Aside from stocks, traders have the option of trading mutual funds as well. In fact, with the help of tutorials and financial professionals, mutual funds are considered a great way for people to invest in their future. That said, people should never invest in something they do not understand. In this article, we take a closer look at what mutual funds are, how they work, the types of mutual funds there are, and how they can be valuable tools in your financial portfolio.
What is a mutual fund?
Mutual funds are professionally managed investments that allow investors to pool their funds together to invest in something. They are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is typically structured and maintained to match the investment objectives it states in its prospectus.
Mutual funds, therefore, give small or individual investors access to professionally managed portfolios of stocks, bonds, and other securities. Each shareholder participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is generally tracked as the change in the total market cap of the fund – derived by the aggregating performance of the underlying investments.
How are they priced?
The value of the mutual fund depends on the performance of the securities in which it invests in. When buying a unit or share of a mutual fund, an investor is buying the performance of its portfolio, or more specifically, a part of its value. Investing in a share of a mutual fund is different from investing in shares of stock. Unlike a stock, mutual fund shares do not give holders any voting rights.
A price of a mutual fund share is referred to as the net asset value (NAV) per share, sometimes expressed as NAVPS. A fund’s NAV is calculated by dividing the total value of the securities in the portfolio by the total amount of outstanding shares.
Types of mutual funds
There are several types of mutual funds available for people to invest in, though most mutual funds fall into a few main categories, as seen below.
These funds primarily invest in stocks. Within this group are various subcategories. Some equity funds are named for the size of the companies they invest in – either small, mid or large-cap. Others are named by their investment approach – aggressive growth, income-oriented, value and others.
Funds can also be classified based on the size of the companies, their market caps, and the growth prospects of the invested stocks. On the other hand, growth funds look to companies that have had strong growth in earnings, sales, and cash flows. A compromise between strict value and growth investments is called a blend and refers to companies that are neither value nor growth stocks and are classified as being somewhere in the middle instead.
A mutual fund may also blend its strategy between investment styles and company size. For example, a large-cap value fund may look to large-cap companies that are in strong financial shape but have recently seen their share prices fall. The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects – small-cap growth.
As its name suggests, index funds invest in stocks that correspond with major market indexes such as the S&P 500 or the Dow Jones. This strategy requires less research from analysts and advisors, so there are fewer expenses passed onto shareholders and these funds are often designed with cost-sensitive investors in mind.
These are mutual funds that generate a minimum return and are part of the fixed-income category. A fixed-income mutual fund focuses on investments that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments. The fund portfolio generates interest income, which is then passed on to shareholders.
Sometimes also referred to as bond funds, they are often actively managed and seek to buy relatively undervalued bonds to sell them at a profit. They are likely to pay higher returns, though bond funds are not without risk. For instance, a fund specialising in high-yield junk bonds is much riskier than a fund that invests in government securities.
As there are many different types of bonds out there, bond funds can vary dramatically depending on where they invest. All bond funds are also subject to interest rate risk.
Balanced funds invest in a hybrid of asset classes, whether stocks, bonds, money market instruments, or alternative investments. The objective of these funds is to reduce the risk of exposure from across asset classes.
Some funds are defined with a fixed allocation strategy, so the investor can have predictable exposure to various asset classes. Other funds follow a strategy for dynamic allocation percentages to meet various investor objectives. This may mean responding to market conditions, business cycle changes, or the changing phases of the investor’s own lifestyle. The portfolio manager is commonly given the freedom to switch the ratio of asset classes as needed to maintain the integrity of the fund’s stated strategy.
Income funds are named for the purpose to provide current income on a steady basis. These funds invest primarily in government and high-quality corporate debt, holding these bonds until maturity to provide interest streams. While fund holdings may appreciate, the primary objective of them is to provide a steady cash flow to investors. As such, the audience for these funds tends to consist of conservative investors and retirees.
International and global funds
An international fund or foreign fund invests only in assets located outside an investor’s home country. Global funds can invest anywhere around the world. Their volatility often depends on the unique country’s economy and risk. However, these funds can be part of a well-balanced portfolio by increasing diversification since the returns in foreign countries may be uncorrelated with returns at home.
These funds are targeted strategy funds aimed at specific sectors of the economy, such as financial, technology, or healthcare. Sector funds can be extremely volatile since the stocks in a given sector tend to be highly correlated with each other.
Regional funds tend to make it easier for investors to focus on a specific geographic area of the world. This can mean focusing on a broader region or an individual country.
Socially responsible funds or ethical funds only invest in companies that meet the criteria of certain guidelines or beliefs. For instance, some socially responsible funds do not invest in industries such as tobacco, alcoholic beverages, and more. Other funds invest primarily in green technology, such as solar and wind power or recycling.
Money market funds
These funds generally invest in short-term debt securities. These are basically money loaned to a government, company, or bank for a very short period of time. The money borrowed, plus interest is usually due back to investors in less than a year. While an investor will not earn substantial returns, the principal is guaranteed. A typical return is a little more than the amount earned in a regular checking or savings account.