If you have a sum of money you want to invest but you don’t know zilch about where to start, well, you might want to join the train of mutual funds.
Whether small or large capital, there are professional financial management companies that exist just for this kind of situation; to help you put your money in a place where it will yield returns in no small way.
What is a Mutual Fund?
A mutual fund is a type of financial investment that uses money from contributions from investors to invest in securities such as bonds, stocks, gold, money market, instruments and other similar financial assets that are worth investing in.
Mutual funds are managed and run by financial companies, also known as professional money managers; they assign the fund’s assets and make an effort to generate capital growth or income for the fund’s investors.
Usually, there are stated objectives that the investors are also aware of and as such, their portfolio is structured towards obtaining such objectives.
The collective holdings of the mutual fund are known as its portfolio. For example, a debt fund will have its specified objective which is to invest in fixed income instruments or products such as bonds, government securities, debentures and so on.
In the same vein, an equity fund will invest in stocks and other equity products.
Mutual funds also cater to small or individual investors by granting them access to varying, professionally-managed portfolios such as bonds, equities and other securities, all at a low price.
In essence, these small investors get to partake commensurably in the loss or gains associated with the fund.
Mutual funds are one of the top instruments Americans use to increase their wealth and save for retirement, in fact, about 100 million individual Americans had $18.9 trillion invested in mutual funds in 2018, according to the Investment Company Institute.
Mutual funds are segregated into several groups; characterizing the types of securities they invest in, investment objectives, and the type of prospective returns.
Mutual funds collate such monies by charging annual fees called expense ratios and in some cases commissions which most times affects the grand-total returns.
The value of a mutual fund company depends on the portfolio performance, i.e. the type of securities it invests in, in essence, when a small investor buys a unit or share of a mutual fund, then they are buying into the present performance of such portfolio, i.e. they have a part in the value of the portfolio.
When you invest in a mutual fund, you don’t get voting rights unlike when you invest in shares of stocks; the reason is that mutual fund investors don’t directly own the stock in the companies the fund purchases, but share uniformly in the profits or losses of the fund’s total holdings.
A mutual fund share is represented investments in various stocks and other securities and is not limited to just one holding.
The average mutual fund contains hundreds of different securities, which translates into the fact that mutual fund shareholders gain important diversification at a low price.
Therefore, when an individual invest in mutual funds, even if a bad quarter is recorded for one of the companies, such investor doesn’t look significantly because it is not the only company such invested in.
6 Main Types of Mutual Funds
Remember we mentioned that mutual funds invest in diverse securities and in diverse companies and your capital to be invested will define the type of mutual funds share you can buy into.
Now, we want to look at those types of mutual funds in a simplified manner, perhaps, it will help you determine what type to invest in.
Stock/Equity Funds: This type of mutual fund is considered as the most popular type of mutual fund and said to account for 55% of all mutual funds owned in 2017 (investment company institute), in the same vein, it also carries the greatest percentage of risk involved riding closely on the heels of the greatest potential returns an investor can get.
This is so because fluctuations in the market can considerably affect the returns of the equity funds.
There are several types of funds in this category, they include; income funds (invests in stocks that pay regular dividends), growth funds (invests in stocks that may not pay the dividend regularly but has the potential for above-average financial returns), sector funds (focuses on a particular segment of the industry) and Index funds (keeps a tab on a particular market index such as the Standard).
Each of them has certain characteristics and objectives whose portfolios are tailored after.
Bond/Fixed-income Funds: Also considered a big category, this type of mutual fund accounts for 22% of all U.S. mutual funds according to ICI stats show. It is less risky than stock funds and also has different types of bonds. It focuses on investments that give a set rate of return, which includes, corporate bonds, government bonds and other debt instruments when the fund portfolio generates interest income, it is passed on to the shareholders.
In this type, the managers seek to buy relatively undervalued bonds to sell them at a profit; therefore, they are actively managed and monitored. After stock funds, bond funds pay higher returns than others but also come with higher risk.
Since this type of fund also is diversified, its return or loss is also dramatic; they can’t be fully predicted as it depends on where they invest.
Also, almost all bond funds are subjected to interest rate risk. In essence, if the rates go up, the value of the fund depletes.
Money-market Funds: This type has the lowest returns because it also has the lowest risk. This type of fund is bound by legality to invest in high-quality and short-term investments that are sanctioned by the government or government’s corporations.
They make up 15% of the mutual fund shares. This character, therefore, makes it a safe place to put in your money, of course, there are no substantial returns but there will be no need of monitoring it for losses or worrying about losing your capital.
Balanced Funds: Also known as hybrid fund, it invests in a mix of bonds, stocks and other securities.
It also specifies in diversifying and reallocating assets toward safer investments to reduce the risk of exposure especially as an investor approaches retirement age. They account for 8% of the mutual fund market.
Income Funds: just as their name implies, the purpose of this type of mutual fund is to supply income on a fixed basis.
These funds invest basically in government and high-ranked corporate debt, letting them mature before providing interest.
The primary objective of this type of fund is to provide steady cash-flow to investors, as such; it is avoided by tax-conscious investors and attracted by conservative investors and retirees.
