What are Mutual Funds?
Mutual Funds serve as alternative to stock investing especially for those who don’t have expertise or time to analyse or monitor stocks by themselves. By definition, a mutual fund is a company that usually pool money together from different investors to purchase stocks, bonds, short term money market instruments and other securities. The combination of these securities and assting in mutual funds is similar but quite different from stocks investing. When you invest in mutual funds, you are buying the shares of the mutual fund company. The mutual fund in turn uses the money you invested along with that of other investors to buy stocks of different companies, bonds and other securities. You can either buy the shares of a mutual fund from the company directly or through a professional investment broker. But in the case of stock investing, you are buying stocks of specific companies from the stock market. In this case, you can decide the stocks to buy by yourself or through a stock broker. The main objective of every investor is to achieve reasonable return on their investments. How do mutual funds investors earn income on their investments? If you invest in mutual funds, you can expect returns from three sources. When companies in which a mutual fund invested pay dividends, it usually distributes this amount to investors in proportion to the shares they hold in the fund. Also, just the same way an individual may decide to sell a stock that has appreciated in price in order to cash in the gain, mutual funds can do this as well. The gains on such stocks will be shared among investors. However, you may decide to reinvest your own share of dividend capital gain into the fund. Another way you can into the fund. Another way you can enjoy returns on mutual funds is by way of capital appreciation. When the value of securities in which a mutual fund invests increase, the share price of the fund increases as well. You can decide to sell your share in the fund back to the fund so that you can realise your gain. However, this may attract a capital gain tax.
Why Mutual Funds?
You may want to know why people may choose to invest in mutual funds instead of buying stock directly from the stock market. There are certain features that mutual funds have which tend to attract investors. These features are discussed below:
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You must have been told that investing in stocks involves risks. This is true. When you invest in stocks of a particular company, if anything negative happens to the company, its share price will go down. This can make investors to lose your investment in such stocks. In other to reduce such risk, experts usually advise investors to diversify by investing in stocks in different companies in different sectors of the economy. If a particular sector is not performing due to one reason or the other, your investment in other sector that is performing will help you cushion the effects of any loss you might suffer from the stocks in a non performing sector. But there is a constraint here. If you are a beginner with just little amount to invest say like $500, it is likely that you will invest all the money in buying just a particular stock. This will amount to putting all your eggs in one basket. Even though you would have loved to diversify your investments by buying stocks from different sectors, the amount you have at your disposal is not enough for that. If you invest the $500 in mutual funds, even though you are buying the share of the mutual fund company, your money along with contributions from other investors can be used to buy stocks from various companies in different sectors. Apart from stocks, the money can also be invested in bonds and other securities. By spreading your money across various investment vehicles, mutual funds help you reduce your risks. You own a proportion of the mutual funds’ portfolio.
However, you need to understand that investing in mutual funds does not eliminate risks. It only reduces risks through diversification. The value of your investment in mutual funds is determined by the Net Assets Value of the mutual fund. Remember that mutual funds usually invest in stocks, bonds and other securities. The performance of the securities has direct impacts on the Net Assets Value of the mutual fund. If the prices of the securities go up, the Net Assets Value of the mutual fund equally goes up. On the other hand, if the prices of the securities go down, the Net Assets Value of the mutual also goes down. That is to tell you that there is no investment that does not involve an element of risks. Therefore, you should bear it in mind that when you invest in mutual funds, there is not guarantee that your investment will remain intact. Nevertheless, there are different types of mutual funds. I will discuss more about this later. You can choose the mutual fund that will help you achieve your investment goals.
Mutual funds employ crop of experts and professionals who have expertise in money and investment management. In fact, the investment portfolio of mutual funds is usually managed by separate investment advisers that are registered by Securities and Exchange Commission. You may not have time or expertise in selecting and monitoring stocks performance or stock price movement. When you invest in mutual funds, you don’t need to bother yourself about monitoring stock performance. Even if you have the time to analyse stocks, you will be doing it on a part time basis. However, these investment managers are likely to be more updated in the happenings in the stock markets. Besides, their knowledge and expertise extend to other securities. So, investing in mutual funds allows you to tap into the wealth of experience which the investment managers have.
