Mutual funds never lose their popularity among private and professional investors. MF apologists prefer to have it all, or simply access a broad pack of investments together rather than picking up individual stocks or bonds.
What is a mutual fund?
A mutual fund is a widely used investment product in which the funds of many investors are pooled together into a range of different securities and managed professionally. Those securities are selected in order to reach the fund's investment goals.
As any other type of investment, mutual funds have their pros and cons. The major advantages of investing in MFs are: broader diversification, higher liquidity and professional management. The primary negative side lies in various fees.
Investing in mutual funds
There are hundreds of mutual funds available worldwide, which hold assets that totals more than $40 trillion. Many people prefer mutual funds as a part of their retirement plan, or an individual retirement account (IRA). A mutual fund’s share price is known as ‘NAV’, which stands for net asset value. The countries with the largest mutual fund industries are: the USA, Luxembourg, Ireland, Germany, France, Australia, the United Kingdom, Japan, China and Brazil.
While some mutual funds monitor and follow the performance of a certain market index (i.e. passively managed index funds), the majority of mutual funds are managed in an active way (i.e. through fund managers who elaborate and follow a particular investment strategy to trade various securities in an attempt to beat the market). Mutual funds can track almost every part of the market, investing in a variety of assets including commodities, stocks, bonds and real estate.
A glimpse of history
The first investment fund – the predecessor of modern mutual funds – was established in the Dutch Republic in 1770s. To beat the consequences of the financial crisis of 1772-1773, Abraham van Ketwich created a trust called “Eendragt Maakt Magt”, which means “unity creates strength”. His goal was to give any small investor the possibility to diversify.
How to choose the best mutual fund
Sometimes, a wide pool of different mutual funds makes it difficult for some investors to choose the one that suits them best. In order to facilitate this challenge, here are some major points for you to consider.
Identify your goals and risk tolerance
How to invest in mutual funds? Before putting your money into something, you should clearly set your goals. Are you targeting long-term profits or a more short-term income?? Are you going to pay for your college tuition, or save money for your retirement, which may be decades away from now?
In addition to setting your investment goals, it is very important to find out your personal risk tolerance. Are you okay with drastic swings in the value of your portfolio, or is a more conservative investment preferable? It is extremely important to find a balance between your expectations for returns and your ability to tolerate risk.
Another factor that you shouldn’t ignore is time. Mutual funds are regarded as a long-term investment. As mutual funds require some fees and charges, which can swallow a substantial part of your returns over a short period of time, it may be reasonable to consider a longer investment horizon to reduce the effect of these charges.
Identify the type of mutual fund
There are several types of mutual funds. The main goal of a growth fund is capital appreciation. Therefore, if you are interested in longer-term investments and can accept a certain amount of volatility and risk, a long-term capital appreciation may be the best choice for you. These funds hold a pretty big part of their assets in stocks, which are considered volatile. Although the risk is higher, the potential for profit in the long-run is also higher.
The bad thing? Growth funds usually don’t pay dividends. Therefore, if you are seeking an immediate profit from your investment portfolio, an income fund may serve you better. Income funds usually deal with bonds and other debt assets, which pay interest regularly. Bond funds are usually less volatile and have low correlation to the stock market. It makes them a good choice to diversify your stock portfolio.
Don't forget about fees
How does a mutual fund make its managers money? They charge fees. Some funds work with and charge a sales fee, which is also called a 'load’. This fee is usually charged when you buy (frond-end load) or sell ( back-end load) the investment. The fee is the highest for the 1st year you hold the shares. This is made to prevent investors from selling and buying too often. Usually, mutual funds with front and back-end loads charge from 3 to 6% of the total invested amount. This number may be even higher and reach a top of 8.5%.
There are also no-load funds, which don’t charge front and back-load fees. However, they charge other fees, including a management expense ratio, which can be expensive.
Passive or active mutual funds
How mutual funds work: another thing you should be aware of is passive and active fund management. Mutual funds with active management operate with the help of professional portfolio managers who undertake the responsibility to decide which assets should be included in the fund. Portfolio managers carefully consider macroeconomic factors, company fundamentals and other parameters important for the fund’s successful performance.
Top mutual funds with active management tend to outperform passive, or benchmark, mutual funds. Passively managed funds, often referred to as index funds, usually track and follow a particular benchmark index. The fees of passive funds are usually lower and they do not trade their assets very often. However, passive funds may have thousands of assets under management, which makes them very well-diversified.
In the end
Picking up the best mutual funds to invest in may seem difficult. However, the main thing is to set your own investment goals and risk tolerance. Being honest with yourself about your ambitions and current financial position will increase your chances for success.