Table of Content
Mutual funds are an investment option suitable for both amateurs and professionals. It has become quite common in recent years due to the increasing desire of individuals to invest.
There was a steady increase in the percentage of households who owned mutual funds, according to data from the Investment Company Institute.
What Is A Mutual Fund?
When you acquire mutual fund shares, you're obtaining a right to a piece of the returns generated by the fund's stock, bond, and other asset portfolio. Mutual implies you split the earnings (and losses) with the other investors in the fund. The investments in a mutual fund's portfolio generate dividends and interest.
Depending on their strategy and overall market conditions, fund managers can choose to reinvest gains or distribute them to their investors. When asset managers make capital gains (or losses), those gains (or losses) are passed on to investors.
The idea of mutual funds is that they provide diverse investments — in stocks, bonds, and cash — without forcing investors to make individual purchases and trades.
Mutual funds provide individual investors with a convenient and cost-effective way to access a diversified investment portfolio, even with relatively small amounts of money. They offer various options suited to different risk appetites and financial goals.
Mutual Funds Common Types
Capital gains and dividends are the two types of income generated by mutual funds. Though a fund's net profits must be distributed to shareholders at least once a year, the regularity with which various funds distribute their profits varies greatly.
Funds that focus on growth equities and use a buy-and-hold strategy are appropriate if you want to build wealth over time rather than generate immediate income because they often incur lesser expenses and have a more minor tax impact than other types of funds.
-
Stock Funds
This fund buys stocks that might gain value quickly and substantially, therefore trying to achieve a high return. Of course, this is a risky venture.
These funds are designed to grow quicker than money market or fixed-income funds. Therefore there is a greater chance of losing money. You can invest in growth stocks (which don't usually pay dividends), income stocks (which pay significant dividends), value stocks, large-cap stocks, mid-cap stocks, small-cap stocks, or a combination of these.
Generally, stock promising high returns in the near future is volatile, and during a potential economic decline, they might lose their value rapidly. Usually, investors who are ready to lose money prefer this strategy.
-
Index Funds
Index funds are a type of mutual fund that aim to replicate the performance of a specific market index, like the S&P 500. They offer a diversified portfolio, as they hold all or a representative sample of the index's assets.
With lower management fees and reduced risk due to broad market exposure, index funds are popular among long-term investors seeking steady returns without active stock picking.
Their passive management approach makes them an efficient and accessible choice for those looking to invest in the overall market rather than individual stocks.
-
International Funds
International funds are mutual funds that invest in assets outside the investor's home country.
These funds aim to diversify risk and capture opportunities in global markets, offering exposure to foreign equities, bonds, or other securities. Investors seeking geographical diversification and potential higher returns often consider international funds.
However, they also carry additional risks, including currency fluctuations and geopolitical factors. These funds provide a convenient way to access international markets without the need for direct investment in foreign companies or markets.
-
Bond Mutual Funds
When you buy a bond, you're simply giving money to a corporation or the government in exchange for a regular revenue stream (in the form of dividends and interest payments made to you). A bond mutual fund is formed when a group of investors pools their funds to purchase various bonds.
While bonds (and bond mutual funds) are seen to be a “safer” investment than stocks, you'll have to settle for lackluster returns that barely surpass inflation… and why would you want that?
-
Balanced Funds
Also known as growth-income funds, they employ both growth and income strategies. These mutual funds invest in both stocks and fixed-income products. They try to balance the desire for better profits and the danger of losing money.
Most of these funds use a formula to distribute the money among several investments. They have a higher risk than fixed-income funds but a lower risk than pure equity funds. Conservative funds hold fewer equities and more bonds, whereas aggressive funds hold more shares and fewer bonds.
If you are not strictly focused only on income and want potential growth, this is your type of mutual fund.
-
Money Market Funds
This may be the safest option. Their primary objective is to maintain their share prices low and follow the principle “don't lose money.” Usually, money market funds invest in debt securities with very minimal risk.
Nevertheless, inflation will eat up the buying power over the years when your money is not keeping up with inflation rates. They are, however, highly liquid, so you would always be able to alter your investment strategy. Negative interested rates also pose a severe threat to this fund.
Pros And Cons Of Mutual Funds
Investing in mutual funds has both advantages and disadvantages. Let's take a look at some of the pros and cons:
Benefits | Drawbacks |
|---|---|
Diversification | Fees and Expenses |
Professional Management | Capital Gains Taxes |
Liquidity | No Individual Control |
Affordability | Underperformance |
Convenience | Lack of Flexibility |
- Diversification
Mutual funds pool money from multiple investors and invest in a variety of assets (stocks, bonds, etc.). This diversification helps spread risk and reduces the impact of a single investment's performance on your overall portfolio.
