If you are interested in the finance world definitely you know what a fund is and how it works. If you are a beginner let us give you a brief definition of funds. A fund is a pool of money set aside for a specific aim. This money can be invested and professionally managed in order to generate returns for its investors. There are different types of funds such as pension funds, insurance funds, foundations, and endowments.
In this article we are going to focus on mutual funds. What are these mutual funds and how do they work to generate money for your benefit in the long term?
You know there is an old saying “don’t put all your eggs in one basket”. Mutual funds affirm this old advice. Mutual funds are baskets filled with different types of investments (usually stocks) that allow people to invest while mitigating the risk of choosing individual securities. We can also call them multiple funds.
Instead of requiring investors to perform the massive task of picking individual stocks themselves, mutual funds allow average investors to simply choose types of funds that would suit them.
Today’s social media platforms are full of people who give financial advice or talk about investment tools, mutual funds or trust funds. Mutual funds are typically one of those personal finance topics people pretend they know about but most of them they don’t actually have any idea what they are. This is why we recommend that our customers read and research about this topic before making any long term serious investment decisions.
Like any other funds, mutual funds charge annual fees, expense ratios, or commissions, which lower their overall returns. It is important to take them into account when you are doing your numbers. Mutual funds also offer more security on their investment objectives, and the type of returns they seek. There are different categories such as stock funds, bond funds, index mutual funds, balanced funds, money market mutual funds, income funds, international mutual funds, regional mutual funds, sector and theme mutual funds, socially responsible mutual funds and so on.
Primary Mutual funds fall into three main categories:
As we know the risk factor in investing has different levels and different returns. Equity funds are made up of investments of only common stock. These can be riskier (and earn more money) than other types. These funds are generally associated with stock market volatility and losses. However, the return in the long term can be much higher. Equity funds are also categorised. Primarily they are categories as passive and active investments. Active equity funds require more action such as buying and selling constantly and management by a manager fund. Passive funds are easier to manage as they are planned for more long term goals.
Just like any other type of investment equity funds also require a good strategy. These strategies can be created depending on the growth and value or market capitalization. Geographic funds, sector funds and specialty funds also fall under the equity funds.
Another important point is tax on equity funds. Every country has a different tax system. Make sure you talk to your accountant or tax advisor regarding your tax obligations if you are going to invest in equity funds.
Fixed-income funds are made up of government and corporate securities that provide a fixed return and are usually low risk. These instruments pay a set interest rate return in exchange for investors lending their money and pay a set level of income to investors, typically in the form of fixed interest or dividends. We can categorise them under short term investments. They offer lower risks and lower returns compared to equity funds. When you invest in fixed income securities in case of bankruptcy, fixed-income investors are often paid before common stockholders.
Here common types of fixed income products:
-Treasury bills (T-bills)
-Treasury notes (T-notes)
-Treasury bonds (T-bonds)
-Treasury Inflation-Protected Securities (TIPS)
-A municipal bond
-Corporate bonds
-Junk bonds
-A certificate of deposit (CD)
For fixed-income securities generally it is advised to follow Ladder strategy. This strategy includes investment in short-term bonds with different maturities.
The biggest advantage of these funds is that you can create a decent income for yourself by investing in fixed-income securities. If you go for Treasury bonds they are under the guarantee of the government. And corporate bonds, while not insured, are backed by the financial viability of the underlying company. When we look at the disadvantages of fixed income funds we need to consider credit and default risks as well as interest rate risk and Inflationary risk.
Balanced funds combine both stocks and bonds in the investment pool and offer a moderate to low risk. While low risk may sound good, it is also accompanied by lower rates of return-meaning you risk less, but your investment won’t earn as much. You have to decide how much risk you’re willing to take on before you invest your money.
Here the aim is to create a mixture of growth and income. You can divide your portfolio between 70% stocks and 30% bonds. These types of bonds are more suitable for those looking for more safety and modest capital. If you are looking for tax benefits, Balanced funds are not for you. There is less volatility and low-risk.
How Do Mutual Funds Work?
When you buy shares of a mutual fund, you’re purchasing a right to a portion of the returns earned by the fund’s portfolio of stocks, bonds and other assets. Mutual means that you split the profits (and the losses) with the other investors in the fund, says Brandon Renfro, a Certified Financial Planner and assistant professor of finance at East Texas Baptist University. When purchasing shares in a mutual fund, you can choose to receive your distributions directly, or have them reinvested in the fund.
A mutual fund earns dividends and interest from the various investments held in its portfolio. Fund managers can choose to reinvest the profits or distribute them to their investors, depending on their strategy and overall market conditions. When the managers generate capital gains (or losses) by selling assets, they’re also passed on to investors.
