What are Mutual Funds?
Mutual Funds are pools of money collected from many investors for the purpose of investing in stocks, bonds, or other securities. Mutual funds are owned by a group of investors and managed by professionals. In other words, a mutual fund is a collection of securities owned by a group of investors and managed by a fund manager.
Understanding How Mutual Funds Work
When you purchase a mutual fund, you are pooling money with other investors. The money pooled together by you and other investors are managed by a fund manager who invests in financial assets such as stocks, bonds, etc. The mutual fund is managed on a daily basis. Below is a diagram of how mutual funds work:
Common Types of Mutual Funds
There are six common types of mutual funds:
1. Money Market Funds
Money market funds invest in short-term fixed income securities. Example of short-term fixed income securities would be government bonds, Treasury bills, commercial paper, and certificates of deposit. These types of fund are generally a safer investment but with a lower potential return than other mutual funds.
2. Fixed Income Funds
Fixed income funds buy investments that pay a fixed rate of return. This type of mutual fund focuses on getting returns coming into the fund primarily through interest.
3. Equity Funds
Equity funds invest in stocks. Furthermore, there are different types of equity funds such as funds that specialize in growth stocks, value stocks, large-cap stocks, mid-cap stocks, small-cap stocks, or a combination of these stocks.
4. Balanced Funds
Balanced funds invest in a mix of equities and fixed income securities – typically in a 40% equity 60% fixed income ratio. The aim of these funds is to generate higher returns but also mitigate risk through fixed income securities.
5. Index Funds
Index funds aim to track the performance of a specific index. For example, the S&P or TSX. Index funds follow the index and go up when the index goes up and goes down when the index goes down. Index funds are popular as they typically require a lower management fee compared to other funds (due to the manager not needing to do as much research).
6. Specialty Funds
Specialty funds focus on a very small part of a market such as energy, telecommunications, healthcare, industrials, etc.
Benefits of Investing in a Mutual Fund
There are several key benefits to investing in a mutual fund:
1. Professional Management
Mutual funds are actively managed by a professional who constantly monitors the fund’s portfolio. In addition, the manager can devote more time in selecting investments than a retail investor would.
2. Investment Diversification
Mutual funds allow for investment diversification. A mutual fund invests in several asset classes and not just a single stock or bond.
Mutual funds possess high liquidity. In general, you are able to sell your mutual funds within a short period of time if needed.
Disadvantages of a Mutual Fund
There are important disadvantages to consider when investing in a mutual fund:
1. Management Fees and Operating Expenses
Mutual funds typically charge a high MER (management fee and operating expenses). This would lower the overall return. For example, if the mutual fund posted a 1-year return of 10%, the MER would lower this return.
2. Loss of Control
Since mutual funds are managed by a manager, there is a loss of control when investing in a mutual fund. Remember that you are giving someone else your money to manage to when investing in a mutual fund.
3. Poor Performance
Mutual fund returns are not guaranteed. In fact, according to research, a large majority of mutual funds fail to beat major market indexes like the S&P 500. In addition, mutual funds are not insured against losses.
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