- Professional Management
Mutual funds are managed by experienced professionals who make investment decisions on behalf of the investors. This relieves individual investors of the need to actively manage their investments.
- Liquidity
Mutual funds are generally considered liquid investments, meaning you can buy or sell your shares at the current net asset value (NAV) at the end of each trading day.
- Affordability
Many mutual funds have low minimum investment requirements, making them accessible to a wide range of investors.
- Convenience
As a passive investor, you don't need to be actively involved in the day-to-day management of the investments.
- Fees and Expenses
Mutual funds charge fees, including expense ratios, sales loads, and transaction fees. These expenses can eat into your returns over time.
- No Individual Control
When you invest in a mutual fund, you entrust the decision-making to the fund manager, leaving you with no control over the specific investments made.
- Capital Gains Taxes
Mutual funds distribute capital gains to their shareholders, which can lead to tax implications, even if you haven't sold your shares.
- Underperformance
ot all mutual funds outperform the market or their benchmarks. Some funds may underperform due to poor management or adverse market conditions.
- Lack of Flexibility
You may face restrictions on when and how you can withdraw your money, depending on the fund's policies.
Can I Get Monthly Income From Mutual Funds?
Setting up a Monthly Income Plan (MIP) mutual fund strategy is the best approach to earn you a stable monthly income. The fund falls under a debt or hybrid fund. It allows investors to receive monthly dividends payout while reducing their risk exposure. Typically, the fund is more conservative since only a tiny percentage goes to stock while a more significant portion goes to secure securities.
While comparing it to other financial instruments with a similar target, like FDs and PPFs, MIP offers more stable returns during inflation. In addition, they attract lower taxation. However, MIPs are not guaranteed to yield consistent fixed monthly income. The fund, like any other portfolio, has its downsides. For instance, your fund may not pay consistent monthly dividends in economic instability.
What Is An Expense Ratio And Why It's Important?
The expense ratio is a crucial metric used to measure the cost of owning a mutual fund. It represents the percentage of a mutual fund's assets that are deducted annually to cover the fund's operating expenses. These expenses include management fees, administrative costs, custodian fees, legal fees, marketing expenses, and other costs associated with running the fund.
For example, if a mutual fund has an expense ratio of 1%, it means that the fund will deduct 1% of the total assets under management each year to cover its expenses. If you have $10,000 invested in the fund, you would pay $100 in fees that year.
The expense ratio is important for several reasons:
- Impact on Returns: The expense ratio directly impacts the overall return you will receive from the mutual fund. All else being equal, a higher expense ratio will reduce the fund's net return to investors. Over time, even seemingly small differences in expense ratios can significantly erode the value of your investment.
- Comparison Tool: The expense ratio allows investors to compare the costs of different mutual funds. Lower expense ratios are generally more attractive to investors because they leave more of the fund's returns in the investors' pockets.
- Transparency: The expense ratio provides transparency about the costs associated with the mutual fund. It allows investors to understand how much they are paying for the fund's management and services.
- Consistency of Costs: The expense ratio is deducted directly from the fund's assets, so investors do not need to worry about paying the fees separately. This consistency simplifies the process of understanding and managing investment costs.
- Long-Term Impact: Over the long term, the impact of high expense ratios can compound, leading to substantial differences in returns compared to lower-cost funds.
It's important to note that expense ratios vary widely among mutual funds. Generally, passively managed funds, like index funds and some ETFs, tend to have lower expense ratios compared to actively managed funds
Can I Lose Money in Mutual Funds?
Investing in a mutual fund does not guarantee you will gain a lucrative return from your investment. Even the safest funds attract a certain level of risk. Factors like prevailing economic conditions impact the volatility of the fund. Poor or good management is also another vital element that hugely affects returns.
However, there are certain things you can do to select a safer mutual fund. To begin with, you should to buy your mutual fund from a reputable broker. Also, take your time to study the past performance of the mutual fund before tossing in your coin.
Mutual Funds or ETFs: Which Is Better?
Mutual funds and exchange-traded funds (ETFs) are both types of investment funds that pool money from investors and invest it in a variety of assets. However, there are some key differences between the two.