International Funds: also known as foreign funds, this type of mutual fund invests only in assets outside the home country.
It differs from the global fund which invests anywhere around the globe, including your country. It is hard to say if this type of mutual fund is riskier than local investments or otherwise but they’ve shown to be more intricate as it is often associated by unique country and political risks.
On the other hand, they can reduce risk by adding up in diversification.
Advantages of Mutual Funds
Looking at the statistics and seeing the trend of investment in mutual funds, there must be many advantages that inform investors’ decisions. Let’s take a look at some:
- Dividend Reinvestment: Dividends and other interest income sources of the funds are used to purchase additional shares in the mutual fund which in turn contributes to the growth of your investment.
- Advanced Portfolio Management: Management fee comes with the package of buying a mutual fund but it is a small price to pay for having unfettered access to professional help in the management of an investment portfolio. The management fee is used to hire a professional portfolio manager who will, in turn, buy and sell stocks, bonds and other securities on your behalf.
- Reduction in Risk: When there is diversification, there is a reduction in portfolio risk; this is because most mutual funds will invest anywhere, ranging from 50 to 200 varying securities. Several stock index mutual funds own more than 1,000 individual stock positions.
- Liquidity: It is somewhat easy to buy and exit a mutual fund scheme unless you invested in close-ended mutual funds. You can decide to sell your units at any point and open another investment portfolio. You only have to watch out for the objectives and terms and conditions of the portfolio you choose to invest in.
- Diversification: Investing in more than one asset class helps to spread risk and ultimately minimize them. This is referred to as diversification as mutual funds also have its share of risks since their performance is largely influenced by the market movement. In diversifying, when one asset class doesn’t perform, the other can always pull through for the investors.
- Small Investment Option: Mutual funds cater to both small and big capital, and when an investor partakes in smaller denominations, such investor is afforded the exposure to the whole stock, i.e. he can invest in any of the asset class and not necessarily restricted to one or two.
- Quick and Seamless Process: There is no pressure to start big, an investor can start from one mutual fund asset class and diversify in the process. Also, tracking your investment doesn’t need a special effort from the investor; it is mostly handled by the financial manager maintaining your portfolio. You are also not saddled with the stress of when and how to invest; all you need to do is receive the maximum returns steadily.
- Bulk Transactions, Lesser Cost: The more volume an investor buys in a particular asset class, the lower the price he has to pay, i.e. buying of multiple units at a time reduces the processing fee and other commission charges.
- Cost efficiency: Mutual funds afford its investors with a considerable varying range of asset class to choose from, i.e. an investor gets to choose from a zero-load mutual fund to fewer expense ratio to high-risk portfolios, he can check the expense ratio of different mutual funds and choose the one that fits into his budget and financial aims and goals.
- Accessibility: mutual funds are easy to access and can be gotten from brokerage firms, insurance companies, online financial sites, banks and mutual fund companies. Opening an account as a beginner is not arduous and can be easily opened within minutes.
Major Disadvantages of Mutual Fund
While there are many attractive features of mutual fund like diversification, accessibility and their likes, there is no asset without its flaws and drawbacks. Here are some challenges that come with a mutual fund system.
- Lock-in Periods: Exiting some mutual funds portfolio can take up to five to eight years. If an investor decided to exit before then, then he will have to forego any prospective interest and also stands the chance of losing a better part of his capital.
- Fund Management Costs: Since the market analysts and portfolio managers are paid from the money of the investors, then one might want to count the cost before investing. In essence, total fund management is one of the key factors to consider and look into when choosing an asset class in a mutual fund system.
- Fluctuating Returns: Just like many other investments, there is always a chance that the value of an investor’s mutual fund will depreciate, i.e. there is no 100% guaranteed return. There are experiences of price fluctuations by some of these asset class especially Equity funds and mutual fund investments are not backed up by the Federal Deposit Insurance Corporation (FDIC), in essence, there is no insurance for any setback.
- Overload: With mutual fund, many investors tend to overcomplicate matters by taking on many funds that are similar and as a result, investors don’t get the risk-reduction benefits that come with diversification. Also, owning mutual funds does not guarantee automatic diversification because the investment may be in a particular sector or region; this still exposes the portfolio to high risk. In essence, it is possible to have poor returns due to diversification.
- Absence of Liquidity: Even though a mutual fund allows you to make a requisition of conversion of your shares to cash at any point, it is still pertinent to understand that many mutual fund redemptions happens at the end of each trading day, unlike stock that trades throughout the day.
- Tax issues: For every security or share that a fund manager sells, a capital-gain tax is invoked therefore this doesn’t in any way benefit investors who are tax-conscious. Taxes can be invoked by investing in tax-sensitive funds or by possessing non-tax sensitive mutual funds in a tax-deferred account, for example, IRA.
How Mutual Funds Work
Picture a basket filled with different wool balls of different colours, that’s just how mutual funds are. It is a basket filled with many investments, giving people the chance to invest while avoiding risks. Therefore, instead of having to suffer through the herculean task of wading through the murky waters of investment, mutual funds allow investors to simply choose the type of fund they want and sit back to watch their money go into action.
