In a world where financial investments play a significant part of many people’s wealth building, savings and retirement planning, pooled investments managed by professionals are becoming popular. Rather than selecting stock and keeping an eye on its performance, mutual funds combine funds from numerous investors and employ a disciplined investment approach. In this way, trillions of dollars have been invested in markets across the globe.
As the number of mutual funds continues to grow, the strategies used to maintain them increase as well. They are seen as a way for the average investor to get involved in the action. Instead of spending time analysing financial reports, all you need to do is buy a mutual fund and let a professional manage it. That’s the simple way of looking at it, though seasoned investors such as Henner Diekmann – an attorney who specialises in international trade and foreign direct investment – know that there’s more to them. This is why it’s important to understand how they work and the different types that exist.
To varying degrees, the various types of mutual funds carry some level of risk and reward. The higher the potential reward, the higher the level of risk involved. Although some funds carry less risk than others, it’s never possible to avoid risk completely. This is true for all investments. However, knowing which type of fund to focus on can help in making better decisions.
At a basic level, mutual funds are divided into the following broad categories: fixed-income funds (invest in bonds), equity funds (invest in stocks), those that invest in both groups (called balanced funds), and money market funds (those that provide risk-free rates).
Money Market Funds
These funds typically invest in short-term securities such as treasury bills and government bonds. They’re a safe bet for any investor who doesn’t mind minimal returns with the assurance of keeping the principal amount. Money market funds offer potentially lower returns than all other types.
Fixed Income Funds
Their name betrays their sole purpose: to provide a steady income on a regular basis. These funds invest in high-yield government or corporate debt, with the investor gaining money from the interest earned on these investments. The typical audience for such funds is conservative investors who want a steady flow of cash.
Equity Funds
Equity funds invest in stocks, with the aim being to grow the money faster than fixed-income or money market funds. There’s an element of risk with these funds and they represent the majority of mutual funds. Due to the different types of equities available, investors have a range of investment funds to choose from.
Balanced Funds
Their primary purpose is to provide a mixture of safety while generating as much income as possible for the investor. They typically balance the portfolio between fixed income and equities. Most fund managers who offer these allow for a formula to split the money. The more aggressive funds tend to have fewer fixed income funds than equities, with the reverse happening for conservative funds.
Speciality Funds
This classification explains a group of mutual funds that don’t necessarily abide by the major categories. Rather, they tend to focus on a particular sector of the economy or employ a certain strategy. Sector funds, for example, concentrate on a sector of the economy such as health or technology. Ethical funds (or socially responsible funds) invest in companies that advocate certain beliefs such as diversity and environmental conservation while shunning industries such as weapons, alcoholic beverages or gambling.
How Investors Benefit
Typically, investors gain returns from mutual funds in the following ways:
- Interest earned from bonds and dividends on stocks. A mutual fund pays out a big chunk of the income it receives over the year in the form of distribution. Many funds give investors the opportunity to either reinvest the earnings or cash in their distribution
- Capital gains from selling securities that appreciate in price. These benefits are passed on to investors through distribution.
- Selling of mutual funds for a profit in the event the fund’s holdings increase in price, thus increasing the fund’s share price.
Benefits of Mutual Funds
The major draw of mutual funds is the management by knowledgeable professionals. The investor doesn’t have to keep a close eye at all times; the investment manager is on hand to do the research and trade prudently.
Secondly, individual investors benefit from the economies of scale afforded by the mutual fund. The transaction costs of buying and selling large amounts of securities are lower, and the pooling of resources helps funds invest in certain assets that individual investors may not afford to.
Third, mutual funds provide an aspect of diversification to investors. Rather than putting all your eggs in one basket, a mutual fund spreads the investment across various assets so that gains in one asset balance against a loss in another.
