Making informed decisions about your financial future takes research and attention. The next step? Learning about mutual funds and what they can bring to your investment portfolio.
5 min read
Future investors might already be aware that mutual funds can potentially boost your financial game. Whether you're a seasoned investor or just starting your investment journey, understanding mutual funds is key to building a robust investment portfolio. Not sure what mutual funds are, much less whether they make sense for you and your finances? By the end of this article, you'll have the basics you need to navigate your investment options and make more informed decisions about your financial future. Let's get started!
The basics: What is a mutual fund?
At its most basic, a mutual fund is group investment. Multiple investors pool their money and invest in a diversified portfolio of stocks, bonds, or other securities. These funds are managed by professional fund managers who make decisions about buying, selling, and holding securities within the fund's portfolio. Mutual funds are important because they provide individual investors access to a diversified investment portfolio, even with small amounts of money. This diversification helps spread risk and can reduce the impact that market volatility might have on an investor's overall portfolio. Additionally, mutual funds offer professional management — investors benefit from the financial expertise of experienced fund managers.
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Like any investment, the returns from mutual funds vary. It depends on the fund's investment strategy, the performance of the underlying securities within the fund's portfolio, and market conditions. Mutual fund returns are typically measured as either total returns or annualized returns:
Total returns include capital gains (or losses) from changes in the value of the fund's investments. Total returns also include any income that was generated, such as dividends or interest payments.
Annualized returns are the average rate of return each year with a specific period, such as one year, three years, or five years.
It's important to note that mutual fund returns are never guaranteed and can fluctuate over time. Past performance is also not indicative of future results. You should carefully consider your investment goals, risk tolerance, and investment time horizon to ensure you choose funds that align with your financial goals. Don't forget to consider fees and expenses associated with mutual funds, too — they will influence your expected return.
Types of mutual funds
Mutual funds are categorized into various types based on investment objectives, asset classes, and management styles. Some common types of mutual funds include:
Equity funds: These funds invest primarily in stocks or equities, aiming for capital appreciation over the long term. Equity funds may focus on specific sectors, industries, market capitalizations (large-cap, mid-cap, or small-cap), or geographic regions.
Bond funds: Bond funds invest in fixed-income securities such as government bonds, corporate bonds, municipal bonds, or mortgage-backed securities. These funds provide regular income through interest payments and are less risky than equity funds.
Money market funds: Money market funds invest in short-term, high-quality debt securities such as Treasury bills, certificates of deposit (CDs), and commercial paper. These funds are considered relatively low risk, with more stability and liquidity.
Balanced or hybrid funds: Balanced funds invest in a mix of stocks and bonds, so there’s more diversification across asset classes. These funds try to strike a balance between managing risk, generating income, and giving capital a chance to appreciate.
Index funds: Index funds passively track a specific market index, such as the S&P 500 or the FTSE 100, by holding a portfolio of securities that mirror the index's composition. These funds replicate the performance of the index they track and typically have lower fees than actively managed funds.
Sector funds: Sector funds focus on specific sectors or industries, such as technology, healthcare, energy, or financial services. These funds can capitalize on growth opportunities within a particular sector, but on the other hand, may be more vulnerable if there’s a downturn in that industry.
International or global funds: International or global funds invest in securities issued by companies outside of the investor's home country. These funds let investors access international markets and may invest in developed or emerging market economies.
Target-date funds: Target-date funds, or lifecycle funds, are designed to align with your retirement timeline. These funds automatically adjust their asset allocation over time, becoming more conservative as the target retirement date approaches.
These are just a few examples of the types of mutual funds available to investors. Don't forget to research further and understand the characteristics of each type of fund before investing any of your own cash.
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Mutual funds charge fees and expenses to cover the costs of managing the fund. Common fees associated with mutual funds include:
Management fees: These fees compensate the fund manager and management team for their services in managing the fund's portfolio. Management fees are typically expressed as a percentage of the fund's assets under management (AUM) and are deducted from the fund's assets on an ongoing basis.
Expense ratio: The expense ratio represents the total annual operating expenses of the fund, including management fees, administrative expenses, and other costs. The ratio is expressed as a percentage of the fund's average net assets. Expense ratios are disclosed in the fund's prospectus and can vary widely among funds.
Other fees: Mutual funds may also charge other fees, such as redemption fees, account maintenance fees, or 12b-1 fees (marketing and distribution expenses), which can impact an investor's overall return.
“Mutual funds and other pre-made portfolios can help you overcome analysis paralysis,” explains Guido Lonetti, Head of Product Investments at N26. “If you're an adventurous investor, you can choose an asset company and let them handle your investments for you. It's also an option if you don't have the time to research financial information,” he adds. That said, it's essential to consider not only the potential returns of a fund but also its fees and expenses — over time, these can significantly impact your net returns on your investment.
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Disclaimer
These statements do not constitute investment advice relating to any financial instrument. Financial instruments can be subject to high fluctuations in value. A decline in value or a complete loss of the money invested is possible at any time.
FAQs
Mutual fund prices, known as net asset value (NAV), are typically calculated once per day after the market closes. Investors can buy or sell shares at this price, and transactions are usually executed at the end of each trading day.
Open-end funds issue new shares to investors on demand and redeem shares when investors want to sell. Closed-end funds issue a fixed number of shares that trade on an exchange like stocks, with prices determined by supply and demand.
If a mutual fund’s underlying investments earn money, it can distribute part of these earnings to its shareholders in the form of dividends. Investors can usually choose to receive dividends as cash or reinvest them to buy additional shares in the fund.
A fund's turnover ratio represents how often the fund buys and sells its holdings within a year. A high turnover ratio may indicate higher transaction costs and potential tax implications, which can affect the fund's overall returns.
Mutual funds can generate taxable income through capital gains distributions and dividend payments. Even if you reinvest this income, it may still be taxable for the year that you earned it. With mutual funds, it's important to think about tax efficiency, especially for taxable investment accounts.
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