Mutual Funds: Understanding Your Investment

When you invest in mutual funds, you're buying into a portfolio of stocks, bonds, or other securities. Mutual funds pool money from multiple investors, allowing individual investors to gain exposure to a professionally-managed portfolio. This provides diversification, as well as access to a wide range of assets, for a relatively low cost. Mutual funds are also known for their ease of investment, with most funds setting a low dollar amount for the initial investment. However, it's important to be aware of the fees associated with mutual funds, as these can eat into your overall returns over time.

Active vs. passive funds

When you invest in mutual funds, you are buying into a portfolio of stocks, bonds, or other securities. Mutual funds pool money from multiple investors to purchase a diversified portfolio of these assets, according to the fund's stated strategy.

Now, onto active vs. passive funds:

There are two main types of funds: actively managed funds and passively managed funds. Actively managed funds are overseen by professionals who research the market and buy and sell with an eye toward beating the market. Passive funds, on the other hand, are more hands-off and typically track an existing group of investments called an index. Passive investing is often cheaper and may deliver better overall returns.

Active Funds

Active investors research and closely follow companies, buying and selling stocks based on their view of the future. This approach requires a lot of time and effort and is therefore more common among professionals. Active funds are also more expensive due to the higher fees associated with active management.

Passive Funds

Passive investors take a long-term approach, buying a basket of stocks and buying or selling regularly, regardless of how the market is performing. This strategy requires discipline and a long-term mindset, as it involves ignoring the market's daily fluctuations. Passive funds tend to be cheaper because they are not actively managed, and they often deliver better returns.

Both active and passive funds have their advantages and disadvantages. Passive funds tend to be more cost-effective and may deliver better returns, but active funds offer more flexibility and the potential for higher returns if the fund manager is skilled.

Ultimately, the choice between active and passive funds depends on your investment goals, risk tolerance, and preferences. Some investors may even choose to blend the two approaches to take advantage of the strengths of each.

Types of mutual funds

Mutual funds are an excellent way to invest in a diverse range of assets without having to pick and choose individual investments. They are also a great way to benefit from the stock market's historically high average annual returns. There are four main types of mutual funds: equity (stock) funds, fixed-income (bond) funds, money market funds, and balanced or hybrid funds (both stocks and bonds).

Equity mutual funds are the most common type of mutual fund, making up 55% of the market. They invest in the stocks of publicly traded companies and are generally considered riskier but offer higher potential rewards. These funds can be further categorized based on company size, industry or sector, growth and value, and geographic location.

Fixed-income mutual funds, such as bond funds, are the second most common type, making up about one-fifth of the market. They are considered safer than equity funds but offer lower potential growth. Bond funds invest in government and corporate debt, which provides a fixed return to investors.

Money market mutual funds are fixed-income funds that invest in short-term, high-quality debt instruments and are considered one of the safest investments. They make up about 15% of the mutual fund market.

Balanced or hybrid funds combine equity and fixed-income funds in a fixed ratio, such as 60% stocks and 40% bonds. Target-date funds are a well-known type of balanced fund that automatically adjusts the ratio of stocks to bonds as the investor gets closer to retirement.

Other types of mutual funds include index funds, which aim to replicate the performance of a specific market index, and specialty or alternative funds, which include hedge funds, managed futures, commodities, and real estate investment trusts.

How mutual funds make money

When you invest in mutual funds, you are buying into a portfolio of stocks, bonds, or other securities. Mutual funds pool money from many investors and use it to purchase a diverse range of assets, which are selected and managed by a fund manager or team of fund managers.

There are different types of mutual funds, including stock, money market, bond, and target-date funds, and they can be actively or passively managed. Actively managed funds employ professionals to constantly adjust the mix of investments to try to beat the market. Passively managed funds, on the other hand, aim to replicate the performance of a specific index, like the S&P 500, and are often referred to as index funds.