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Required Minimum Investment
It will interest you to note that you can start investing in mutual funds with just small amount. The amount you need to open a mutual fund account may even be smaller than what you need to buy penny stock. For instance, you can start investing in mutual funds with just $200. This amount may seem insignificant to you. But when you consider the pool of investors that contributes to mutual funds every month, you will realise that the amount usually pooled together by mutual funds can be very huge. For instance, if 5,000 people contribute just $200 each in a month, that will amount to $1,000,000. I am trying to be conservative in my example. There will be investors who will be able to afford to contribute $2,000 or more. With this pool of money, your money can be invested almost immediately without necessarily the need to wait till your contribution reaches a particular amount. Each amount you contribute qualifies you for your own share of the big pie.
Just like when you invest in stocks, you can decide to sell all or part of your investment in mutual funds in any working day. You can redeem your share at the net asset value of the mutual funds at the close of business and you can be sure of getting paid within seven days. You may need to pay redemption fees and capital gain tax on the proceeds. If you invest in stocks that are not well traded, you may find it difficult to sell your stocks at times. But in the case of mutual funds, you are not selling any stocks. You are just selling the share you hold in the mutual fund.
Less susceptible to Fraud
Unlike penny stocks, mutual funds are well regulated by law. They are expected to file prospectus with securities and exchange commission. The prospectus and shareholders’ report are available to help investors and prospective investors make informed decision. In you are investing in penny stocks, you can easily fall victims of scammers or pump and dump schemes. Also, the fact that the investment portfolio of mutual funds are managed by investment advisers that are registered with Securities and Exchange Commission serves as another protection for investors. Nevertheless, you may need to find out who the investment advisers of a fund are before you invest your money in the fund.
Drawbacks of Mutual Funds
With all the advantages discussed above, mutual funds have some drawbacks as well. When you compare these drawbacks with the advantages, you will be able to decide whether it will be a good investment option for you or not. Below are the main disadvantages of mutual funds.
Mutual funds have different fees which they charge their customers. Among the popular ones are account fee which may be charged annually. There are transaction fees, that is, front-end load or back-end load. These are the fees you pay when you buy or sell share in the fund. This depends on the each mutual fund. Besides, there are other operating expenses which may be charged against your account. The operating expenses are used to pay fund managers, accountants, research staff and other marketing and distribution expenses. When you sum up all these fees, it can be very high. This tends to reduce the returns on your investment. Unfortunately, whether you are making gain on your investment or not, you may still need to pay the fees. Therefore, before you settle for any mutual fund, it is important that you find out what their fees look like so that you can compare them with what other mutual funds charge. The fees are usually listed in the section called “Fee Table” in the prospectus of every mutual fund. If you are good at financial analysis, you may want to consider the fund operating expenses ratio. The ratio is calculated by expressing the total operating expenses of a fund as a percentage of its income or net assets. If you consider that the fee you will be paying by investing in mutual funds will be too high, it may worth considering managing your own portfolio if you have the time and expertise required.
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Lack of Control
When it comes to how your funds will be invested, you don’t have any say. You can only buy shares in a fund. The fund has the prerogative to invest the money in any securities as it deems fit in line with their modus operandi. However, you can choose the type of mutual funds that support your investment goals and your attitude to risks.
The same way diversification can be an advantage, it can also turn out to be a disadvantage. When a mutual fund over-diversifies; it may end up investing part of your fund in securities that don’t perform very well. This may even erode the gains you realise on the performing securities. Some investors will not mind keeping all their eggs in a good basket and watch over it. By this, they will be able to maximise their returns. Let’s assume that a mutual fund has two securities in its portfolio. In each security, a sum of $10,000 was invested. If the first security achieved 50% return, that will be $5,000 gain. But if the second security recorded 50% loss, that would have eroded the whole $5,000 gain in the first security. But supposing the whole $20,000 was invested in the security that achieved 50% return, the gain would have been $10,000 instead of nothing. So, diversification can hinder returns at times. Also, when it comes to diversification, mutual fund may be confused on how to allocate funds. For instance, a mutual fund may end up allocating more resources into a security that may not perform very well at the end of the year. So, it won’t matter if the security with little resource allocation performs excellently, it won’t make much impact on the total investment.
Mutual funds share price is not available real time as obtainable in stocks trading. Mutual funds have to do their own calculation at the end of trading day. It may take hours before the information is available to investors. The share price of a mutual fund is usually arrived at by removing its liabilities from its assets, hence the term net asset value.
