Mutual funds can be a powerful vehicle to financial independence. If you understand how to invest in mutual funds, you can easily find a way to improve your finances.
In this article, we explore what mutual funds are, how to invest in them, and see their advantages and disadvantages.
What is a Mutual Fund?
A mutual fund is a type of investment security that allows investors to pool their funds together into one professionally managed investment.
Mutual funds are a means for achieving broad diversification for a fairly little amount of money. Most small investors would otherwise not be able to achieve this kind of diversification.
Mutual funds can be invested in bonds, stocks, and cash, among other assets. The underlying security types, known as holdings, combine to create one mutual fund, also known as a portfolio. Purchasing a fund is not the same as purchasing individual bonds or stocks.
Namely, when you purchase a mutual fund, you’re gaining an ownership stake in an investment company. Moreover, you share equally in gains and losses with other investors in the fund.
This helps to spread risk form poorly performing investments while, over time, enjoying the total gains of the fund.
When you invest in a mutual fund, you’ll normally have to pay annual fees for the management of the fund. These fees are called expense ratios, and they’re based on a percentage of the total value of your investment.
Account minimums and fees are some of the things you’ll need to consider when choosing the right mutual fund in which to invest.
Types of Mutual Funds
There are two to seven different types of mutual funds depending on how they are categorized. They can be categorized by structure, investment objective, and nature of the schemes.
When categorized on the basis of investment objective, mutual funds can be of seven types, namely:
- Fixed income funds
- Equity funds
- Tax saving funds
- Balances funds
- Money market funds
- Gilt funds
- Exchange-traded funds (ETFs)
When classified according to structure, mutual funds can be of these two types:
- Open-ended schemes
- Closed-ended schemes
When they are categorized based on nature, they can be of three types:
- Equity funds
- Debt funds
- Balanced funds
Some of the mutual funds can fall in more than one category. That said, let’s take a deeper look at each of the types of mutual funds.
Equity funds are also called growth funds. They invest in equity shares with the aim of capital gains over medium or long-term. These funds are considered a high-risk investment as they are associated with the highly volatile stock markets.
Nonetheless, they deliver high returns. If you have a great appetite for risk, equity funds can be an ideal investment option for you.
Fixed Income Funds
Fixed income funds are also called debt funds. These types of mutual funds invest in fixed income or securities such as corporate bonds, debenture, government securities, commercial papers, and a variety of money market instruments.
If you are looking for regular and steady income, devoid of risk, investing in fixed income funds can work well for you. Fixed income funds are further classified into:
- Liquid funds
- Gilt funds
- Income funds
- Short term funds
- Monthly income plans (MIPs)
If you are looking for a mutual fund that delivers a regular income and growth at the same time, then you should consider investing in balanced funds.
They invest in a mix of equity shares and debt instruments. Balanced funds are a perfect investment option if you’re willing to take moderate risks over medium or long-term.
Exchange-Traded Funds (ETFs)
These funds trade in the stock exchange and own a collection of assets such as bonds, precious metals, foreign currency, oil futures, and more. With ETFs, you enjoy the flexibility of buying and selling units on the stock exchanges all through the day.
Tax Saving Funds
If you wish to grow your capital while saving tax at the same time, a tax saving fund can be a perfect investment option. With this kind of investment, you get to enjoy tax rebates according to Section 80C of the Income Tax Act, 1961.
If you want a type of investment where you can enter and exit at will, then an open-ended scheme can work well for you. In open-ended schemes, units are purchased and sold continuously, allowing you to enter and exit at your convenience. Buying and selling of funds is done at the Net Asset Value (NAV).
In a close-ended scheme, only a given number of units can be sold as the unit capital remains fixed. You cannot purchase the units in a close-ended scheme once the New Fund Offer (NFO) has passed. Therefore, you can’t exit the scheme before the term ends.
