Mutual funds, sometimes referred to as unit trusts or collective investment schemes, are companies that pool money from many investors and invest the funds in a diversified portfolio of assets such as stocks, bonds, money market instruments and short-term debt. Investors purchase the shares of a mutual fund, with each share representing the particular investor’s part-ownership of the fund and the rights to a proportion of the income it generates. These funds provide professionally managed portfolios to small or individual investors. Usually, they form part of larger investment companies such as Vanguard or Fidelity Investments.
Key Features of Mutual Funds
Mutual funds are professionally run by fund managers, also known as investment advisors. These managers conduct research for investors, choose the securities and keep track of their performance.
Diversification of Investment
Mutual funds usually invest in various industries and companies, helping lower investors’ risk if a particular company fails.
Investors in mutual funds can easily redeem their shares at any time for the current net asset value (NAV) and any relevant fees.
Mutual funds generally have relatively low minimum initial investment requirements, as well as for subsequent purchases.
Types of Mutual Funds
While there are many types of mutual funds, they can be split into four main groups:
Money Market Funds
Money market funds maintain a stable NAV by investing in short-term, high-quality securities sold on the money market. Money markets generally invest in the safest, most-stable securities, such as commercial paper and treasury bills.
Equity Stock Funds
These are the most common type of mutual funds and are mainly composed of investments in stocks. Equity stock funds focus on implementing particular investment strategies such as Real Estate, Growth, Energy, Large Caps and Small Caps, etc.
Also known as fixed income funds, they invest majorly in debt instruments such as government-issued bonds, mortgage-backed securities, or corporate bonds.
They invest in a mixture of stocks and bonds, as well as other investments, and the combination may change as time passes, in line with the fund’s strategy.
Returns from Mutual Funds
A mutual fund’s value depends on the performance of the underlying securities; when an investor purchases a share of the fund, they are effectively buying a share of the portfolio’s value. A mutual fund’s price, or net asset value (NAV), is derived by dividing the total value of the portfolio’s assets by the outstanding number of shares. Mutual fund shares can ordinarily be bought or redeemed at the fund’s current NAV, which is settled daily at the close of business.
For an investor, money is made from a mutual fund in three ways. First, investors earn income from dividends paid out on stocks and bonds held by the fund. These funds usually provide investors with the option of either receiving a cheque for dividend distributions or reinvesting the earnings to buy even more shares of the particular fund.
Second, investors earn income through capital gains, whereby the fund sells securities for a higher price than they purchased and distributes the money among the investors. Notably, higher capital gains also represent a larger tax bill for investors. Finally, investors can simply sell their shares for profit in the open market if they increase in price.
However, investors also need to note a mutual fund’s operating and shareholder fees, if any, since they directly affect their potential earnings. Annual operating fees, also known as the expense ratio, are a percentage of the value of the funds under management, usually between 1-3%. The expense ratio is generally a summary of the firm’s administrative, advisory, and management costs.
Control Over Investment
One of the key features of mutual funds that is attractive to investors is the diversification of investment into various asset classes. The performance of the fund and its management fees, however, depends on whether it is actively or passively managed. Passively managed mutual funds try to match the performance of a particular benchmark, such as the S&P 500. Usually, they do not need management by a professional, leading to lower costs for the fund and subsequently relatively lower fees. Passive investing is particularly popular when engaging with exchange-traded and index funds (ETFs).
On the other hand, actively managed funds have a professional manager or team making investment decisions using the fund’s pool of money. Active investors research and keep close tabs on companies and industries, buying stocks based on their assessment of the future. Fund managers, in this case, usually try to outperform the market. Still, studies have demonstrated that passive investing often delivers greater returns for investors.
Notably, it is not cast in stone and investors can mix and match; they can be active traders of passive funds, betting on the market performance rather than buying and holding like a classic passive investor. Alternatively, passive investors can have actively managed funds, betting on a good fund manager to beat the market.
In whichever case, however, an individual investor who buys shares of a mutual fund has limited control over their investments in mutual funds. Most investors can control their fund choice based on their prospectus, strategy, and past performance. However, they still cannot control the particular securities or indexes that the fund managers choose to purchase or sell.
Money market funds pool money from many investors and invest it in diverse securities, sometimes attempting to beat the market and sometimes trying to mimic it. Key attractive features of mutual funds are:
- The liquidity they offer.
- Diversification leads to lower risks for investors.
- Minimal initial and subsequent investment requirements.
On the flip side, mutual funds carry several cons from an investor’s perspective, such as the lack of a guaranteed return on investment and the requirement of significant amounts of fund holdings to be in cash to maintain liquidity and accommodate withdrawal (cash drag). They also harbor high funds due to professional management, which involves overcomplicating strategy by fund managers leading to worse returns.