Mutual funds make money in the following ways:

• Dividends and interest: Mutual funds receive income in the form of dividends on stocks and interest on bonds that they hold in their portfolio. These earnings are then distributed to investors as dividends.
• Capital gains: If the fund sells securities that have increased in price, it realises a capital gain, which is usually passed on to investors.
• Net asset value (NAV): The shares you sell may generate a higher NAV than when you bought them due to an increase in the price of securities, resulting in a profit or capital gain.
• Fees: Mutual funds charge various fees, including annual fees, expense ratios, sales charges or loads, redemption fees, and account fees. While these fees reduce investors' returns, they are a significant source of revenue for mutual fund companies.

How to choose a mutual fund

There are thousands of mutual funds to choose from, so it's important to do your research and understand your objectives. Here are some key things to consider when choosing a mutual fund:

• Active vs Passive Funds: Active funds are managed by professionals who buy and sell investments to try and beat the market. Passive funds, on the other hand, aim to mimic the market, often by tracking an existing market index. Passive funds tend to be cheaper and often perform better than active funds.
• Budget: Mutual funds have minimum investment amounts, which can range from $0 to a few thousand dollars. Decide how much money you are comfortable investing.
• Risk Tolerance: Consider your risk tolerance, especially in relation to your age. If you are closer to retirement age, you may want to invest in more conservative options. Younger investors usually have more time to ride out the highs and lows of the market.
• Asset Allocation: Think about the composition of your portfolio. If you're just starting, consider broad mutual funds that invest in different areas of the stock market, such as an index fund that tracks the S&P 500. You can also explore funds that focus on specific sectors, company sizes, or geographies.
• Fees: Mutual funds come with various fees that will impact your overall returns. Look out for expense ratios, sales charges or loads, redemption fees, and account fees. Passive funds tend to have lower fees than active funds.
• Performance: While past performance doesn't guarantee future results, it can be an indicator of the quality of the fund manager. Compare the fund's performance over the last three, five, and ten years, and check if it has outpaced the S&P 500.
• Fund Managers: Evaluate the fund managers by reviewing their past results and investment literature. Check if they have delivered results consistent with general market returns and if there was unusual volatility or turnover.

How to buy and sell mutual funds

When investing in mutual funds, you are buying into a portfolio of stocks, bonds, or other securities. Mutual funds pool money from multiple investors to purchase a diversified portfolio of these assets, according to the fund's stated strategy.

Now, here is a step-by-step guide on how to buy and sell mutual funds:

How to Buy Mutual Funds:

• Decide between active or passive funds: Active funds are managed by professionals aiming to beat the market but often come with higher fees. Passive funds, on the other hand, are more hands-off and usually have lower fees.
• Calculate your investing budget: Consider how much money you can comfortably invest, keeping in mind that many mutual funds have minimum investment requirements ranging from $500 to $3,000, with some as low as $100 or even $0.
• Decide where to buy mutual funds: You can buy mutual funds through an employer-sponsored retirement plan, directly from the fund company (e.g., Vanguard or BlackRock), a "supermarket" offering funds from multiple providers, or through a human broker or financial planner (who may charge extra fees).
• Understand mutual fund fees: Mutual funds charge annual fees, expense ratios, or commissions, which vary depending on the type of fund. Be sure to research and understand all associated costs before investing.
• Manage your mutual fund portfolio: Consider rebalancing your portfolio annually to maintain your desired diversification. Avoid chasing short-term performance, as this rarely works out in the long run.

How to Sell Mutual Funds:

• Contact your financial advisor or the mutual fund company: If you're working with a financial advisor, they can guide you through the process of selling your mutual fund shares. Otherwise, you can contact the mutual fund company directly.
• Inquire about fees and charges: Before selling, be sure to understand any fees or charges that may apply, such as redemption fees or early redemption penalties.
• Determine the number of shares you want to sell: Decide how many shares you wish to sell, keeping in mind that selling a large number of shares at once may impact the fund's performance.
• Provide instructions on what to do with the money: Once you have sold your shares, you will need to decide what to do with the proceeds. You may choose to reinvest the money elsewhere or withdraw it.

Frequently asked questions