Mutual Funds: Investing Basics And Strategies

Mutual funds are a popular investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are managed by professional money managers and provide individual investors with access to a wide mix of assets. Mutual funds are known for their diversification, professional management, variety of offerings, and minimal investment requirements. They are also cost-efficient, allowing investors to build a diversified portfolio with a relatively small minimum investment. However, it is important to consider the fees associated with mutual funds, as they can significantly impact overall returns. When investing in mutual funds, investors typically follow a few key steps, including checking with their employer for additional products, ensuring they have a brokerage account, identifying funds that match their investment goals, and determining the amount they want to invest.

What is a mutual fund?

A mutual fund is an investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. It is a company or trust that collects money from a number of investors who share a common investment objective. The fund then invests this money in securities such as stocks, bonds, and short-term debt, with the goal of generating revenue or capital gains for the investors. The combined holdings of the mutual fund are known as its portfolio.

Mutual funds are managed by professional or expert fund managers, who oversee the fund and make strategic investment decisions to meet its objectives. They aim to optimise returns while prudently managing risk through careful asset allocation and selection. Mutual funds offer benefits such as lower transaction costs, diversification, strategic asset selection, and guidance to help investors pursue their financial goals.

Mutual funds are ideal for investors who lack large sums for investment or those who do not have the time or inclination to research the market but still want to grow their wealth. They provide a way for small investors to access professionally managed portfolios and benefit from economies of scale.

There are several types of mutual funds, including equity funds, bond funds, money market funds, debt funds, hybrid funds, index funds, sector funds, tax-saving funds, liquid funds, gilt funds, gold funds, thematic funds, multi-asset allocation funds, retirement funds, dividend yield funds, aggressive growth funds, international funds, overnight funds, and banking and PSU funds.

Mutual funds can be open-ended or closed-ended. Open-ended funds allow investors to buy and sell shares at any time, while closed-ended funds are only open for subscription during the initial offer period and have a fixed maturity date. Mutual funds can also be actively or passively managed. Actively managed funds involve the fund manager actively making investment decisions, while passively managed funds simply follow a market index.

How do mutual funds work?

Mutual funds are a type of investment vehicle that pools money from multiple investors, which is then used to purchase a diversified portfolio of stocks, bonds, or other securities. The fund is managed by professional fund managers, who make strategic investment decisions to optimise returns and manage risk. Each investor owns shares in the fund, and the fund's total value is determined by the net asset value (NAV), which is calculated based on the collective value of the fund's assets minus its liabilities.

When you invest in a mutual fund, you are typically buying shares in the fund itself, rather than from other investors. The price you pay for these shares is the fund's per-share NAV, plus any fees charged at the time of purchase, such as sales loads. Mutual fund shares are "redeemable", meaning that investors can sell their shares back to the fund at any time, usually within seven days.

Mutual funds offer several benefits to investors, including professional management, diversification, affordability, and liquidity. Professional fund managers use their expertise and research skills to select and monitor the fund's portfolio of investments, aiming to generate returns while managing risk. By pooling money from multiple investors, mutual funds allow individuals to invest in a diversified range of securities, spreading their risk across different assets. Most mutual funds have relatively low initial investment requirements, making them accessible to a wide range of investors. Mutual funds also offer liquidity, allowing investors to buy or sell shares on any business day, providing flexibility and easy access to funds.

In terms of generating returns, mutual funds can provide income through capital appreciation, interest income, and dividends from the underlying securities in the fund's portfolio. These profits are then distributed to investors in the form of cash or additional shares, along with periodic income distributions.

When investing in mutual funds, it's important to consider the fees and expenses associated with the fund, as these can impact your overall returns. Common fees include expense ratios, sales charges or loads, redemption fees, and other account fees. It's also essential to carefully read the fund's prospectus, which contains information about the fund's investment objectives, risks, performance, and expenses.

What are the benefits of mutual funds?

