A mutual fund is an important investment product you need to be aware of. It is important to know what is a mutual fund. Mutual funds invest in a large group of assets like bonds and stocks. The fund is managed by experienced professionals. You do not buy and sell the shares, your fund manager does it for you. They buy shares based on the performance of the underlying securities of the fund. As an investor, you do not directly own the shares in the company but you share the profit and loss of the total holdings of the fund.
How do mutual funds work?
The price per share of a mutual fund is represented in the form of Net Asset Value. It is the value of the fund’s assets minus liabilities and it shows whether the fund is overvalued or undervalued. Irrespective of the category of the fund, the performance and fees will depend on how the fund is managed. An actively managed fund will seek to outperform the market indices and they carry the potential for a higher return than a passively managed fund. With high returns, they have high risks. In contrast, a passively managed fund invests according to a set strategy. In this fund, they try to match the performance of a market index before investing. It requires a little skillset. These funds carry low fees than an actively managed fund.
Investors pay two types of fees for the fund- sales commission and expense ratio. Sales commission is paid at the time of purchase of the shares and at the time of redemption of the same. It is the compensation paid to financial experts to buy the shares. The expense ratio is the cost of ongoing expenses like operating costs and fund administration. This expense is paid as a percentage of the total assets in the fund and it is paid annually.
Benefits of investing in mutual funds
Professional fund management: Your mutual fund will be managed by a professional, qualified fund manager. The manager will make buy or sell decisions according to market performance. These decisions will be based on the goals of the fund. If you have invested in a high growth fund, the manager will strive to achieve higher results by investing in a major stock market.
Simplicity: If you can find the right type of fund for your investment, you have a small role to play. You only have to invest and the managers will handle everything else. You do not need to study the stock movement or make any investment decisions.
Liquidity: Compared with any other assets, mutual funds are easy to purchase and sell. They are high on liquidity and you can invest in or exit the fund with ease.
Affordable: When it comes to investing in mutual funds, you do not need to set aside a huge amount. Mutual funds have a minimum requirement between $500 and $5,000. Brokers waive minimums in case you make a direct deposit to purchase additional fund shares.
Diversification: An important principle of investing is diversification. When one company fails, the money you invested in the company will be gone. However, with mutual funds, you can reduce the loss by investing in different companies.
Types of mutual funds
- Stock funds: Equity or stock fund is a common type of mutual fund and it carries high risk alongside the potential for high returns. Market fluctuations affect the returns on the fund. There are many types of equity funds like growth funds, sector funds, and income funds. Every type has a portfolio of stocks. Equity funds are the most popular mutual fund in the market today.
- Balanced funds: As the name suggests, a balanced fund will invest in a mix of bonds, stocks, and other securities. They are also known as fund of funds and they invest in a group of other mutual funds.
- Bond funds: A low-risk fund, bond funds are fixed-income funds and they invest in bonds. There are various types of bonds and you need to research well to determine the risk associated with it.
- Money market funds: These funds are low risk and they have the lowest returns. These funds are legally required to invest in quality investments that are issued by the U.S. government.
How the funds make you money
Whenever you invest in a mutual fund, the value can increase in different ways. First is in the form of dividends. Whenever the fund receives dividends, it is distributed to the investors. At the time of investment, you may choose to receive the dividends or to reinvest them. The price of the fund is represented in the form of net asset value. When the value of the fund increases, the NAV increases, and the value of your investment grows.