Mutual funds are popular among people who are too busy or lack the expertise to make independent investment decisions. Read this article to get to know how these funds function.
If you want to invest in one or several types of assets, you might consider joining a mutual fund. It will enable you to diversify your portfolio and get a good income in the long run. From this article, you’ll get to know what a mutual fund is and which benefits it has. You’ll learn about different types of mutual funds and will be able to decide which one fits you best.
What Is a Mutual Fund?
A mutual fund is a collection of investments that belongs to a group of people who rely on the services of a professional manager to make a profit on these assets. It doesn’t matter whether the assets belong to one particular type (such as government bonds, stocks from certain countries or companies) or not. Thanks to the fund, you’ll be able to compile a more diversified portfolio than you could do on your own.
In a mutual fund, your money will be pooled together with the contributions of other investors. To put money in such a fund, you need to purchase its shares or units. The number of these shares or units is not limited and the fund can issue new ones to cater to new clients.
An experienced portfolio manager makes decisions every day on when to buy and sell investments according to the objectives of the fund. When the fund buys stocks of a certain company, you won’t become a direct owner of these assets. But you’ll share equally in the profits or losses of the fund’s total holdings.
What’s the Difference Between Passive and Active Mutual Funds?
In active funds, managers make decisions on how to invest the money. Sometimes, they might outperform a benchmark index or the market. Yet passive investing strategies tend to deliver higher returns.
Passive funds invest to align with a specific benchmark. They try to match the performance of a market index, so they don’t need a professional to manage them. Such an approach involves lower fees for the members.
Mutual Fund Types
Both active and passive funds can belong to one of the following four types.
Stock (equity) funds
Within this category, you can choose from sector funds, income funds and growth funds. Each of these groups tries to maintain a portfolio of stocks with certain characteristics. Such funds normally offer the highest potential returns — but your risks will also be considerably higher than with the other two types. The returns will highly depend on the fluctuations in the stock market.
Bond (fixed-income) funds
These involve lower risks. The exact level of risk might vary depending on which exact type of bond you invest into.
Balanced funds
These are also known as hybrid or allocation funds. They invest in a mix of bonds, stocks and other securities.
Money market funds
They carry the lowest risk and provide the lowest returns. Such funds invest in liquid, short-term instruments, such as cash.
How Mutual Funds Make Money?
Mutual funds use three ways of making a profit.
- Dividend payments. The fund receives interest or dividends from the securities in its portfolio and distributes a proportional amount of that income to its investors. When you receive your share, you can either reinvest it in the fund or use it for any other purpose.
- Capital gains. This term denotes the revenues that a fund gets by selling a security that has gone up in price. If the price of the security has decreased, that would be a capital loss. Normally, you can expect to receive your net capital gain once per year.
- Net asset value. Mutual fund share purchases are final after the close of the market when the total financial worth of the underlying assets is valued. The term “net asset value” denotes the price per mutual fund share. When the value of the fund goes up, the price to purchase its shares increases too.
No matter which type you choose, you should realize that mutual funds are good for long-term investment. If you would like to make a quick profit, you might need to search for other forms of investment. The fund will require a timeframe of several years to be able to make the most of its assets.
The Main Benefits of Mutual Funds
You might want to join a mutual fund for the following reasons.
- Simplicity. All you need to do is to select a credible fund and let its manager make money for you.
- Affordability. To get started, you might need to invest only a few hundred dollars.
- Liquidity. The assets that mutual funds operate with are easy to sell and purchase.
- Diversification. Mutual funds never put all their eggs in one basket. They will spread the money that you entrust to them across a number of companies or industries. If one of these sectors or organizations fails, you’ll still get your profit because others will flourish.
And of course, you’ll benefit from professional management.
Two Shortcomings of Mutual Funds
The only thing you might dislike is a lack of control. You won’t be able to make independent decisions on how to invest your money. But that’s exactly what busy people and investors with little experience like about mutual funds.
Also, you should be ready to pay a fee to the fund. Yet this fee will be rather affordable and your income will be large enough.
As you see, the advantages of mutual funds are more numerous and meaningful than their few drawbacks.
Final Thoughts
Hopefully, this article came in handy and now you better understand the specifics and benefits of mutual funds. Such funds are especially popular among investors with little experience and busy people who lack time to make independent investment decisions. You entrust your money to a mutual fund and it invests it in one or several types of assets, pooling it together with other investors’ money. You pay an affordable fee to the fund for using its services and you receive your passive income according to a set schedule.
