What are Mutual Funds?
Investing in a Mutual Fund is a great way of getting exposure to the world of finance. Rather than investing in stocks one by one, with Mutual Funds you get to invest in a collection of diversified, professionally managed portfolios of investment assets, such as stocks and bonds and other securities, which are ‘bundled’ together as a single investment.
Mutual Funds are a type of financial vehicle which is expertly managed by a fund manager who decides where and when to invest your money on your behalf. They will then combine your funds with those of other people to invest in numerous assets. Of course, there is a charge for the management of the Mutual Fund, but we will get to that later in this blog.
This type of investment means you can hold shares in high-profile portfolios you may not be able to afford as an individual investor. As such, they are ideal for both experienced investors and those who are beginners, as it lowers the risk of putting all your eggs in one basket, as it were.
What are Some Types of Mutual Funds?
There are many types of Mutual Fund investments to choose from, depending on their objectives, the types of securities they invest in, and the returns they seek.
As an investor, you should choose the kind of fund that is ideal as far as your investment objectives, financial goals, and spending capabilities/budget go.
Which of them you choose also relies on how much risk you are prepared to take, and how much return on your investment (ROI) you are looking to get. As an investor in a Mutual Fund, you would not directly own the stock in the companies the fund purchases, but you would share equally in the profits or losses of the fund’s total holdings.
As with most investments, there is no guarantee that you will make money, or even get your money back if you invest in a Mutual Fund, as some kinds of Mutual Funds are riskier than others.
How Do They Work?
A Mutual Fund is both an investment and a company. Its fund manager is hired by a board of directors and is legally obliged to work in the best interests of the Mutual Fund investors.
The value of the Mutual Fund company is contingent on the performance of the securities it buys. When you purchase a share of a Mutual Fund, you are buying the performance of its portfolio’s value. This is different from investing in shares of stock. For one, Mutual Funds shares do not give holders any voting rights, unlike in stock.
A typical Mutual Fund holds over a hundred different securities, which means shareholders get diversification at a lower price than if they invested in each one individually.
Types of Mutual Funds
Mutual Funds are divided into several categories, which represent the types of securities they have in their portfolios and the kind of returns they are looking for. There is a Mutual Fund for practically every kind of investor or investment approach, so you can choose which one is the best for you.
Here are some of the most common Mutual Fund types:
- Fixed-Income Funds: This kind of Mutual Fund concentrates on those investments which pay a set rate of return. These include corporate bonds and government bonds. The fund portfolio produces income for interest, which is then passed on to the shareholders.
- Equity or Stock Funds: This type of fund invests mainly in stocks. Some equity funds are named for the size of the companies they invest in, while other receive their name according to their investment approach.
- Money Market funds: Considered the ‘safest’ and the lowest risk for the lowest returns, these kinds of Mutual Funds are frequently used as short-term investments and often consist of Government Treasury bills.
- Index Funds: The investment strategy of index funds is based on the belief that it is very difficult, and often costly, to try to beat the market consistently. To this end, the index fund manager will purchase stocks that correspond with a major market index, like the S&P 500, for instance.
- Balanced funds: These funds include a mix of the above, thereby reducing the risk of exposure across asset classes.
Mutual Fund Fees
The fees for Mutual Funds are categorised as either shareholder fees, which are made up of commissions, sales charges and redemption fees, or as annual operating fees (also known as the ‘expense ratio’), which are made up of an annual percentage of the funds which are under management.
Some Mutual Funds also charge penalties for early withdrawals or if you sell the holdings before a certain time has elapsed.
Advantages of Mutual Funds
There are several reasons why Mutual Funds have been the preference of many investors over the years:
- One of the main advantages of investing in a Mutual Fund is diversification, which is the combining of investments and assets within a portfolio to lessen risk. Financial experts say that rather than a single investor purchasing individual securities, investing in a Mutual Fund is a faster, easier, and relatively cheap way of boosting your portfolio’s returns while decreasing risk.
- One of the biggest advantages of Mutual Funds is having a professional and skilled fund manager who has the time and expertise, to take care of it for you.
Simplicity of Access
- Since they trade on the major stock exchanges, it is relatively simple to purchase and sell Mutual Funds.
Economies of Scale
- Mutual Funds provide economies of scale, because buying just one, saves the investor from paying the numerous commission charges and large transaction fees usually needed to build up a diversified portfolio.
- Mutual funds are subject to industry regulation. This means that accountability and fairness are safeguarded.
Variety of Choice
- As we saw earlier in the blog, there are numerous different types of Mutual Funds that you can choose from if you decide to invest. You can also choose managers with different management goals and styles.
Disadvantages of Mutual Funds
Factors such as professional management and diversification make Mutual Funds attractive to many investors. But of course, they have some disadvantages too:
- Mutual Funds have no guaranteed return. This means that there is always the chance that the value of your Mutual Fund will decrease, depending on price fluctuations of the stocks which make up the fund.
- As we have discovered earlier, professional management comes at a cost. They must be paid by the investors, regardless of whether the fund performs well or badly.
- What is ‘Diworsification’? This is when a Mutual Fund is made up of an excessive number of different stocks purely for the sake of diversification. Yes – you can have too much of a ‘good’ thing, and it is possible to have a poor ROI because of this. Diworsification sometimes occurs when there is no clear purpose in managing the fund.
- Investors need to keep in mind that a capital gains tax is triggered when a fund manager sells a security.
Passive vs. Active Management
A passive Mutual Fund simply tracks the performance of a benchmark index, such as the S&P 500. Actively managed funds, on the other hand, employ portfolio managers who actively make decisions on which assets and securities to include in the fund.
In a nutshell, the goal of a passive Mutual Fund (also known as an Index Fund) is to match the performance of a particular index. The goal of an active one is to beat it.
Since the managers do a lot of research and other types of work for an active fund, fees are usually higher than those for passive funds.
How Do I Make Money from Mutual Funds?
Your potential returns will be contingent on the kind of Mutual Fund your fund manager takes care of.
There are three primary ways to see an ROI:
- Interest and Dividends– Money earned over a given year is distributed to investors as interest on bonds, or dividends on stocks.
- Capital – If securities within the fund have gained value, it will be shared among the shareholders.
- Shares – If your fund’s value has increased in price, you can sell some or all your shares for a profit.
Can I Lose Money When Investing in Mutual Funds?
Always keep in mind that the value of all investments and the income from them is not guaranteed.
Risk is a factor in all investments, and you could potentially lose money by investing in a Mutual Fund. However, since diversification is one factor of this kind of investment, this does minimise the risk somewhat, as it is spread over several industries and/or companies.
For instance, Mutual Funds tend to carry less risk than if you invest in the stock market as your financial portfolio will contain a selection of different assets, rather than shares in just one company.
Which Mutual Fund should I go for?
While reviewing your options, you should first evaluate your goals. Ask yourself what is it exactly you want to achieve from investing in a Mutual Fund – saving for your children’s education, setting money aside for your retirement or something else? It is also important to identify your risk tolerance (to ensure you choose a fund which fits in with your risk profile), and your time horizon (Mutual Funds are normally more suited for long-term rather than short-term investments).
For more information on how to invest in Mutual Funds, please check out our dedicated page on Mutual Funds and ETFs, or get in touch with one of deVere Group’s financial advisors today.