Mutual funds are gaining increasing attention these days due to their unique set of advantages over other forms of investing. However, for the private investor interested in mutual funds, there is a dizzying array of data and information to get your head around. This guide will decode and provide answers to all your questions, including:
- what mutual funds are,
- how they operate,
- why they could be right for your portfolio,
- how to choose a mutual fund,
- and how to buy and sell funds.
This article will tell you everything you need to know to be a successful investor in mutual funds.
What Is A Mutual Fund?
First things first. A mutual fund is just a name for an investment that you can buy which holds within it numerous other investments. By this we mean that a mutual fund may hold shares in Barclays, Rolls Royce and Apple for example, and so if you bought a share of this mutual fund you would indirectly be owning shares in Barclays, Rolls Royce, Apple, and whatever else is held by the mutual fund. If the average value of those companies goes up, then so does the fund.
This should make it clear why investors like to make use of mutual funds – it means that by buying a single asset (a share in a mutual fund), you gain exposure to a wide variety of different companies.
These companies could be all from one country, or from one sector, or be a cross-section of global markets all together.
For example, the Vanguard Total Stock Market Index Admiral Shares tracks the investment results of the whole USW market, including small, mid-sized, and large companies that primarily trade on the New York Stock Exchange and NASDAQ.
On the other hand, an example of a more targeted mutual fund would be Franklin Asian Equity Fund. This fund invests in Asian companies and sectors with high growth potential including Samsung and Tencent, as well as much smaller companies too.
In this way you can think of mutual funds as simply convenient ways to gain access to a larger and more diverse portfolio than most investors have the time or knowledge required to assemble by themselves. Rather than researching endlessly and spending hours every day keeping up to date with the latest movements in the markets, by simply placing your savings into a mutual fund you can trust that a professional money manager is doing this for you and is picking stocks and bonds for the fund based on detailed research.
As such, mutual funds can be perfect for a wide array of investors and can complement other investment products to improve any portfolio.
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How Do Mutual Funds Operate?
There are loads of different types of mutual funds out there. Each will have its own characteristics, and so once you’ve decided you might be interested in mutual funds, you then need to think about which type would suit you best.
Every fund will have a fund manager, and every fund manager will have a different approach to picking assets for the fund. This is sometimes referred to as ‘investment philosophy’, and every fund will publish detailed info on how they approach the task of making your money grow over time.
For example, some managers will have a high appetite for risk, because their experience in the markets has taught them that this can lead to substantially higher gains. Such managers will spend their time hunting for small or medium-sized companies who are about to soar in value, because the percentage gains these companies might enjoy will be far in excess of what already large companies can achieve. This growth-focused approach has performed extremely well of the last decade, with numerous tech stocks achieving exponential growth from very low starting valuations.
However, just because a company is currently cheap and the founder has a bright idea is in no way a guarantee of future success! Accordingly, fund managers hunting for outstanding growth will have to accept that not all their picks will go to the moon, and many will fail to take off at all. If you are happy with this level of risk for potentially higher returns, then a mutual fund focused on small-cap growth stocks would be suitable for you.
For example, Boston Partners Small Cap Value is an actively managed small-cap fund. The fund management look for micro- and small-cap companies with attractive prices, sound fundamentals (including sustainable competitive advantages), and positive business momentum.
At the other end of the risk spectrum sit bonds – fixed interest, low risk, but very dependable. Those who don’t like volatility would be better suited to selecting a fund manager whose approach is to accrue small but consistent gains by investing the mutual funds resources into bonds. Both government and corporate bonds could be included in a mutual fund looking for small steady capital gains over time, and this more cautious investment philosophy would suit someone who expected to withdraw their money relatively soon from the markets.
An example of a long-term bond fund would be the Calvert Core Bond Fund. The investment seeks total return with an emphasis on income. This fund typically invests at least 80% of its net assets in investment grade dollar-denominated bonds. This makes it very safe and stable, although unlikely to grow rapidly. However, it may invest up to 5% of its net assets in below-investment grade, high-yield debt instruments (commonly known as "junk bonds") to provide some growth potential.
Every fund will publish a comprehensive prospectus outlining what they aim to do and how they plan to do it. Potential investors should always start with this document if they are tempted to commit their capital to a fund.
Check Out: How To Start Investing In Mutual Funds Today
What Advantages Do They Have?
Although above we talked exclusively about the fund manager in terms of how the fund would actually operate, needless to say each fund manager is supported by an extensive team of investment professionals who assist and contribute to these decisions. These will include many different research analysts who cover specific sectors and know these inside-out, thus meaning they can do detailed research into individual stocks.
