In a world where financial investments play a significant part of many people’s wealth building, savings and retirement planning, pooled investments managed by professionals are becoming popular. Rather than selecting stock and keeping an eye on its performance, mutual funds combine funds from numerous investors and employ a disciplined investment approach. In this way, trillions of dollars have been invested in markets across the globe.
As the number of mutual funds continues to grow, the strategies used to maintain them increase as well. They are seen as a way for the average investor to get involved in the action. Instead of spending time analysing financial reports, all you need to do is buy a mutual fund and let a professional manage it. That’s the simple way of looking at it, though seasoned investors such as Henner Diekmann – an attorney who specialises in international trade and foreign direct investment – know that there’s more to them. This is why it’s important to understand how they work and the different types that exist.
To varying degrees, the various types of mutual funds carry some level of risk and reward. The higher the potential reward, the higher the level of risk involved. Although some funds carry less risk than others, it’s never possible to avoid risk completely. This is true for all investments. However, knowing which type of fund to focus on can help in making better decisions.
At a basic level, mutual funds are divided into the following broad categories: fixed-income funds (invest in bonds), equity funds (invest in stocks), those that invest in both groups (called balanced funds), and money market funds (those that provide risk-free rates).
Money Market Funds
These funds typically invest in short-term securities such as treasury bills and government bonds. They’re a safe bet for any investor who doesn’t mind minimal returns with the assurance of keeping the principal amount. Money market funds offer potentially lower returns than all other types.
Fixed Income Funds
Their name betrays their sole purpose: to provide a steady income on a regular basis. These funds invest in high-yield government or corporate debt, with the investor gaining money from the interest earned on these investments. The typical audience for such funds is conservative investors who want a steady flow of cash.
Equity Funds
Equity funds invest in stocks, with the aim being to grow the money faster than fixed-income or money market funds. There’s an element of risk with these funds and they represent the majority of mutual funds. Due to the different types of equities available, investors have a range of investment funds to choose from.
Balanced Funds
Their primary purpose is to provide a mixture of safety while generating as much income as possible for the investor. They typically balance the portfolio between fixed income and equities. Most fund managers who offer these allow for a formula to split the money. The more aggressive funds tend to have fewer fixed income funds than equities, with the reverse happening for conservative funds.
Speciality Funds
This classification explains a group of mutual funds that don’t necessarily abide by the major categories. Rather, they tend to focus on a particular sector of the economy or employ a certain strategy. Sector funds, for example, concentrate on a sector of the economy such as health or technology. Ethical funds (or socially responsible funds) invest in companies that advocate certain beliefs such as diversity and environmental conservation while shunning industries such as weapons, alcoholic beverages or gambling.
How Investors Benefit
Typically, investors gain returns from mutual funds in the following ways:
- Interest earned from bonds and dividends on stocks. A mutual fund pays out a big chunk of the income it receives over the year in the form of distribution. Many funds give investors the opportunity to either reinvest the earnings or cash in their distribution
- Capital gains from selling securities that appreciate in price. These benefits are passed on to investors through distribution.
- Selling of mutual funds for a profit in the event the fund’s holdings increase in price, thus increasing the fund’s share price.
Benefits of Mutual Funds
The major draw of mutual funds is the management by knowledgeable professionals. The investor doesn’t have to keep a close eye at all times; the investment manager is on hand to do the research and trade prudently.
Secondly, individual investors benefit from the economies of scale afforded by the mutual fund. The transaction costs of buying and selling large amounts of securities are lower, and the pooling of resources helps funds invest in certain assets that individual investors may not afford to.
Third, mutual funds provide an aspect of diversification to investors. Rather than putting all your eggs in one basket, a mutual fund spreads the investment across various assets so that gains in one asset balance against a loss in another.
FAQs
A mutual fund is a pool of money managed by a professional Fund Manager. It is a trust that collects money from a number of investors who share a common investment objective and invests the same in equities, bonds, money market instruments and/or other securities.
Are mutual funds enough? ›
Investing in many large cap mutual funds is not necessary. One well-chosen large cap mutual fund should be enough. Mid cap equity mutual funds invest in mid cap companies only.
How do you understand investing in mutual funds? ›
A mutual fund is a managed portfolio of investments that investors can purchase shares of. Mutual fund managers pools money from many investors and invest the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio.
Will you consider investing in mutual funds? ›
Professional management
A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments. Mutual funds require much lower investment minimums, providing a low-cost way for individual investors to experience and benefit from professional money management.
What is the basic knowledge of mutual funds? ›
A mutual fund is a collective investment vehicle that collects & pools money from a number of investors and invests the same in equities, bonds, government securities, money market instruments. The money collected in mutual fund scheme is invested by professional fund managers in stocks and bonds etc.
How does mutual fund work with an example? ›
Mutual funds can be actively managed funds or passively managed funds. In actively managed funds, the fund manager performs market research to align the portfolio with the fund's objective. While passively managed funds replicate the index or benchmark. For example, exchange traded fund (ETF) and index fund.
How many mutual funds are enough? ›
There is no one right answer to questions like how many funds should I invest in. But just adding new funds to the portfolio to 'diversify' or reduce risks doesn't work. So, in general, having 1-2 schemes in the chosen fund category would be sufficient.
Are mutual funds easier than stocks? ›
Mutual funds and stocks both trade on public exchanges and give you access to the shares of your favorite companies. However, mutual funds require less work and offer instant diversification. Many mutual funds hold hundreds of stocks, and a dedicated fund manager oversees the portfolio.
Are mutual funds better than stocks? ›
Mutual funds or stocks—which one offers more security? Mutual funds typically offer more security compared to individual stocks because they spread investments across various assets, reducing the impact of market fluctuations. However, the level of security depends on the specific mutual fund or stock chosen.
What are the pros and cons of mutual funds? ›
Some of the advantages of mutual funds include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing, while disadvantages include high expense ratios and sales charges, management abuses, tax inefficiency, and poor trade execution.
Mutual funds are sold in shares.
The value of the holder's shares varies with changes in the value of the fund's investments. At the end of each business day, the fund determines the value of its assets and divides the total by the number of shares to arrive at the fund's net asset value (NAV).
Should I invest all my money in mutual funds? ›
In many instances, this is not a risk you should be taking on, especially if you have been saving up for a specific purchase or life goal. Mutual funds may also not be the best option for more sophisticated investors with solid financial knowledge and a substantial amount of capital to invest.
Does your money grow in mutual funds? ›
You can also think of it as interest on interest. Compound interest allows your balance to grow faster than simple interest, which only takes the principal amount into account. It's easy to increase your compound interest as a mutual fund investor. The more money you invest and the longer it sits, the more it grows.
Are mutual funds good or bad? ›
Mutual funds can be good for diversification and professional management, but like any investment, they come with risks. It depends on individual financial goals and risk tolerance.
How does a mutual fund make money? ›
Mutual funds make money by charging investors a percentage of assets under management and may also charge a sales commission (load) upon fund purchase or redemption. Fund fees, called the expense ratio, can range from close to 0% to more than 2% depending on the fund's operating costs and investment style.
What is the role of a mutual fund? ›
The primary function of a mutual fund is to pool money from multiple investors and invest it in a diversified portfolio of securities, aiming to generate returns and spread risk across various assets.
What is a mutual fund vs stock? ›
Stocks represent shares in individual companies while mutual funds can include hundreds — or even thousands — of stocks, bonds or other assets. You don't have to choose one or the other, though. Mutual funds and stocks can both be used in a portfolio to help you grow your wealth and meet your financial goals.