Analysis of Performance
It may be difficult analysing the performance of a mutual fund. That is not to say that you can’t compare the performance of one mutual fund with another. The problem is that, you can’t use the past performance to judge the future performance of any fund. The net asset value (NAV) of the price of any fund largely depend on the performance of the securities it invest in. If you are investing in stocks, you can carry out both the technical and fundamental analysis of the stocks to certain extent. This can guide you in predicting what may be its future performance. You cannot do this with mutual fund. Also, every fund has its approach and goal which may be different from the others. Therefore, it may be wrong comparing the performance or returns of two different mutual funds. For instance, comparing the performance of a money market fund with stock fund will be inappropriate.
Types of Mutual Funds
If you decide to invest in mutual funds, it is still important that you properly define your investment goals. Mutual funds are not the same. They come with varying levels of risks and rewards. Therefore, you need to understand your risk tolerance level as mutual funds are not totally risk free. This will guide you on the type of mutual funds you should invest in.
Stock Funds: Stock funds invest primarily in stock markets. They invest in different types of stocks depending on their investment objective and strategies. They may focus on a particular type of stocks or it can be a mix of the stocks. Essentially, the stock funds can be categorised into, growth funds, income funds, index funds and sector funds. Growth funds as the name implies are the ones that invest in stocks that have potential for price appreciation. This type of stocks may not pay dividends but the net asset value of the funds gets enhanced through appreciation of the stocks they invest in. Income funds on the other hand target blue chip companies that have good track of dividend payments. There may not be much room for further growth of the stock price, but one can rely on the fact that the companies will pay dividends at the end of the year. Some may even pay interim dividends. Index funds on the other hand may choose certain group of stocks and decide to invest in them. For instance, index funds may choose to focus on small-cap stocks or large-cap companies and invest in all the companies that make the index. A good example of index fund is S&P 500. Sector funds are sector based and will choose to focus on a particular sector of the economy. Sector funds may decide to focus on banking, manufacturing or insurance sector.
It is important that you match these stock funds with your investment objectives. If you are a retiree, investing in growth funds may not be ideal for you. Instead, you will rather be interested in income funds. It is likely that a retiree may not have other sources of income other than living on passive income. That is why he must focus on the investment that can guarantee him income. Also, he may not be willing to risk his money on growth funds. Growth funds attract more risks and it requires long term perspective.
Bond Funds: This involves investment mainly in bonds and other debt instruments. This kind of funds is good for people that want to preserve their capital while at the same time like to enjoy returns on their investment. That is not to say that there is no risk attached to this type of mutual funds. There is a risk that the borrower may not be able to pay interest on the bond. This means loss of income to the investor. Also, there is a risk that the borrower may not be able to pay back the principal. But in case the borrower files for bankruptcy, secured debts and other debts will be ranked above equity investors.
Money Market Funds: These are generally regulated by law. The law protects investors by ensuring that money market funds are only invested in high quality short term investment such as government securities. The risk involved in money market funds is considerably low when compared to bond funds. Also, the return is low and can be overrun by inflation. People who are risk averse usually favour this type of mutual funds. The short term interest rates on this type of securities may be low but investors rarely lose their money. Therefore, you don’t have to worry about losing your money.
Balanced Funds: As a result of different risks and rewards that are attributable to the types of mutual funds discussed, balance funds attempt to balance theses risks by investing in different type of investment instruments. Balance Funds invest in stocks, bonds and stock money markets. However, it is important to mention that it may be difficult for any fund to achieve balanced assets allocation. Therefore, balance funds still has its own risks.
Target Date Funds: You can call this target date retirement fund or lifecycle fund. This fund usually invests in different securities such as stocks, bonds, real estate and other investments. Overtime, the investment will be restructured to suit the fund’s investment’s objective especially in meeting a set retirement date of the individuals involved. At the beginning, target date funds may focus more on growth stocks and other securities that has high returns potential. It means that the funds is equally willing to take some risks with its investment. But as the set retirement date is approaching, the fund will start focusing more on less risky securities. Target date funds may have more of the securities that constitute its portfolio to be stocks in the beginning . Later it may shift to having more of bonds and later to money market instruments. The essence of the change in the mix of the securities that make up the portfolio is to ensure that the risks involved in the investment reflect the investment goals and the appetite for risks of individuals involved in the fund.
As a result of the different types of mutual funds available, it may be advisable that you seek the advice of a professional in order to ensure that you choose the right mutual fund. The different types of mutual funds also allows you to diversify what you have in your portfolio.