So, one key advantage of investing in a mutual fund is that you are accessing a whole world of investment expertise and knowledge. Whilst no level of research can ever guard totally against the prospect of getting it wrong and seeing the value of an investment fall, the team running a mutual fund will likely be highly experienced and no prone to ‘rookie errors’.
The next big advantage is that you can find pretty much everything within the world of mutual funds. There are funds that invest primarily in stocks. Within this, every country, region, sector, and size of company is represented. Then there are funds that invest primarily in bonds and other sources of fixed income. Again, this will be sub-divided into high risk versus low-risk funds, and funds that mainly hold government versus corporate bonds. For investors who want both the growth potential of stocks, and some of the stability brought by bonds, asset allocation funds are relevant as they invest in both stocks and bonds together.
Money market funds invest in liquid, short-term bonds (sometimes called certificates of deposit). As such try to ride the short-term ups and downs of interest rates to generate growth over time. Commodity funds invest in either commodities themselves (eg oil or oil futures), or commodity-related companies, such as energy or mining companies. These funds have been unpopular for the past decade, but are starting to come back into favour. Growing talk of a common ‘commodities super cycle’ has massively boosted their popularity.
Finally, so-called ‘alternative’ funds invest in non-traditional assets outside the stock-bond spectrum and often use complex trading strategies. These non-traditional assets could include unlisted private equity or venture capital firms; real estate; infrastructure projects; or natural resources. Investors interested in this last flavour of fund should check out Preqin, a London-headquartered research firm providing specialised coverage of alternative assets.
How Should I Choose A Mutual Fund?
Now we have covered the basics, you can start thinking about what sort of fund or funds you would be interested in. Essentially, you need to think about the following questions:
- how long will you be keeping your money invested for?
- what sectors do you believe will thrive?
- how much are you willing to pay in fees?
The first question essentially boils down to what are you saving for? If it is to live on in retirement, and you are quite a way off from this milestone, then you can afford to take a bit of risk. This is because over the long term, you can be fairly confident that your investments will go up, even if in the short-term things look a bit more dicey. However, if you plan to buy a house in 2 years’ time, then you should keep your deposit in a lower risk fund. A single recession could wipe half the value off your investments, and that could set your plant to buy back several years.
The second question can only be answered by each individual investor based on their own thoughts, views and experience. We all have concepts about how and where future growth will occur, and we all try to mould our investment portfolio to fit these ideas. An investor who believes that Japanese small firm will tend to outperform their Chinese or American or European rivals could look at Hennessy’s Japan Small Cap Fund, for example. Meanwhile, another investor who feels global growth will inevitably carry consumer discretionary stocks higher may go for the Fidelity Select Consumer Discretionary Portfolio to capture this growth.
The third question means you need to consider what sort of fees you are willing to pay in order to access the advantages described above.
These benefits don’t come cheap, but at the same time you need to ensure the fees you are paying aren’t excessive. Yes, it’s worth paying a little more to get the best manager for your sector, but if the fees are too high these will eat away at your potential gains over time.
Fund fees vary, but the most important one to look for is the expense ratio. This is the annual fee the funds charge shareholders for the privilege of keeping their money in the fund. It is expressed as a percentage of the assets under management and is deducted from the fund each year to cover its costs. So, an expense ratio of 2% means the fund needs to achieve growth of at least 2% for you not to see the value of your investment fall that year.
You shouldn’t pick a fund just because it’s cheap, but likewise you should always compare funds expense ratios to check that you are getting a deal comparable to other funds tracking the same sector.
How Can I Buy And Sell Mutual Funds?
Lastly, the technical matter of how do you actually put money into these funds.
Investing in mutual funds is slightly different to buying stocks directly. This is because you buy and sell mutual funds directly through the fund manager. You can do this via your normal broker, but it will be the fund who receives the request and issues your shares. Mutual funds can be invested in on a per-share basis, where you propose to buy a certain number of shares in the fund, or in a specific amount of money. For example, you could buy 200 shares of a fund or you could buy £1,000 of the fund, because fund managers are willing to sell fractional shares. So, you could instruct you broker to put £300 every month into a mutual fund, and each month exactly that amount would be converted into shares at whatever the current market price of the fund is.
The price of shares in a mutual fund is determined by the fund's net asset value (NAV). This is found by adding up the current value of all the fund's holdings, taking away the fund's expenses and then dividing by the number of shares investors hold. This vitally important figure is calculated each day after trading closes, and will determine how much cash you get if and when you decide to sell your shares. Selling shares in mutual funds is known as ‘redeeming’, as you are returning your shares to the company in return for your cash back, hopefully much enlarged.
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