Mutual also means that the performance of a mutual fund depends not only on the fund’s manager, but also on the behaviour of the investors. When holders sell their mutual fund shares, the fund manager may need to liquidate holdings from the portfolio. The sale of those assets could be ill-timed, resulting in losses for the fund—which may be passed on to the remaining investors.
Also you need to understand capital gains to broaden your understanding of how mutual funds work. For example when a fund sells a security that has gone up in price, this is a capital gain. And vice versa when a fund sells a security that has gone down in price, this is a capital loss. Generally funds distribute net capital gains annually and this reflects on tax bills. This affects individuals who will pay higher capital gains tax rates. If you are not a high-net-worth individual then you don’t need to worry about these tax rates.
Mutual Fund Fees
As we have commented before there are fees associated with investing in mutual funds. You need to consider these costs because they might significantly affect your investment returns over time. Let’s explain some mutual fund fees here; however please make sure you are not missing extra costs and fees while you are investing.
Expense ratio: This is an annual fee that covers the fund’s operating expenses, including management fees, administrative costs, and marketing expenses.
Sales charges or loads: Some mutual funds charge sales fees, known as “loads,” when you buy or sell shares. These fees can change depending on the platform that you manage your funds.
Redemption fees: Some mutual funds charge a redemption fee when you sell shares within a short period (from 30 to 180 days) after buying them. This fee might vary depending on the country. Each country’s securities have their own limits. Also note that this fee is designed to discourage short-term trading in these funds for stability.
Other account fees: Some funds or brokerage firms may charge extra fees for maintaining your account or transactions, especially if your balance falls below a certain minimum.
Even though many mutual funds are “no-load”, it might be a better option to purchase a fund directly from the mutual fund company instead of going through an intermediary to avoid brokerage fees and commissions.
Mutual Funds are not only for stock market investing
The biggest misconception about investing in Mutual Funds is – investors usually assume that Mutual Funds only invest in the stock markets. But, this is not exactly true. If you are a conservative investor, and you do not prefer to take too much risk, then through Debt Mutual Funds, you can also invest in debt instruments, where the risk factors are much less.
Hence you can choose Mutual Funds, as per your risk appetite, investment horizon, or your investment objectives. And there are tons of Mutual Funds to choose from, and you can pick the one that fits your criteria perfectly.
So in a nutshell let’s see what are the pros and cons of Mutual Funds:
Mutual fund pros and cons
Mutual funds are preferred by many people because they are very solid investment tools. We have mostly talked about the pros of mutual funds however there are also cons that we need to watch out for and research.
Pros
Let’s talk about main advantages to investing in mutual funds:
Professional management: Generally mutual funds are managed by experts and professionals called fund managers. They take daily decisions and create strategies on purchasing and selling based on the fund’s goals. For example if the fund owner is looking for high growth, managers can go for major stock markets to get better returns. Or they can try to get the highest returns with the lowest risk. If you are willing to pay the price to grow and secure your funds, you can get this service for mutual funds investments.
Simplicity: If you do good research and find a solid investment mutual fund, then you don’t need to do much. You can let the rest to the fund managers so they can work their way to grow your investments.
Budget Friendly: It is possible to find mutual funds starting from $500, however you can also find funds with lower minimums.
Easily cashable: Mutual funds are easy to buy and sell when you need them. If you need money quickly you don’t need to wait long to turn it into cash.
Don’t put all your eggs in just one basket. This is a key principle of investing: If you invest all your money in a single company and it fails, you might lose everything. However, if one company within a mutual fund fails, your loss is limited. Mutual funds offer a way to access diversified investments without the challenge of individually purchasing and managing multiple assets.
Like we have mentioned before there are some disadvantages, let’s see what are the cons of mutual funds.
Cons
Main drawbacks of mutual funds:
Fees: One of the biggest disadvantages of mutual funds is the fees, which you have to pay regardless of the fund’s performance. However, fees tend to be lower for passively managed funds compared to actively managed ones.
Lack of Control: Investors don’t have control over the specific assets in the fund’s portfolio and may not know exactly what’s being purchased. However, this can be advantageous for those who lack the time or interest to manage a diverse portfolio.
Differences between Mutual Funds vs. ETFs vs. Stocks
Right now there are so many different investment options available, it can be challenging to decide which one suits you best. Please make a good research and quick comparison of these three popular investment choices: mutual funds, ETFs, and stocks. You can compare the fees and buying processes. So you can decide which one is more suitable for your investment goal.
