Investing in mutual funds shouldn’t be a difficult decision, as long as you fully understand the main principles and categories of funds.
For starters, let’s note a brief definition of a mutual fund: an investment vehicle that consists of money collected from diverse investors with the sole purpose of investing in securities – stocks, bonds, money market instruments.
A mutual fund has to be operated by a professional money manager, aiming to produce capital gains to assure income for the investors. He does so by allocating the fund’s investments, following the pre-stated investment objectives.
Which would be the major output if you decide to invest in a mutual fund? Not only will you have your money managed by a professional, but investing in a mutual fund will give you access to a portfolio of equities, bonds and other securities. Once you decided to invest, you participate proportionally, along with the other shareholders, in the gains or losses of the fund.
There’s a wide choice of securities for mutual funds investors. The change in the total market capitalisation of the fund is the one that brings the performance derived from the performance of the investments.
As an investor, one can purchase mutual fund units or shares depending on the fund’s needs and value. You will find this value expressed as a net asset value (NAV or NAVPS). To find out the fund’s NAV, divide the total value of the securities in the portfolio by the total amount of shares outstanding.
You can look at a fund in two ways: an investment or a company in itself. Think of it this way: when you decide to buy stock from a company, you actually buy your way in: a part ownership of the company and its assets.
And this goes the same for mutual funds: you buy part ownership of the mutual fund company and its assets.
As mentioned before, the money come from multiple investors that decide for the same mutual fund. They can decide for stocks or bonds or other securities. The performance of the underlying assets the performance of the mutual fund – and by this we understand its value. In other words, when you decide to buy a share in a mutual fund, you are buying its portfolio’s performance.
An average mutual fund will have in its portfolio hundreds of different securities. This translates to diversification at a very low price.
Mutual Fund Companies
Here’s a little glimpse of how things work in a mutual fund company, in case you are considering to invest.
As mentioned before, a mutual fund is built by buying stocks and/or bonds and acts like a virtual company. A mutual fund is led by a fund manager or an investment advisor. This person is hired by a board of directors. In some cases, this person can be the owner of the fund. However, no matter its connection to the fund, the financial advisor or fund manager is legally obliged to work in the best interest of the shareholders.
The financial advisor or fund manager is helped by some analysts. These analysts can refer different investments or are in charge of the market research.
The fund’s net asset (NAV) is calculated by a fund accountant and this determines whether the prices of the shares go up or down. The legal oversight is assured by a compliance officer.
Mutual fund categories
An important step before deciding to invest in a mutual fund is to understand the different types of mutual funds.
The European Fund and Asset Management Association (EFAMA) determined upon a few major categories, as follows.
Fixed income funds – these funds mainly attract investments that pay a fixed rate of return. Such as: government bonds, corporate bonds, debt instruments. The fund portfolio will generate interests that can later be passed on to shareholders.
Monetary funds – these funds invest primarly in the monetary market (trust funds, deposits, bonds)
Multi-asset funds – action is mixed when it comes to multi-asset funds. The money managers usually decide to invest, in different proportions, in monetary market and in fixed income, stocks and shares.
Equity funds – mainly investing in equity, domestic or international
Absolute-Return Funds – also known as asset allocation fund or balanced funds, these funds invest in stocks and bonds while trying to reduce the exposure risk. These are usually medium and long term investments.
Index funds – the index funds follow a different strategy: the fund manager follows the market index and buys only the stock that correspond to a major market index. This implies less resources, so, furthermore, less expenses.
Advantages of investing in mutual funds
There’s a clear list of advantages when investing in mutual funds. The first one to be mentioned would be the diverse character. Having multiple investments and assets, buying company stocks from all the industries lowers the risk of the investment. The idea of buying diverse works like a constant back-up plan. You can invest in mature industries, in securities with different capitalisations or you can risk at a lower, more calculated risk.
Scaling. Fewer transactions make for fewer commissions. Trying to recreate the same system, so diverse, with a minimum risk, on your own, would prove to be highly expensive. Whilst, investing in a mutual fund, means investing in an already working system.
Access. A mutual fund will grant you access to different exotic commodities or equities that otherwise may seem difficult to access.
Professional Management. Investing in a mutual fund, no matter the amount, grants the fact that your money will be managed and invested by a professional money manager.
The benefit of the individual. Mutual funds are the best solution to start with when you feel like you should invest your money, but not participate actively. Your money will produce money, spearing you the hassle, granting you access to liquidities.
Moreover, your money could come into the hands of whatever money manager you choose. Be it one that focuses on the value, the growth, the macroeconomics or different other styles.
The final investment
Every financial instruments comes with a risk. Following this process, so are the mutual funds. A simple classification would show us which is the safest investment and which bears the higher risk.
Starting from the lower risk, we have the Monetary Funds, followed by the Fixed Income Funds, Absolute-Return Funds, Multi-Asset Funds and Equity Funds.
There’s a proportion between the risk you assume and the income you expect. In simpler words, a low risk investment can bring a constant income, but low, as compared to high risk investments, that have the potential of great earnings. This earning potential is usually present in the share market. Historically, it has been shown that long term investments in shares have brought earnings whose income was superior to other instruments.
While taking into account the risk and the expected income, bear in mind that medium and long term investments can also benefit from the portfolio assessment, due to opportunities that can strike in time.
To sum up, if you are looking to invest, here are three key-factors to take into account:
– Time (meaning the investment term you are planning for)
– Risk (the risk that you are willing to assume)
– Earnings (the expected yield)