Mutual funds are a popular investment choice, with nearly 100 million Americans owning mutual funds. They are an attractive option for investors due to their many benefits, including:

• Diversification: Mutual funds pool money from multiple investors, allowing for diversification across a wide range of investments and assets within a portfolio. This helps to reduce risk, as a loss in one investment may be offset by gains in others.
• Professional Management: Fund managers research, select securities, and monitor the fund's performance, providing expertise and making investment decisions on behalf of the investor.
• Affordability and Low Minimum Investments: Mutual funds typically have low dollar amounts for initial investments and subsequent purchases, making them accessible to a wide range of investors.
• Liquidity: Mutual fund investors can easily redeem their shares at any time, providing flexibility and access to funds when needed.
• Variety of Investment Options: Mutual funds offer a range of investment choices, including money market funds, bond funds, stock funds, and target date funds, allowing investors to choose funds that align with their risk tolerance and financial goals.
• Economies of Scale: The large size of mutual funds allows them to take advantage of economies of scale and operational efficiencies in trading, resulting in reduced costs for investors.
• Easy Access and Tracking: Mutual funds can be bought and sold easily through self-directed brokerage accounts, and information about mutual fund investments is widely accessible, making it simple for investors to source and monitor their investments.
• Simplified Portfolio Management: Mutual funds streamline portfolio management by allowing investors to change their asset allocation, invest new contributions, or sell positions in a single transaction.
• Reinvestment of Dividends and Capital Gains: Mutual funds allow for automatic reinvestment of dividends and capital gains distributions, helping investors to grow their investments over time.

How to invest in mutual funds?

Investing in mutual funds is relatively straightforward. Here is a step-by-step guide:

• Check with your employer if they offer additional mutual fund products, as these may come with matching funds or be more beneficial tax-wise.
• Ensure you have a brokerage account with enough deposits and access to buy mutual fund shares.
• Identify mutual funds that match your investment goals in terms of risk, returns, fees, and minimum investments. Many platforms offer fund screening and research tools to help with this.
• Determine how much you want to invest and submit your trade. You can likely set up automatic recurring investments if desired.
• Periodically check on how the fund is doing, making adjustments as needed.
• When it's time to close your position, enter a sell order on your platform.

It is important to understand the fees associated with mutual funds, as these will affect your overall investment returns over time. Common fees include expense ratios, sales charges or loads, redemption fees, and other account fees.

What are the risks of mutual funds?

Mutual funds are a popular investment option, but they do carry several risks that prospective investors should be aware of. Here are some of the key risks associated with mutual funds:

• Market Risk: Mutual funds are susceptible to market risk, which arises from the potential decline in the value of the securities within the fund. Economic developments, governmental policies, political conditions, regulatory changes, interest rate movements, investor sentiment, and external shocks (such as natural disasters or wars) can all impact the performance of a mutual fund.
• Interest Rate Risk: Rising interest rates can lead to a decrease in bond prices, affecting mutual funds that hold bonds and other fixed-income securities.
• Management Risk: The performance of a mutual fund is heavily dependent on the competence and expertise of its management team. Poor investment decisions by the fund managers will negatively impact the returns.
• Liquidity Risk: Mutual funds typically hold a significant portion of their portfolios in cash to satisfy share redemptions. This cash holdings can earn no return, impacting the overall performance of the fund.
• Inflation Risk: If the returns on a mutual fund do not keep up with the rate of inflation, investors may lose purchasing power.
• Credit Risk: This risk is associated with fixed-income securities. If a bond issuer defaults on their payments or fails to redeem bonds at face value, it can negatively impact the mutual fund's performance.
• Currency Risk: Investments in foreign currencies can be affected by exchange rate fluctuations. If the foreign currency declines against the domestic currency, it can reduce the returns for investors.
• Security-Specific Risk: There are also specific risks associated with individual securities within the mutual fund's portfolio, such as the possibility of a company defaulting on its debenture payments or a downgrade in a company's credit rating.
• Non-Compliance Risk: Mutual funds may face risks due to non-conformance with laws, regulations, or internal policies and procedures by the fund manager. This can have adverse consequences for the fund's performance and investor interests.

It is important to note that not all mutual funds are equally vulnerable to these risks. The level of risk depends on the specific investments and strategies of the fund. Diversification across different types of mutual funds can help reduce the overall risk exposure of an investment portfolio.

Frequently asked questions