What are Mutual Funds?
Investing in mutual funds is another investment vehicle that can help you grow your money and achieve your financial goals.
Mutual Funds are pools of money collected from various individual investors and invested in multiple securities like stocks, bonds, fixed-income securities, among others. Mutual Funds are alternatives to investors picking their stocks. In this system, rather than owning a bunch of stocks, an investor purchase a portion of a mutual fund, which consequently invests all the pooled resources in various classes of securities.
The managers of mutual funds (fund managers) are professionals who have experience and expertise in finance and can make sound investment decisions. A mutual fund seeks to achieve diversification by investing in different types of securities.
An individual investor purchases a portion of the mutual fund at the Net Asset Value (NAV) per share. The NAVPS is the value of the mutual fund on a per-share basis at every point in time. The value of the mutual fund is adjusted at the end of every trading day to reflect the results of that trading day. An investor earns money from mutual funds through dividend/interest (as the case may be), or through capital gains in the securities, the fund is holding on to or through an appreciation in the NAV of the fund (which allows the individual investor to sell his or her stake in the fund for a profit).
There are open-ended and close-ended mutual funds. With open-ended mutual funds, you can purchase and redeem units of the mutual funds throughout the year. However, with close-ended mutual funds, purchase only takes place during an initial offer date and redemption at specific maturity date.
Types of Mutual Funds
There are different ways to classify mutual funds. However, for the sake of simplicity, we will focus on six types of mutual funds:
Equity Funds are mutual funds that invest in shares of listed companies. They can invest in growth stocks, value stocks, or dividend stocks, or a combination of the three. Equity Funds are very good for people who look for high returns, though the risks with equity funds are also high.
Fixed Income Funds
Fixed Income Funds are mutual funds that invest in fixed income securities with a fixed rate of return, majorly in the form of interest. Fixed-income mutual funds have lower risks and lower potential returns when compared to equity funds.
Money Market Funds
Money Market Funds are mutual funds that invest in short term fixed income securities such as treasury bills, government bonds, certificates of deposit, and commercial papers. They are safe investments that earn moderate and immediate returns.
Balanced Funds are mutual funds that seek to bridge the high returns and high risk of equity funds and the lower returns and lower risk of fixed income funds. Balanced Funds invest in a proportion of stocks and balance it with a portion of fixed income securities to reduce the risk. The ratio between stocks and fixed income securities vary among mutual funds.
These mutual funds focus on a specific industry. There are mutual funds that focus on the energy industry, the telecommunications industry, the real estate industry, etc. These funds concentrate their investments on stocks in this particular industry.
Index Funds are mutual funds that track the performance of a particular index. These mutual funds seek to match the performance of a specific index (e.g., S&P 500). Index funds tend to have lower management fees.
These are investment funds traded on the stock exchange market. The share prices fluctuate throughout the day as the exchange-traded funds are bought and sold. ETFs have lower expense ratios and management fees.
Pros of Investing in Mutual Funds
There are many advantages of investing in mutual funds, especially when compared to stock investing or bond investing.
The first and obvious advantage is that with mutual funds, you have the benefit of professional management. Fund managers are professionals who have the knowledge, experience, and competence to research securities and make sound decisions (in most cases).
An average investor will not have the funds to achieve a level of diversification that maximizes returns and minimizes risk. However, when these funds are pooled together, it provides better opportunities for diversification, which in turn, helps individual investors maximize their returns.
With mutual funds, the options and varieties and endless. You can choose from different types of mutual funds following your financial goals and risk appetite.
Investing in open-ended mutual funds allow you to redeem your portion in the mutual funds whenever you want. Mutual Funds, therefore, provide you with liquidity, enabling you to cash out when you want.
Picking your stocks involves a lot of research and effort. With mutual funds, you can save yourself time and effort.
Purchasing mutual funds saves you from the fees you will pay on every stock purchase. To create a diversified portfolio, you will need to buy different shares, and the fees can add up quickly.
Cons of Investing in Mutual Funds
However, investing in mutual funds also have its disadvantages:
Loss of Control
You are no longer in control of the stocks you purchase. The fund manager makes those decisions on your behalf. It does not matter if you think you have some unusual insights that can bring in huge profits. You do not have any control over “your portfolio.”
Though mutual funds managers are experts, they are not immune to poor decisions and performance.
Management Fees and Operating Expenses
Mutual Funds charge management fees and incur operating expenses, which reduces the returns you get on your purchase of the mutual funds.
Too much liquidity
Since open-ended mutual funds need to be liquid in the case of redemption, they have to leave a specific part of their assets in cash to meet with redemption demands. This can lead to lots of tied-down cash and reduces the possibility of profits.
Difficulty of evaluation
Due to the inability of data, evaluating mutual funds can be a difficult thing to do. It is hard to know what constitutes the portfolio of mutual funds. Important financial ratios available for individual stocks are not available for mutual funds. The unavailability of data also makes it difficult to compare the performances of one mutual fund with another.
Recommendations for Investing in Mutual Funds
Mutual Funds are still one of the reputable investment vehicles that every investor should consider. Here are some few recommendations if you decide to invest in mutual funds:
- Keep your financial goals before you: What you want to achieve with your investments will determine what type of funds you should buy. If you are still very young, investing a greater portion in equity funds or in balanced funds who have higher equity proportions can be a great idea. However, if you are closer to retirement, you will need a greater portion in fixed income securities or balanced funds with higher fixed income portion
- Shop Around: While there are not many available data to compare mutual funds, there are still some relevant information that can point in the right direction. Compare management fees and operating expenses. If possible, get reviews and recommendations from other investors. The reviews and recommendations are the best way to understand the performances of a mutual fund.
- Define your risk tolerance: We all have different risk tolerance levels. Define your risk tolerance level and stay with the types of mutual funds you are comfortable with.
- Consider tax consequences: Purchasing index funds, exchange-traded funds, and the other typical mutual funds come with different tax consequences. You need to consider how your investment in mutual funds affect your taxes and make a decision in line with that.
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Investing your money is a crucial decision that you cannot be entirely passive about. However, a little bit of passivity can be helpful, especially with mutual funds. Investing in mutual funds requires some decision making. It is one of the areas you need to recognize the “personal” in personal finance in addition to adhering to general guidelines.