It is likely you have heard about mutual funds, and you probably know that they can be a smart investment avenue for any investor, especially those pursuing smart financial living. But most people are not aware of exactly what mutual funds are and how they operate. In this article we will define what mutual funds are, how they work, their advantages and basic types, so that you can take more judicious decisions regarding your financial future. So let’s dive into the realm of mutual funds.
Mutual fund investments are one of the most popular investment vehicles for an everyday investor. Want to know why? Because they are really simple, which makes them easy to comprehend and use. So if you are not well-versed in finance or are not among the millions of mutual fund shareholders, don’t worry. You will require about 5 minutes going through this article, which will get you ready for investing.
Moreover, mutual funds investments are so simple in terms of versatility, accessibility and structure that they are equally attractive for all types of investors from beginners to professionals. They can be an appropriate avenue for plenty of investment and saving objectives such as retirement and college funds.
So here is what you need to know about mutual funds so that you can start investing in these profitable investment avenues. In case you have already invested in mutual funds we will inform you about how you can get optimal returns on your investment.
Definition of a Mutual Fund
A mutual fund is an investment vehicle that allows investors to pool funds together in a professionally managed investment. Mutual funds usually invest in stocks, cash, bonds and money market investments or a combination of these assets. The underlying securities are called holdings; these holdings in combination constitute a single mutual fund, which is often referred to as a portfolio.
Put more simply, mutual funds are akin to baskets. Each basket carries specific kinds of stocks, bonds, money market instruments or a combination of bonds or stocks that form a particular mutual fund portfolio. Take an example of an investor who makes investment in a mutual fund called ABC International Stock; this person is purchasing a single investment security, which is called the basket. This basket usually holds multiple stocks ranging from a dozen to hundred from all over the world, therefore the term international moniker.
It is important to realize that investors do not actually own underlying securities, which are referred to as holdings. Instead they own a representation of these securities in the form of mutual fund shares and not the shares of the holdings. So if a certain mutual fund holds shares of Apple Inc in its portfolio, among other securities, the mutual fund investors are not direct owners of Apple stock. Instead, they are owners of shares of that mutual fund. However, investors of this mutual fund will benefit from any appreciation in Apple’s stock.
As mutual funds tend to hold a variety of hundreds or even thousands of bonds or stocks, they are often called diversified investments. The idea of diversification bears close resemblance to the concept of strength in numbers. Diversification helps investors in reducing market risk, which tends to be higher when purchasing individual securities.
The Benefits of Investing in Mutual Funds
We can summarize the benefits of mutual funds in 4 words – versatility, simplicity, accessibility and diversity:
- Simplicity: A majority of investors lack the knowledge, resources and time to develop their own specific portfolio of bonds and stocks, which suits their need and risk appetite. However, professional stock investors have an extensive and thorough knowledge of technical analysis and fundamental analysis.
This is where mutual funds come in handy as they allow investors, who lack a sound grasp of investing strategies and concepts, to own a diverse and professionally managed portfolio. The wealth of knowledge, expertise and experience behind professionally managed mutual funds means investors don’t need to have knowledge of capital markets and their trends in order to be successful.
- Diversity: You all know that putting all your eggs in one basket is a recipe for disaster. It could not be truer for mutual fund investors, whether beginners or professionals. This is where mutual fund diversification comes in. In order to successfully diversify, an investor may need to purchase up to 20 or more stocks to spread the risk. However, a number of mutual funds provide complete diversification in a single security that can be bought with ease. Using this option, mutual fund investors can easily overcome the risks associated with the eggs-in-one-basket rule and later add a few more mutual funds to their portfolio to further diversify risk.
- Versatility: The slew of options available to mutual fund investors gives them access to nearly any segment of the market. Sector funds, for instance, enable investors to purchase into specialized market areas, like technology, financials, healthcare, and even social media.
Apart from sector funds, a mutual fund investor can also access other kind of assets like oil, gold and real estate. This versatility and flexibility can promote further diversification for the investor as his or her portfolio grows. Professional fund managers typically use sector funds for diversification when developing client portfolios.
- Accessibility: One of the best features of mutual funds is that you do not need a hefty amount of money to become an eligible investor. With amounts as low as $100 you can begin investing in mutual funds. And as mutual funds usually invest in dozens, hundreds or sometimes thousands of different securities, investors gain access to and benefit from a complete market of investable securities.
Take the example of an investor who buys shares in a single stock market index fund, by making this investment he or she is gaining exposure to nearly 3,000 stocks that are part of that single fund. This again stresses the simplicity and diversity of mutual fund investments. Although rarely do schools teach investing concepts and strategies, an amateur investor can easily find tips and tricks related to mutual fund investments both online and in books, and start investing in a matter of hours.
Basic Mutual Fund Types
The investment sphere is littered with thousands of mutual funds, but for ease of understanding, we can divide them into some basic categories and types. There are 2 main types of mutual funds, bond funds and stock funds. From here onward, fund categories get more diversified or specialized. For instance, stock funds can be divided into 3 sub-categories in terms of capitalization; these are called small-cap, mid-cap and large-cap. These 3 categories can be further split into value, growth or income and growth. In addition, stock funds can also be classified into foreign, international or global, each type having similar objectives.
Like stock funds, bond funds also have a few categories. They are mainly categorized based on their duration, which are long-term, medium-term and short-term. These funds are then divided into sub-categories, which are US Treasury bonds, corporate bonds and municipal bonds.
There are numerous mutual funds categories that are called index funds; these are often described as passively-managed. This means that portfolio managers of index funds do not actively engage in the buying and selling of securities, instead they match the holdings of their fund with a benchmark index like Dow Jones Industrial Average or S&P 500 index.
Read more about index funds
Amateur investors usually begin with the most desirable S&P 500 index funds. Index funds tend to have hundreds of holdings and usually provide investors the best features of a mutual fund, which are diversity, simplicity and low-cost.
Mutual Fund Costs
Remember that a fund manager does not come cheap. To be honest, mutual fund investments can be quite expensive. In exchange for his or her expertise and services a fund manager charges you an annual fee.
The main fee that you pay is called your expense ratio; this comprises management fee, administrative costs and distribution fee. Most mutual funds have an expense ratio of about 1.5%. Also when you invest in mutual funds, you may be required to pay a commission which is called back-end load or front-end load.
Another reason why mutual funds are expensive is that they are subject to substantial amount of tax and trading fee. The more your fund manager buys and sells securities the greater the amount of tax and trading fee. So it is reasonable to expect a minimum of 2% of your return to be eaten up by various fund related costs.
However, this is where an index fund trumps a conventional mutual fund. As index funds are passively-managed, they do not have money managers, therefore their expense-ratio is much lower than traditional mutual funds. It can be as low as 0.2%, which can mean substantial savings. For example, you have $ 10,000 for investment. You split this amount in 2 equal parts; the first is invested in a mutual fund with an expense ratio of 1.3%, while the second part is invested in an index fund with an expense ratio of 0.3 %. After 20 years, the mutual fund would end up costing you $ 28,000 more.