If you want to take part in the financial markets, there are a wide range of asset classes to choose from. One of the most popular ways of investing for beginner investors is through mutual funds. In this guide about investing in mutual funds, you will learn what a mutual fund is and what its pros and cons are. You will find out whether it satisfies your long-term goals and how to choose the best mutual fund to invest in according to your investment strategy.
- What is a mutual fund?
- How do mutual funds work?
- How to invest in mutual funds?
- What earnings can you expect from mutual funds?
- Different types of mutual funds
- Fees associated with mutual funds
- Pros and cons of mutual funds
What is a mutual fund?
A mutual fund is a collective investment scheme constructed of separate pools of money. All of these pools come from different investors. The money from the mutual fund is usually invested on behalf of the investor in various instruments and assets such as stocks, bonds, FX, etc. Mutual funds are run by fund managers. The goal of these experienced professionals is to achieve the investment objectives set in the fund’s prospectus. By following strictly defined investment strategies, they focus on gaining profits and increase the capital at their disposal.
Mutual funds have established themselves as a very popular instrument among investors. They are considered as an easy and attractive way for all types of investors to gain access to professionally-managed financial instruments. Therefore, a mutual fund is a perfect investment opportunity due to the fact that it allows investors to take part in the financial markets by investing in a diversified portfolio. Mutual funds are especially suitable for beginner investors.
How do mutual funds work?
Investing in mutual funds is very similar to investing in stocks. One difference is that when you invest in mutual funds, you don’t have voting rights. The constant money flow that mutual funds receive, is then reinvested in new securities and other assets. That way, the performance of the fund is optimized and the value of a mutual fund unit can be increased. The performance of the mutual fund is usually tracked by its total market capitalization. If a profit or loss is registered, it is then proportionally spread among each of the mutual fund investors.
There are two main types of mutual funds. The goal of an actively managed mutual fund is to outperform a given benchmark like the S&P 500. The fund manager and his team evaluate the different types of securities and decide in which to invest. That is why, the success of the portfolio manager is measured by the returns of the fund that he runs, compared to the relative benchmark. On the other hand – the securities of the passively managed mutual fund are automatically selected to match an index or a given part of the market.
How to invest in mutual funds?
Investing in mutual funds is an easy task. You can do that by purchasing mutual fund units. The mutual fund units are basically the shares of the mutual fund. That is why, when you decide to buy a mutual fund unit, you are buying the ownership from the company that runs the fund and its assets. The price at which this purchase happens is called Net Asset Value per share. The NAV is calculated when the total value of the securities included in the portfolio is divided by the total amount of all the shares outstanding.
Mutual fund shares are redeemable which means that you can sell them back to the fund whenever you want. In most cases, you will receive your payment within a few days. You can purchase mutual fund units directly from the fund or through third-parties such as banks or brokers. But before you chose from where to buy your mutual fund units, make sure to check the costs and the terms. That way you can save some money from commissions or other fees.
How do you earn from mutual funds?
There are basically three possible ways to earn from your mutual fund investment:
Dividends and interests
Most mutual funds have stocks and bonds in their portfolios. If that is the case with your fund, then you usually will receive a specific payout on a regular basis. It will be calculated from all the generated returns of the dividends and interests of the instruments. You can choose from two different ways to receive your income. You can either choose to reinvest the mutual fund dividend so that you can buy additional units or receive a check for distribution.
Profits from equity trading
Some mutual funds specialize in generating profits from actively trading securities. Once a security increases in price, the fund manager may decide to take profit. Such investment strategies provide the opportunity to generate significant capital gains that the mutual fund company can, later on, distribute to the mutual fund investors.
The performance of the mutual fund
The successful management of a mutual fund usually increases the price of its units. You can profit from the fund’s performance by selling your fund units once the price reaches certain levels.
Types of mutual funds
Depending on their characteristics and the asset classes that they invest in, experts classify mutual funds in types. The most widely spread types of mutual funds are:
Equity funds have established themselves as one of the most popular types. As their name suggests, they focus on investing, for the most part, in stocks. The goal of equity funds is to ensure long-term capital growth. Equity funds offer various types of investment opportunities. Some of them invest in small- and mid-cap stocks, while others focus mostly on large-caps. That provides the mutual fund investor with a good variety of options to choose from.
Fixed income funds
Fixed income ones are another very popular type of mutual fund. By investing in instruments with stable rates of return, their main goal is to preserve their capital and increase it steadily over time. Fixed income mutual funds invest heavily in government, corporate and other types of bonds. Their strategy is to hold the instruments until their maturity and receive interest payments. This type of mutual funds can be a good choice for conservative investors.
Money market funds
This type of mutual funds is very similar to the previous one. Money market funds serve as a shelter for investors who want to find the safest place to keep their money and still receive some returns. Money market funds invest predominantly in risk-free instruments. Bear in mind that this type of fund won’t provide you with significant returns. Yet, money market funds can be a better option than keeping your money in a savings account for example.
Balanced funds are a very popular choice for investors who want to have a portfolio diversified among different asset classes. Most balanced funds usually invest in fixed income and equities. The ratio between these asset classes in most of the balanced funds is 40:60 respectively. Depending on the allocation plan of the fund manager and investment strategy, the weights can vary.
