Mutual funds are great investment options for investors looking for investments with less risk and a good return potential. They offer accessibility and liquidity and help individual investors avoid the management risks that come from managing their portfolios themselves.
This article discusses mutual funds, their types, benefits, and other important things you need to know before investing in them.
What is a Mutual Fund?
A mutual fund is an investment vehicle that pools funds from many investors to buy a diversified portfolio of stocks, bonds, money market instruments, and other securities. People do this to mitigate the risk associated with individual stocks, as it’s extremely difficult for all the assets in a mutual fund to fail at once.
Professional fund manager manage mutual funds. Their responsibility is to make investment decisions on behalf of the investors. These managers charge the investors a fee (expense ratio) to help manage their funds. In Australia, the Australian Securities and Investments Commission (ASIC) regulates mutual funds.
How Does a Mutual Fund Work?
When an investment company launches a mutual fund, it issues shares to the public, and interested investors can buy them to become part-owners of the mutual fund. The value of the mutual fund is the total amount the investors contribute.
Once the funds for the mutual funds are contributed, the fund managers diversify the investment by spreading the funds across various securities, from stocks to bonds, money market assets, and more. This is crucial for maintaining the profitability of the mutual fund, as the better performance of another may offset the poor performance of one asset.
The fund managers calculate the value of the mutual funds daily based on the performances of the assets in the stock market. This value is expressed as the Net Asset Value (NAV) per share and is calculated by subtracting the mutual fund’s liabilities from its assets and dividing by the total number of outstanding shares.
You can buy or sell mutual fund shares at the NAV price. For example, if the NAV price of a mutual fund is 10 AUD and you invest 1000 AUD, you’d have 1000/10, which is 100 units of the mutual fund.
If a mutual fund increases in value, the NAV will be recalculated, and fund managers will distribute capital gains to the investors. You can choose to receive your distributions in cash or reinvest them.
6 Types of Mutual Funds
Mutual funds are categorized in many ways, from their structure to their assets to their investment approach. Here are the most common ones:
1. Equity Funds
Also known as stock funds, equity funds are mutual funds that invest a significant percentage of their funds in stocks. They can be categorized according to their investment style, company size, industry, or geography.
Because the majority of the funds are invested in stocks, equity funds have the potential to offer high returns. However, they also come with high risks, which can lead to significant losses.
The profitability of equity funds lies in the duration of the investment. Due to the volatility of stocks, equity mutual funds are more profitable in the long term, especially when kept for more than five years.
2. Bond Funds
Bond funds are mutual funds that invest primarily in bonds and other debt instruments, from government bonds to corporate and municipal bonds, certificates of deposit, debentures, etc. They’re less risky than equity funds as they are unaffected by stock market volatility. However, they also offer lower returns than stock funds.
3. Money Market Funds
Money market funds are mutual funds that invest in short-term, low-risk securities like Treasury bills and commercial papers. While their returns are small compared to bonds and equity funds, they’re safer and guarantee the return on the invested capital.
Money market mutual fund returns are a little above what you can get in a regular savings account.
4. Index Funds
Index funds are mutual funds that aim to replicate the performance of a specific market index, such as the S&P/ASX 200. They’re great investment options for cost-sensitive investors, offering broad market exposure at a relatively low cost.
5. Sector Funds
Sector or specialty funds are mutual funds that focus on a specific industry or sector of the economy, such as healthcare, finance, technology, or energy. They offer targeted exposure, which makes them riskier.
6. Balanced Funds
Balanced or hybrid funds are mutual funds that invest in various asset classes, such as stocks, bonds, money market securities, etc., to create a balanced portfolio. They aim to reduce risk exposure across asset classes.
5 Benefits of Mutual Funds
Mutual funds have numerous benefits when compared to other investment vehicles. Here are some of them:
1. Diversification
Diversification is one of the key advantages of investing in a mutual fund. It involves investing in various assets to spread the risk across them.
With a diversified portfolio, your funds are spread across assets with different capitalizations and maturities and from different industries. This increases the chances of profitability, as the good performance of others may overshadow the poor performance of one or two securities.
2. Professional Management
Mutual funds are managed by professionals who are financial market experts and capable of making smart investment decisions. This is a great option for investors who do not have the time or knowledge to manage their own portfolios. It’s also beneficial if you’re looking to consult financial market experts but don’t have the resources to pay them.
3. Liquidity
It’s relatively easy to buy or sell mutual funds, as they’re highly liquid in nature. They can be bought or sold at the fund’s net asset value on any business day.
The liquidity of mutual funds makes them good investment options for investors who want easy access to their funds when they need them.
4. Affordability
Investing in individual stocks or other financial assets requires a lot of money to get a reasonable return. But with mutual funds, you can have a diversified portfolio even with a small investment.
5. Transparency
Mutual funds disclose their holdings regularly, giving investors detailed information on where their funds are invested.
4. Disadvantages of Mutual Funds
The same way we have benefits of mutual funds, we also have the demerits. Here are the major drawbacks of mutual funds you must consider before investing in them:
1. Market Risks
Market fluctuations can affect the net asset value of a mutual fund, as its performance is linked to the underlying performance of the assets in the portfolio.
2. Fees
Investors pay management fees and other expenses to the professionals who manage their mutual fund investments. These fees impact the mutual funds’ returns.
3. No Control
Investors don’t have control over the management of the assets in their portfolio and can’t make decisions for the fund managers.
4. No Guaranteed Returns
There are no guaranteed returns in mutual funds, as the value of the fund can either appreciate or depreciate. During economic downturns, investors risk losing their capital in mutual funds, as almost all assets in their portfolio can be affected.
Are Mutual Funds a Safe Investment?
All investments contain risk; however, mutual funds are safer investment options than individual stocks and bonds. This is because they’re mostly diversified across various assets, and a poor performance in an asset may not affect the portfolio’s overall performance.
Besides diversification, the safety of mutual funds depends on the fund managers, market conditions, liquidity, and other factors.
Can Mutual Funds Shares Be Sold at Any Time?
Yes, mutual fund shares can be bought or sold anytime during market hours. This is because most mutual funds are open-ended investments, where the fund company issues and redeems shares based on investor demands.
Are Mutual Funds a Good Option for Beginner Investors?
Mutual funds are good investment options for beginners due to their diversification, professional management, and affordability. Beginner investors who do not have an experience in the financial market can avoid the risks of buying individual stocks and bonds and managing them by simply investing in mutual funds. Their funds are managed by professionals who have experience in the market and can make smarter investment decisions.
Conclusion
Mutual funds are great investment options for investors who don’t have the time, expertise, and resources to buy and manage individual stocks. The benefits of mutual funds are numerous, as they’re safer and more affordable, with potential for good returns.
Hopefully, this article has given you insights on how mutual funds work and the different types you can invest in based on your risk tolerance level.
