Over the past 20 years mutual funds have gone from being just another obscure financial instrument to a part of many people’s daily financial lives. Just about half of households in the United States are invested in mutual funds. For most people, mutual funds are seen as an alternative to a savings account which will allow your savings to grow at a faster rate, and that’s where their analysis ends. Mutual funds are considered an easy, low maintenance way to invest without needing to follow or understand the nuances of financial markets. While in theory this is all true of mutual funds, in practice not all funds deliver on this promise and it can be a bit more complicated to ensure that you are choosing the right mutual fund for your unique circumstances.
A mutual fund is in essence a company which sells shares to a group of investors and then uses the money they have invested to purchase a diversified portfolio of stocks, bonds and other securities. Each share purchased by an investor represents a portion of the company’s total holdings. If the stocks or bonds in a mutual fund’s portfolio earn dividends, this income to the fund is paid out to shareholders in the form of a distribution. If the securities which the fund have purchased increase in value and are then sold, the fund has a capital gain and these are usually also passed on to shareholders as a distribution. If however fund holdings increase in price but are not sold, the fund’s shares also increase in price and an investor may sell them for a profit. Most funds will also allow you to either receive a distribution check, or reinvest the distribution by purchasing more shares.
The main advantage of a mutual fund is that it is professionally managed. Investors who do not have the time or expertise to manage their own portfolios can invest in a mutual fund and have their investments professionally made and monitored for relatively low fees. Mutual funds are also diversified which reduces the risk of investment. Because money from many investors is pooled together in a mutual fund, the fund can take advantage of economies of scale to buy and sell large quantities in a single transaction which lowers costs. Also mutual funds are highly liquid, you can convert your shares to cash at any time. However, as mutual fund managers get paid regardless of the fund’s performance, and the fees of running the fund are all passed on to the investors, if the fees for a fund are high and the management professionals don’t pick stocks that “beat the market” there is the potential for losing money. Also, popular funds face the difficulty of dilution – when money pours into a successful fund it can be difficult to find strong new investments that will maintain the past track record.
There are over 10,000 mutual funds in North America, so no matter your investment style there is almost certainly a fund to match it. In general, as with most investments, the higher the risk of loss, the higher the potential returns. Mutual funds can be broken down into three main types which have different levels risk/return potential. The most conservative type is Money Market Funds. These funds invest in short-term debt instruments such as Treasury bills. They are a safe place to maintain your principal but don’t generate high returns. Typically they earn twice the percentage returns on a regular savings account and less than a certificate of deposit (CD). Fixed-Income or Bond Funds are aptly named; their main purpose is to generate a steady income. These funds invest in government and corporate debt and by doing so seek to provide a steady cashflow to investors. Because there are many types of bonds, these funds can have greatly varying amounts of risk. High-yield junk bonds may have the potential for a greater income than government securities, but they also have a higher risk for loss. Bond Funds are also intrinsically linked to interest rate risk; if rates go up the value of the fund goes down. However lower risk government bond funds can provide a reliable, if lesser, income which can be attractive to conservative investors or retirees. Equity Funds are the final broad category of fund and the most common type of mutual fund. Equity Funds purchase stock with the goal of long-term capital growth along with some income. There are as many varieties of Equity Funds as there are types of equities and they can be differentiated based on the types of companies they invest in.
When buying a mutual fund you can contact some funds directly. Others are sold through brokers, banks, financial planners or insurance agents which usually pay a third party fee. When purchasing a fund the first number to look at is the Net Asset Value (NAV) per share. This is the fund’s assets, minus liabilities divided by the total number of shares, and it is the number quoted in the newspaper. It is basically the price of a mutual fund and it fluctuates daily. When you purchase shares, you will pay the NAV per share plus any front-end load fees. When you sell your shares you receive NAV per share plus any back-end load fees.
To choose a mutual fund, you should begin by identifying your goals and risk tolerance. Are you seeking a steady investment income? Do you want to grow your capital? Do you want security for your principal? Once you have answered these questions you will know what type of fund you are looking for and can begin researching on your own, or if you are using a third party they can make recommendations based on your criteria. Nearly every mutual fund company has its own website where you can view performance and philosophy information which can assist you in making your choice. If you don’t have a specific fund in mind yet, resources such as the Mutual Fund Education Alliance or Morningstar can help you narrow the field.
When evaluation the performance of a mutual fund, 1, 3, and 5 year averages are often used but can be misleading. A high 1 year return on its own is not indicative of long term performance and it can skew 3 year and 5 year averages to the point where they are misleading. For example fund that has a 1 year return of 53%, a 3 year average of 20% and a 5 year average of 11% looks pretty good at first glance. However if you look closer at the math you will see that although the fund performed well for year 1, years 2 and 3 only had 3.5% returns and years 4 and 5 actually had negative returns. This is a simplification of the math but it illustrates the dangers of only looking at averages. Actual yearly returns over a number of years are more indicative of a funds true performance. Of course the performance of a fund is relative, and needs to be compared to an appropriate benchmark index to determine if a fund truly performed above or below its peers.
Mutual funds can be a great way to put your savings to work for you. There is such a variety of funds available it is almost always possible to find one that meets your requirements. However it is important to do the proper research to evaluate a fund’s performance and also to take a hard look at the fees associated with a particular fund as they can have high costs. Doing the legwork ahead of time to make sure a mutual fund meets your needs can be daunting. If you are interested in doing the research yourself it can be very rewarding, or if you don’t have the time or inclination an investment professional can be very helpful in making your choice. Either way you will need to determine your goals and risk limits before beginning your search if you wish to join the more than 80 million people in the United States who are invested in mutual funds.
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