Mutual funds offer a means to achieve broad diversification within a stock portfolio, for a relatively small amount of money. It should be understood that this is a level of diversification that most small investors would be unlikely to achieve on their own, and this is why many industry experts recommend that those with little financial experience invest in mutual funds rather than in riskier assets.
Purchasing a fund is different than purchasing individual stocks or bonds. Instead, when you purchase a mutual fund you are gaining an ownership stake in a collection of assets. In most cases, professional money managers, usually called fund managers, attempt to invest the funds in strategic assets that experience low levels of volatility.
Low Entry Limits
Mutual funds generally allow investments with low entry limits. Many consumers gravitate toward mutual funds because they implement simple investment strategies that benefit from a diverse portfolio. Being able to place all of your investment capital into one fund is much easier (and less time-consuming) than researching and purchasing individual stocks and bonds. Rather than keeping track of a bunch of small investments, you keep track of just one.
When purchasing a fund, you are essentially putting your money into the trust of the fund’s manager. The fund manager invests the money, buying and selling when they think it is the most profitable. Investors are then given a share of the net proceeds (usually either quarterly or yearly).
Types of Mutual Funds Available
Equity funds are meant for investors who are ready to take higher risks in order to maximize returns. These are also called stock funds, and the managers predominantly invest in company stocks. Thus, they are characterized by higher risk when compared to safe-haven assets (like treasury bonds). The portfolio manager may assume different styles of investment (i.e. value, growth, income, or a blend of all three), so different funds might invest in small, medium or large-cap companies (which is determined by the market value of the company).
As the portfolio of these funds reflects the preponderance of company stocks, return on equity funds depends largely on the stock conditions visible in the broader markets. Capital appreciation in the long-term is the primary objective of stock funds, with sector volatility smoothed by complex industry expose.
Fixed Income Funds
Fixed income funds are just the opposite of equity funds, as capital appreciation is not the central focus. Here, the security of the money invested assumes most of the importance because many of the investors in this category are into their retirement years.
Fixed income funds may invest in different types of debt instruments like corporate, municipal, and government bonds. They may also invest in unconventional debt instruments like mortgage-backed securities. It is often easy for retired investors to park their money in these areas. Instead of putting money in a fixed deposit, one might consider investing in fixed income funds. Most of the fixed income funds prefer U.S. government bonds for investment because they have the highest credit quality.
Money Market Funds
Money market funds primarily invest in money market instruments. Thus, the objective of a money market fund is to give a safe investment option to the investor. The fund portfolio contains cash equivalent, short-term liquid assets. The risk involved is very low for money market funds, and this is reflected in their low return profile.
Apart from these three primary types, there are some other minor types of mutual funds that should be noted:
- Sector Funds target a particular industrial sector for investment.
- International Funds invest in international assets.
- Open Ended Funds may issue and redeem fund units at any point in time, depending on the demand for the fund.
- Closed Ended Funds do not allow issuance changes in the number of tradable units (i.e. shares cannot be increased later by fund managers). However, shares can be traded in a market at a characterized by a premium or a discount.
- Index Funds create their portfolios by weighting different stocks in a benchmark index. The return on these funds almost exactly reflects the return of the benchmark index.
With this in mind, investors should understand that there are many different options available when looking to select a mutual fund for investment.