or those that can be converted quickly into cash. These investments include cash equivalent securities or debt-based securities with a short term.

Money market accounts are very low-risk short-term investments. They are generally not appropriate for long-term investors looking for higher-potential returns.

Exchange-Traded Funds (ETFs): An ETF is an investment tool that allows you to invest in a specific type of company, or the entire stock market, rather than one company. The kind of security might be specific to a sector, industry, or region.

ETFs are similar to mutual funds in that they allow you to invest in a pool of investments rather than just one stock or bond. ETFs tend to have lower fees than mutual funds.

Hedge Funds: A hedge fund, like a mutual fund, pools investors’ assets to make investments.

Hedge funds tend to be riskier and more aggressive than mutual funds. There is a higher emphasis placed on making a lot of money. Not just anyone can invest in a hedge fund. Hedge funds are only allowed to manage the money of “accredited investors” — institutions, endowments, or wealthy investors who meet specific minimum wealth/income requirements (not mom-and-pop investors).

Index Funds: An index fund is a type of mutual fund meant to replicate the makeup of a specific stock index. Index funds are not intended to beat the market index — they are designed to match it.

For example, there are many index funds designed to track the S&P 500. If you invest in an S&P 500 index fund, you would expect your returns to match those of the actual S&P 500 closely.

Index funds tend to have lower volatility than individual stocks. All investments carry risks.

Bond Funds: A bond fund usually invests in bonds such as government bonds — including Treasury bills, notes, and securities issued by government agencies. They may also invest in other types of bonds, such as corporate bonds.

Debt-Service Funds: A debt-service fund is a tool used to repay certain types of debt. Governments often use long-term debt to finance projects. An example of a project where one of these funds might be used would be a major construction project. These debt service funds are how the government repays that debt. The fund is used to account for the accumulation of resources for the debt service payments. In many cases, the debt-service fund may be legally required.

Capital Project Funds: Companies and the government use capital project funds to finance capital projects. Capital projects include the building or purchasing of certain land, buildings, and equipment.

Permanent Funds: Permanent funds are money and investments that the government is not allowed to spend. However, the government is typically allowed to spend the interest or revenue from such funds on appropriate governmental functions.

Sovereign Wealth Funds: A sovereign wealth fund is a fund owned by a state, composed of financial assets such as stocks, bonds, property, or other financial instruments. The largest sovereign wealth funds in the world include the Norway Government Pension Fund Global, the China Investment Corporation, and the Abu Dhabi Investment Authority.

Pension Funds: A pension plan is a benefit that an employer might offer to their employees. While pension plans used to be quite common, they are largely disappearing from the private sector today.

The money paid out to employees comes from the pension fund. The fund typically pays according to a formula based on years of service to the company and the average salary.

How do investment funds work and what type of fund is right for you?

When it comes to choosing the right fund for you, there are two main factors to consider:

  1. Your financial goal
  2. The amount of money you’re working with

For most personal funds, it is clear which type of fund you should open based on your financial goal. If you want to save up for a rainy day, then you should build an emergency fund — it’s a rule of thumb to keep 3-6 months of your salary in liquid funds as an emergency fund. If you wish to send your child to college, start a college fund. If you want to save for retirement, sign up for a 401(k) or open an IRA.

You also might have the goal of growing your money. In that case, you may want to invest in stocks or mutual funds. Choosing the right investment fund depends on your risk tolerance. It also depends on the amount of money you want to invest, among other factors. All investments come with risk.

Let's say you have a low-risk tolerance and a small amount of money to invest. You would probably be considering mutual funds or specifically money market funds.

But, you might have a high income and large net worth. Then you may decide to be more aggressive with your investing. Then you could be interested in investing in a hedge fund. These types of investments are higher-risk and have no guarantee of positive returns; you could possibly lose any money you invest.

Many experienced investors choose to rely on a diversified portfolio, which allows them to lower their risk and potentially earn more money in the long term. Again, all investments come with risk; your individual financial situation and risk tolerance will determine the right strategy for you. Robinhood does not give investing recommendations.

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