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What are mutual funds?

Curious about mutual funds? Learn how they work, their benefits and drawbacks, and why they are a popular investment option for many.

What are mutual funds?
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As we explore concepts within the investing world and the various available options, today we are looking into mutual funds to gain a proper understanding of what they are, how these are categorized, and what these actively managed funds could contribute to your investment journey. 

What is a mutual fund? 

A mutual fund is a type of investment vehicle that pools the money of many investors and invests it in stocks, bonds, or other securities. Mutual funds offer investors diversification, professional management, and economies of scale. 

These actively managed funds also provide liquidity since they can be easily bought and sold through a broker or financial advisor. Mutual funds come with various levels of risk depending on their asset allocation strategy, with some being more conservative than others. Investing in mutual funds is a great way for individuals to access the stock market without having to purchase individual stocks themselves.

How can you access actively managed funds?

Investing in mutual funds is an easy and cost-effective way to diversify your portfolio, as they offer access to a wide range of asset classes. Mutual funds are professionally actively managed funds handled by fund managers who make decisions on behalf of the investors. 

Accessing mutual funds is relatively straightforward, investors can buy mutual fund shares directly through a fund house or use the services of a financial advisor or online broker. The price will reflect the mutual fund shares' net asset value plus fees associated with the trade.

When one wants to redeem their shares, they will be worth the net asset value at the time plus any fees. The net asset value (NAV) of a mutual fund, more commonly referred to as its price, is determined by the total worth of all the securities held in the portfolio and divided by the number of outstanding shares.

Before investing in any mutual fund shares it’s important to understand the fees associated with them, such as management fees and sales charges, so that you can choose the best option for your needs. Mutual fund investing can be lucrative, but there are still risks associated.

The different types of mutual funds available

As with most investment options, there is never just one type. When it comes to mutual funds, there are roughly six different types that one can explore. Any interested mutual fund investor should become familiar with the following types:

1. Stock Funds

Also known as equity funds, stock funds are made up of stocks (publicly traded shares of a company). Stock funds allow mutual fund investors to invest in multiple publically traded companies, and effectively own a tiny piece of each. These stock funds are known to deliver the highest returns when compared to other mutual funds and have the greatest growth potential, however, they are also considered to be the most volatile. 

Growth stock mutual funds, in particular, are known to grow at a faster rate than the rest of the markets. These are categorized by the companies' value, with small-cap funds incorporating companies valued below $2 billion, medium-cap funds $2-10 billion, and large-cap funds looking at companies valued at $10 million or higher. 

These mutual funds can be further broken down into a number of categories, and offer a perfect means to diversify within the stock funds category:

Growth and Income Funds (Large Cap)

Aiming for slow and steady development, these calm-growth stock mutual funds invest in large-cap companies that have relatively modest rises and falls when compared to their smaller counterparts. As a result, mutual fund investors can be sure of long-term gains with minimal risk.

Growth Funds (Medium Cap)

A perfect medium between small-cap and large-cap funds, these mutual funds invest in mid-sized companies for moderate growth and volatility.

Emerging Market Funds (Small Cap)

These are the most volatile funds as they have the capability to offer massive profits or losses in a brief period. Investing heavily in up-and-coming startups with the potential for exponential growth is an integral part of these aggressive mutual funds.

International Funds

International growth stock mutual funds allow one to diversify their money even further and are composed of a variety of companies from across the world and differentiated by capital size. These mutual funds typically include the likes of international brands and market giants beyond the borders of a specific country. 

2. Bond Funds

With bond funds, you have the option of investing in government or corporate bonds. Here, instead of buying a company's stock, your money is lent to governments and in return one earns interest. Unlike growth stock mutual funds which can be volatile and unstable in nature, bond funds offer steady returns and are known to provide consistent profits over time. 

While bond funds err on the side of caution, it's important to remember that in order for an investment to be worthwhile it needs to grow at a faster rate than inflation. History shows that these types of mutual funds earn between 5-6% per annum, which should be evaluated against the inflation rates (typically 3-4%). While bond funds are a safe bet, one must consider whether they will generate wealth.

3. Index Funds

Index funds are a kind of mutual fund that seeks to match the performance of an index or certain segment of the market. Unlike most mutual funds which have their investments actively managed by professionals, index funds only buy the investments included in a specific index, a process known as passive management.

For example, the renowned S&P 500 index tracks the stock prices of some of America's leading businesses to measure their financial performance. Investing in an index fund of this nature allows you to invest in multiple companies at the same time.

While many investors believe index funds are more beneficial in the long run due to their lack of management fees, there is a plethora of professionally managed mutual funds that routinely surpass these. Not only this but investors who invest in mutual funds will always benefit from an experienced investment professional monitoring one's portfolio, making up for any additional costs with increased profits. 

4. Income Funds

Those seeking regular income from their investments should consider mutual funds that focus on stocks paying dividends. Investors who opt for such a fund are not worried about the volatility of stock prices, instead, they're prioritizing receiving reliable small amounts of money from companies inside these mutual funds throughout the year.

5. Money Market Funds

Money market mutual funds provide investors with the opportunity to earn returns from loaning money out for short-term periods. Money market funds are typically loaned out to governments, banks, and companies that have contractual agreements in place to pay back investors within a year or less.

In comparison to bond funds, money market funds often fall short in terms of building wealth. For example, they typically pay an average return rate that is no higher than 3%, meaning your capital can actually decrease with time if inflation exceeds this level. 

Money market mutual funds can act as a protective guard over one's cash. While it safeguards against any potential losses, its conservative nature also limits the chances of any significant growth.

6. Hybrid Mutual Funds

To ensure your investments are well-rounded and secure, hybrid mutual funds cleverly spread out the money across stocks (equity) and bonds (debt). Two common types of these intelligent funds include balanced funds and target-date funds. Investing with hybrid mutual funds offers returns in smaller time frames. 

Balanced Hybrid Mutual Funds

Balanced hybrid mutual funds are investment funds that provide a combination of stocks and bonds, allowing investors to benefit from both the potentially higher returns of equities while also mitigating some of the risks with fixed-income investments. 

These mutual funds typically have an asset allocation mix between 60% stocks and 40% bonds, but this can vary depending on the fund's objectives. Balanced hybrid mutual funds offer diversification within one single fund, making them ideal for those seeking to minimize their overall portfolio risk.

Similar to most mutual funds, these types of mutual funds are actively managed by experienced professionals who continually monitor market conditions in order to make adjustments when necessary.

Target-Date Hybrid Mutual Funds

Target-date hybrid mutual funds are a type of investment fund that combines both stocks and bonds to provide investors with the potential for higher returns while mitigating some of the risk associated with equities. 

These mutual funds typically have an asset allocation mix that is based on when one plans to retire, allowing investors to benefit from diversification within one single fund. Target date funds can also be referred to as lifecycle funds.

Why invest in mutual funds?

Investing in mutual funds is a great way to diversify your portfolio and maximize your returns. Mutual funds are pools of money from several investors that can be used to purchase stocks, bonds, or other investments. 

Most mutual funds allow investors to spread out the risk associated with investing across multiple assets instead of just one, reducing the volatility of your overall portfolio. Additionally, mutual fund managers have access to greater research capabilities than individual investors do which can help them identify profitable investments more quickly. 

Overall, investing in mutual funds is an excellent way for individuals to benefit from professional management while also reducing their own risk exposure. Mutual funds are also recommended for long-term investment goals, particularly for retirement. 

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