So, how does it work? Well, you pool your money together with the money of other investors and it will be invested in portfolios that individually, you may not be able to afford but will be able to do so by investing alongside other investors. We have three broad categories of mutual fund namely: large-cap, mid-cap and small-cap. Mutual funds are popularly known for their characteristic of low risk due to diversification, i.e. it allows you to pick one asset class which has many stocks, so, unlike individual investment, you’ll not be putting all your eggs into one basket or having to monitor the market, scout out prospects and keep updated, all these are done on your behalf.
The mutual fund pays out in two different ways:
- Distributions: If the asset class chosen by an investor pays dividends, i.e. money a company pays to its shareholders, then the fund manager will distribute the dividends equally to the shareowners. It can be in the form of interest or capital gains.
- Capital Gains: Capital gain accruement is gotten when your initial purchased fund is sold for a higher price than you bought it.
How to Choose a Mutual Fund in 7 Easy Steps
Now that you have a good knowledge of what mutual funds is all about and how it works, it is pertinent to know how to choose one. Let’s see how that works out with the following easy steps;
Step 1: Goal and Risk Level: There are a plethora of funds to choose from, not less than 10,000 mutual funds exist, therefore, to get it right, you have to figure out at first what your goal is, here are some questions to help you figure this out if you are confused as to what your goals should be in the first place;
- Do you desire constant cash-flow or capital gains (long-term appreciation)?
- Do you have the mindset to use the money for college funding or do you have retirement in mind?
- Do you prefer a conservative investment method or you don’t mind risks and erratic ups and downs? This is to measure your risk level.
- How many years do you have in mind; nearest future or long-term future?
Step 2: Expense Ratio: This factor in itself can break or mar you in the mutual fund industry. It takes money to run a mutual fund, there are people to pay, bills to pay and it is until they break even that interests will be paid out so you want to make your research to know what the additional charges and expense ratio comes with the type of asset class you are choosing.
Step 3: Credible Management Team: Not every mutual fund manager succeeds or is an expert in the money market; therefore, you want to be careful with those you choose to invest with. Do your homework, ask extensive questions, look out for recommendations online and offline and do a little ‘snooping’ before taking the big step of investing. Any fund manager should have a litany of track record, accessibility, transparency and working contact information. Also, any good and viable fund manager should have a substantial portion of net worth invested with other investors.
Step 4: Objectives Compatibility: Every mutual fund company has their objectives; some go after value investment, e.g. Warren Buffet, Tweedy, Browne & Company, Fairholme Funds, etc. while some are more concerned with buying the fastest, best companies not minding the price, they are concerned about the here and now and are large risk-takers. Still, some are more comfortable investing in blue-chip companies with healthy dividend pay-out. It is essential you know which of the objectives matches yours before investing.
Step 5: No-load Mutual Fund: There is a No-load mutual fund package and a Sales Load mutual fund package. If you are just striking out, a No-load is the best option for you so that when your return gains come in, it is not some percentage less than your overall capital.
Step 6: Diversification Goal: Just as earlier said, there is no automatic diversification in mutual funds, it depends on what class of asset you are buying into and your fund manager, so, after settling with a good manager, ensure that your asset class boasts of enough diversification. Make sure to spread your asset out over different sectors, companies and industries, this will help you mitigate the risk of internal upheaval, ethics breaches and other internal issues.
Step 7: International Funds: If you want to consider the international market by owning a fund, make sure you invest in established markets such as Germany, Brazil, Japan, and other stable companies. Most emerging international markets pose a greater risk of political and economic risk even though they promise prospective greater gains.
How to Buy Mutual Funds
In the days when mutual fund just started (1924) down to the analog age, mutual funds could only be purchased through verifiable financial professionals namely financial planners, analysts, brokers and money managers
In this internet age, if you have a phone or laptop, you can easily access a mutual fund account online, all you have to pay attention to is; Where to buy them from, What kind of fund you want to buy, regular taxable account or a tax-deferred one and What type of commission fees you might come across. Whatever the case may be, there are three basic ways to buy mutual funds online:
Investment and Financial Companies
If you are looking into diversifying your fund family, then you want to consider this, as some investment companies allow you to use an in-house account to buy and sell mutual funds and exchange-traded funds offered by other firms.
The flip side though is that you may have to pay an additional transaction fee or additional commission if you want to dabble in other firms.
This is the most obvious option as these firms are channeled towards direct offering and maintaining mutual funds. They offer a variety of funds ranging from passive index funds to actively managed funds to a high-gain bond fund.
They are constructed to satisfy the cravings of any and every investor. When you buy directly from a mutual fund firm as an investor, you can be assured of no sales commission or brokerage fees, instead, all your capital goes to work right there for you although you will be limited to that company’s family of funds.
It is considered the most expensive form of investment as it charges a transaction fee or commission fee per trade not excluding other cost fees like maintenance fee, the upside, however, is that they offer the biggest basket of mutual funds to choose from.
Now that you are fully equipped with the information you need on mutual funds, you can now take the necessary informed steps to invest wisely, whether long term or short term.