For individuals looking to invest in another financial asset, they can try investing in mutual funds. Mutual funds are investment vehicles that pool money from multiple investors to invest in a diversified portfolio of securities. In this article, we take a look at how they work, the types of mutual funds people can invest in, and why people should invest in mutual funds. Keep reading below to learn more.

What are mutual funds?

A mutual fund is a financial vehicle that focuses on pooling assets from shareholders to invest in a security, such as stocks, bonds, and other instruments. Mutual funds are typically operated by professional money managers, who help to allocate the fund’s assets for the purpose of producing capital gains or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the objectives it states in its prospectus.

Mutual funds often give small or individual investors access to other professionally managed portfolios of financial instruments. Each shareholder participates in the gains and losses of the fund proportionally. Mutual funds generally invest in a large number of securities, and performance is tracked as the change in the total market cap of the fund. This is derived from the aggregating performance of the underlying investments.

How are mutual funds priced?

The value of a mutual fund will depend on the performance of the securities in which it invests. When buying a unit or share of a mutual fund, an investor is actually buying the performance of its portfolio or a part of the portfolio’s value.

The price of a mutual fund share is referred to as the net asset value (NAV) per share. It is sometimes expressed as NAVPS. A fund’s NAV is derived by dividing the total value of the securities in the portfolio by the total amount of outstanding shares. These include shares held by shareholders, institutional investors, company officers or insiders.

Types of mutual funds

There are several types of mutual funds available for people to invest in. Most of these mutual funds four into a few main categories, such as stock funds, bond funds, index funds, and more.

Bond funds

Bond funds are mutual funds that generate a minimum return, which makes them part of a fixed-income category. A fixed-income mutual fund focuses on investments that pay a set rate of return. These include government bonds, corporate bonds, and other debt instruments. The fund portfolio generates interest income, and this is passed onto shareholders.

These funds are often actively managed, with the focus on buying relatively undervalued bonds to sell them at a profit. Bond funds are likely to pay higher returns, that said, they still come with risks that traders should be aware of. For instance, a fund specialising in high-yield junk bonds is a lot riskier than a fund investing in government securities.

With so many different types of bonds available, bond funds can vary drastically depending on where they invest. All bond funds are subject to interest rate risk, which investors should keep in mind.

Index funds

Index funds invest in stocks that correspond with a major market index such as the S7P 500 or Dow Jones. This strategy requires less research on behalf of analysts and advisors, so fewer expenses are passed on to shareholders. As such, these funds are typically designed with cost-sensitive investors in mind.

Balanced funds

Balanced funds mainly invest in a hybrid of asset classes, such as stocks, bonds, or other alternative investments. The objective of this type of fund is to reduce the risk of exposure across asset classes.

Some funds are defined with a specific allocation strategy that is fixed. This is because the investor can have predictable exposure to various asset classes. However, other funds may follow a strategy for dynamic allocation percentages to meet other investor objectives. This may include responding to business cycle changes, market conditions, or other phases in an investor’s own life.

Portfolio managers are usually given the freedom to switch the ratio of the asset classes as needed to maintain the integrity of the fund’s stated strategy.

Stock funds

These funds invest primarily in equity or stocks. Within this group, there are plenty of subcategories. Some funds are named for the size of the companies they invest in – such as small, mid or large-cap. Others are named for their investment approach – aggressive growth, income-oriented, value, and more.

Funds can be classified based on the size of the companies, their market caps, and the growth prospects of the invested stocks. The term value fund refers to a style of investing that looks for high-quality, low-growth companies that are not in favour with the market.

On the other hand, growth funds look for companies that have strong growth in sales, earnings, and cash flows. These companies typically have high P/E ratios and do not pay dividends.

Large-cap companies generally have high market capitalisations, with values over $10 billion. These companies are usually blue-chip firms. Small-cap stocks refer to stocks with a market cap ranging from $250 million to $2 billion. These smaller companies tend to be newer, and riskier investments. Mid-cap stocks fill the gap between small and large-cap.

Benefits of investing in a mutual fund

There are plenty of reasons why people choose to invest in mutual funds. Below, we discuss a few reasons why people use them.

Diversification

Diversification refers to the mixing of investments and assets within a portfolio to reduce risk. This is a major advantage for those investing in mutual funds. A diversified portfolio has securities with different capitalisations and industries, as well as bonds with varying maturities and issuers. Therefore, buying a mutual fund can achieve diversification cheaper and faster than simply buying individual securities.

Easy Access

Mutual funds can be bought and sold with relative ease, making them highly liquid investments. When it comes to certain types of assets, such as foreign equities or exotic commodities, mutual funds are usually the most feasible way – and sometimes the only way – for individual investors to participate.

Economies of scale

Mutual funds help to provide economies of scale by bypassing numerous commission charges that investors need to create a diversified portfolio. This is because buying only one asset at a time leads to large transaction fees in the long run. The smaller denominations of mutual funds allow investors to take advantage of dollar-cost averaging.

Variety and freedom of choice

Investors have the freedom to research and select from various managers all with their own styles and management goals. A fund manager may focus on value investing, growth investing, developed markets, emerging markets, income, or even macroeconomic investing, among many other styles. This variety allows investors to gain exposure to not only stocks and bonds, but also commodities, foreign assets, and real estate through special mutual funds. Mutual funds can also provide opportunities for both foreign and domestic investments that may not otherwise be directly accessible to most ordinary investors.

Professional management

A professional investment manager is experienced in doing careful research and navigating the markets. A mutual fund is a relatively inexpensive way for small investors to gain a full-time manager to make and monitor investments on their behalf. Mutual funds require much lower investment minimums, so these funds provide a low-cost way for individual investors to experience and take advantage of a professional money manager.

Bottom line

It is important that investors consider their investment goals, risk tolerance level, and investment time horizon before investing in mutual funds. Before committing to a mutual fund, make sure to read through its prospectus, understand its investment strategy, past performance, and fees. If in doubt, investors should consult with a financial advisor that can help them more informed investment decisions.