Benefits of Investing in Mutual Funds
From advanced portfolio management to competitive pricing, there are many reasons mutual funds are popular among investors. Let’s explore some of the important benefits of investing in mutual funds:
With a single mutual fund, you can invest in securities from hundreds of issuers. This broad diversification helps to minimize the risk of a major monetary loss due to challenges in a particular business or industry.
You don’t need much money to get started with mutual fund investment. You can start purchasing shares with as little as $500. Some mutual funds also allow you to purchase additional units on a regular basis with as little as $50 per month.
You don’t have to worry if you don’t have the time or the skills to manage your investments. The same goes for evaluating the numerous securities available in the financial markets.
Simply invest in mutual funds and all that will be taken care of on your behalf. Mutual funds are run by professionals who have the knowledge, expertise, and resources to research a vast range of investment opportunities and invest your money prudently.
Mutual fund firms normally manage a wide variety of funds, such as fixed income, money market, index, sector, and global funds. They offer you the opportunity to switch between these funds at an affordable fee or free of charge. That means you can change your portfolio whenever market conditions, your personal needs, or your financial objectives change.
You can sell or buy shares or units in a mutual fund any business This makes it easy to access your money whenever you need it.
Drawbacks of Investing in Mutual Funds
Despite their great benefits, mutual funds also have some drawbacks. These include high expense ratios, mismanagement, and tax inefficiency. Let’s take a detailed look at some of the drawbacks:
Sometimes mutual fund managers abuse their authority by making unnecessary trading, excessive replacement, or selling the losers before the quarter-end to correct the books. This can result in turnover, churning, and window dressing.
Exorbitant expense ratios and sales charges
Some mutual funds can have extremely high expense ratios and sales charge. It is advisable to avoid mutual funds with expense ratios that exceed 1.20%. These are considered to be on the higher side of the costs.
In fact, you should generally be cautious of 12b-1 advertising fees and sale charges. You should look for mutual fund companies that have no sales charges. There are many of them out there.
Poor trade execution
If you are looking for faster trade execution times, probably due to day trading, short investment horizons, or timing the market, mutual funds may not work well for you as they offer a weak execution strategy.
There are three main ways to buy mutual funds, and there are numerous online platforms where you can make the purchase. Let’s take a deeper look at these three ways:
Through a retirement account
If you have a self-controlled retirement account, such as an individual retirement account (IRA) or 401(k), the financial institution managing your account probably allows for mutual funds trading through its website.
If you wish to grow your retirement savings through a tax-deferred account or you want to invest in a mutual fund that makes regular taxable distributions but don’t need the investment income now, ask your retirement plan administrator if it’s possible to trade through it directly.
Through the financial institutions
You can also purchase mutual funds directly through the financial institutions offering them. There exist several reputable investment companies in the United States that offer a wide selection of mutual funds, so you can choose one that perfectly suits your investment needs.
Through an online brokerage account
You can also choose to buy mutual funds using an online brokerage account through reputable sites such as E-TRADE, Charles Schwab, or TD Ameritrade.
Keep in mind that these accounts normally charge a transaction fee for every trade. You may also be required to pay for account setup or maintenance.
Alternative Investments to Mutual Funds
- Stocks – Individual stocks can have amazing upside, but also come with some risk.
- Bonds – A hedge against the volatility of the stock market, bonds can get you solid returns.
- Real Estate – A great option for diversification, you can own or simply invest in real estate.
- Small Business – Whether owning or just investing, small businesses present a great investment option.
- ETFs – A close relative of the mutual fund, ETFs give you a great diversification option.
- Commodities – Not as well known as other investments, you can invest in the markets for hard goods.
- Peer to Peer Lending – You can become the bank by lending your money as a part of private loans.
Final Thoughts on Investing in Mutual Funds
Mutual fund investing is one of the most common forms of investing today. The investment helps you diversify your funds and minimize risk. The process of investing in mutual funds is not difficult and can lead to great wealth.