Index funds are very similar to exchange-traded funds (ETFs). These instruments are perfect for those who believe that professional fund managers can’t outperform the market. Most of the index funds contain liquid stocks, part of a major index. If you want to replicate the performance of major indices, then you can choose index funds. That way, you will be basically investing in indices like S&P 500, DJIA, NASDAQ, etc.
Except the types listed above, there are many other types of mutual funds. For example, global funds have their focus mostly on foreign assets, while specialty funds are sector-specific ones. Once you have defined your investment goals and overall strategy, you will surely find suitable mutual funds to invest in.
Mutual fund fees
The benefits of investing in mutual funds do not come for free. Here are the two types of fees that you will be paying if you decide to invest in mutual funds:
Annual operating fees
Investment funds charge you annual operating fees on a yearly basis, in the form of a percentage of the funds under management. The amount of the fee is usually between 1% and 3%. These fees are also referred as the expense ratio. The expense ratio is a sum of all the fees – the advisory, management, and the administrative fees.
Transaction fees, on the other hand, come in the form of commissions or redemption fees. You pay them whenever you buy or sell fund units. The commissions can be two different types – front-end loads and back-end loads. The front-end loads are assessed when the shares are purchased, while the back-end ones when the shares are sold.
There are also no-load mutual funds that won’t charge you any commission costs. They are usually available right from the mutual fund companies (the issuer) and are a good way to reduce the fees, associated with your investment. Bear in mind that some mutual funds may charge additional fees if you withdraw your money earlier. That is why you should make sure to get familiar with the fund’s prospectus at an early stage.
Pros and cons of mutual funds
In order to judge whether mutual funds are a suitable investment class for you, it is important to take a look at the main arguments pro and contra mutual funds.
- Professional management
- Economy of scale
- Low investment minimum
- Flexible and easy to buy
Investors prefer mutual funds due to their significant diversification. This type of investment is very well diversified and the risk is spread among a large number of instruments. Mutual fund managers focus on combining different types of instruments from various sectors which allows them to mitigate the risk. If you want to generate capital gains, while at the same time maintain a well-diversified portfolio, then mutual funds can be the right choice for you.
Investing in separate different stocks to structure your own diversified portfolio can be more expensive. Mutual funds reduce the costs, while at the same time allow you to replicate the performance of your preferred instruments. That way, with a way lower investment, you can diversify your portfolio with sector-specific stocks with different caps, bonds with various issuers and maturities or other asset classes.
One of the main benefits of mutual funds is their professional management. Mutual funds are the easiest and one of the cheapest ways to have your investment managed by a professional. Fund managers perform in-depth research, back-testing, and thorough market analysis in order to pick the best investments out there. All that comes at the cost of a small fee. This makes mutual funds a very suitable choice for investors with not so solid experience.
Economy of scale
By investing in a mutual fund, you basically reduce the transaction costs that you will otherwise pay, if you decide to invest in separate instruments. For example – if you buy stocks of 10 different companies, you will pay 10x the transactional cost. With mutual funds, you pay it once, while at the same time you get exposure to all stocks that you want. That way you can structure a well-diversified portfolio at low cost.
Low investment minimum
Mutual funds can be a good choice for those who do not want to invest significant amounts. For example, some mutual funds have investment minimums as low as $50. Nevertheless, most of them are in the range of $1,000 – $3,000. That makes them a suitable investment tool for the wide investment public.
Flexible and easy to buy
Mutual funds are suitable for all types of investors. Due to all the different types of mutual funds, even the inexperienced investor can find what he wants. Different fund managers employ different investment strategies – from value and growth investing, to focus on developed or emerging markets.
Investors have all the freedom to choose their most preferred type of fund. Mutual funds are easy to understand, while at the same time offer high liquidity and significant diversification opportunities. You can take advantage of these flexible instruments easily. You can buy mutual fund shares easily through your bank or online broker.
Like every other investment opportunity, mutual funds also bear some risk. Although it are professional fund managers that run mutual funds, they can be on the losing side. Mutual funds bear the risk of their underlying assets. No matter whether they are bonds, equities or cash, the mutual fund is at risk for its value to depreciate.
A major obstacle when choosing in which mutual fund to invest in is the fact that they are often hard to evaluate. Unlike stocks, mutual funds don’t have specific ratios and metrics such as Price-to-Book, Price-to-Earnings, Earnings-per-Share, etc. One metric to use when you compare mutual funds is the performance of the NAV (Net Asset Value). When choosing the top mutual funds to invest in, make sure to evaluate the performance of a mutual fund, make sure to look back at the returns for at least the last 3 to 5 years.
The professional management of mutual funds comes at a cost. The truth is that you must pay the management fees and transactional costs even if the fund underperforms. That is why finding a mutual fund that offers reasonable fees and good performance at the same time is very important.
Due to liquidity concerns, mutual funds should maintain a part of their portfolios in cash. However, keeping cash means that the fund cannot invest the money and generate any return. That is why, if you prefer to avoid such liquidity requirements, then mutual funds may not be your best choice.
The bottom line
Mutual funds are a universal investment tool that has something to offer to every type of investor. The most important thing to do before finding the best mutual funds to invest in is to define your investment strategy and goals. Then do your research and find the top-performing mutual funds with transparent history, high average mutual fund return, reasonable investment minimums and low expense ratios.