Here is a table summarizing the key differences between mutual funds and ETFs:
Feature | Mutual Funds | ETFs |
|---|---|---|
Price | Traded at the end of the trading day based on net asset value (NAV) | Traded throughout the trading day based on market price
|
Minimum investment | Typically have a minimum investment requirement | No minimum investment requirement
|
Expense ratios | Typically have higher expense ratios than ETFs | Typically have lower expense ratios than mutual funds
|
Tax efficiency | Can be less tax-efficient than ETFs, especially if held in a taxable account | More tax-efficient than mutual funds, especially if held in a taxable account
|
The best type of investment fund for you will depend on your individual circumstances and investment goals. If you are looking for a low-cost, tax-efficient way to invest, then an ETF may be a good option for you.
If you are looking for a fund with a minimum investment requirement or a fund that offers professional management, then a mutual fund may be a better choice.
Are Mutual Funds Safer than Stocks?
Admittedly, mutual funds attract low risks, but also, they earn low-medium yields. On the downside, they come with higher fees than stocks. In comparison, stocks are riskier, but their reward is potentially medium to high. Their investment implication is in ownership of a company. Meaning, if the company grows to a behemoth, so do the shares.
The fund managers of a mutual fund do not necessarily invest in shares. They diversify the portfolio to bonds or other debt securities to shield investors from adverse risks. As an investor, you have to evaluate your risk tolerance versus your income goal. Generally, if you have a low-risk tolerance, a mutual fund is a better option. However, if your goal is a higher reward without being bothered by the risk level, invest in stocks.
Mutual Fund Fees
Mutual fund fees are the charges that mutual fund companies charge investors to cover the costs of operating the fund.
It is important to consider the fees when choosing a mutual fund. Higher fees can eat into your returns over time. A good rule of thumb is to choose funds with expense ratios below 0.5%. If you are looking for even lower fees, you can consider index funds, which typically have expense ratios of 0.1% or less.
These fees can take several forms, including:
- Sales loads: These are fees that are paid when you buy or sell shares of a mutual fund. They can be either front-end loads, which are paid upfront when you buy the shares, or back-end loads, which are paid when you sell the shares.
- Management fees: These are fees that are paid to the fund's investment manager to cover the costs of managing the fund's portfolio.
- Distribution fees: These are fees that are paid to cover the costs of marketing and distributing the fund.
- Other fees: These include fees for things like shareholder servicing, legal expenses, and accounting fees.
The average mutual fund fee has declined over time. In 1996, the average expense ratio for equity mutual funds was 1.04%. By 2022, the average expense ratio had fallen to 0.44%. This decline is due to a number of factors, including increased competition among mutual fund companies, the rise of index funds, and the availability of low-cost online brokerage platforms.
FAQs
What is the best way to buy and sell mutual funds?
Rather of buying from other investors, investors purchase mutual fund shares directly from the fund or through a fund broker. The fund's per share net asset value plus any fees payable at the time of purchase, such as sales loads, is the price that investors pay for the mutual fund.
Shares in mutual funds are “redeemable,” which means that investors can sell them back to the fund at any time. In most cases, the fund is required to provide you the payment within seven days.
What happens to mutual funds when the market crashes?
The immediate outcome of a market crash to mutual funds is a drastic reduction of investment income. The returns earned from your mutual funds will take a hit, and the streams will decline or dry up. Though bonds and debt securities have a high tolerance to risk, they will equally feel the pinch but not as hard as stocks. To shield yourself from these adverse effects, you should ditch leveraged funds, spread your risks through diversification, invest in bonds funds, or even invest in noncyclical funds, among other tactics.
Which mutual fund is best for beginners?
As a beginner mutual fund investor, you must first determine your investment horizon and the amount of risk you are willing to take. For a start, a novice investor should consider investing in mutual funds that are no-load and low-cost. No load mutual funds are inexpensive, since they do not charge broker commissions to investors, and you get to keep most of the returns earned.
Index funds are also a good pick for beginner investors, since they are selected to mimic large funds such as the S&P 500, hence they can help novice investors diversify their portfolio. Before investing in a specific fund, an investor must conduct due diligence and compare several funds to choose funds that align with their overall investment goals.
How to Evaluate Mutual Funds
Generally, there are 5-popular mutual funds evaluations strategies.
The first strategy involves understanding the mutual fund holding. This strategy helps investors understand the fund strategy.
Also, you should understand the expense ratios or loads fees of the fund. The expense ratios show the percentage cost of investing in the fund. The loads, in comparison, are transactional fees charged by the broker.
Besides, you must understand the investment strategy of the fund. This helps investors to decide whether to invest in a fund or not depending on their individual goals.
Another significant element in evaluation is the management style of the fund. Here, the available options are between a passive or an active mutual fund.
The last strategy involves comparing the performance of the fund against different benchmarks and competitors. Though not future-proof, it is a must-have tool.
