Encore Essentials: Mutual Funds
In this article we will break down the basics of mutual funds and give you an overview of how they work and why so many investors like them!
What Are Mutual Funds?
A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates.
The particular investments a fund makes are determined by its objectives and, in the case of an actively managed fund, by the investment style and skill of the fund’s professional manager or managers. The holdings of the mutual fund are known as its underlying investments, and the performance of those investments, minus fund fees, determine the fund’s investment return.1
Why Do People Buy Mutual Funds?
Mutual funds have become a popular choice among novice and expert investor alike for the following reasons:
- Professional Management. The fund managers do the research for you. They select the securities, monitor the performance, and report back regularly.
- Diversification or “Don’t put all your eggs in one basket.” Mutual funds typically invest in a range of companies and industries. This helps to lower your risk if one company fails.
- Most mutual funds set a relatively low dollar amount for initial investment and subsequent purchases.
- Mutual fund investors can easily redeem their shares at any time, for the current net asset value (NAV) plus any redemption fees.
What type of mutual funds are there?
While there are literally thousands of different types of mutual funds to choose from most all of them fall into one of the following four categories:
- Stock funds invest in corporate stocks. Not all stock funds are the same. Some examples are:
- Growth funds focus on stocks that may not pay a regular dividend but have potential for above-average financial gains.
- Income funds invest in stocks that pay regular dividends.
- Index funds track a particular market index such as the Standard & Poor’s 500 Index.
- Sector funds specialize in a particular industry segment.
- Bond funds invest in bonds and have higher risks than money market funds because they typically aim to produce higher returns. Because there are many different types of bonds, the risks and rewards of bond funds can vary dramatically. (A bond is a loan to a company or government that pays back at a fixed rate of return.)
- Target Date funds invest in a combination of stocks, bonds, or other investments. The mix of investments will gradually shift depending on the fund’s overall investment strategy. These types of funds are designed for individuals with particular retirement dates in mind.
- Money market funds invest in very short-term investments and are sometimes described as cash equivalents. These tend to be low risk as they are required by law to invest in high-quality short-term investments issued by U.S. corporations, and federal, state and local governments.
TIP: To find all the details on a particular fund, including investment strategy, risk profile, performance history, management, and fees ask to see a prospectus. You should always read a fund’s prospectus.
Mutual Fund Management: Active vs. Passive
Mutual Funds are managed either actively, by a professional investment manager(s) whose goal is to choose top-performing investments they feel will beat the market, or passively, where the fund is set up to meet certain benchmarks rather than exceed.2
- Actively Managed Mutual Funds
- Offer experience and investment knowledge you may lack
- Potential for higher than average returns
- Higher management fees and trading costs may reduce or negate overall returns
- Studies show most actively managed mutual funds fail to exceed benchmarks in the long run.
- Passively Managed Mutual Funds
- Investments will typically mirror a particular index
- An index is a statistical measure of change in a securities market (S&P 500 for example)
- Don’t have a management team that actively pick stocks
- Lack flexibility to react to price declines
- Investments will typically mirror a particular index
What Are The Benefits And Risks Of Mutual Funds?
Mutual funds offer professional investment management and potential diversification. They also offer three ways to earn money:
- Dividend Payments. A fund may earn income from dividends on stock or interest on bonds. The fund then pays the shareholders nearly all the income, less expenses.1
- Capital Gains Distributions. The price of the securities in a fund may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, the fund distributes these capital gains, minus any capital losses, to investors.1
- Increased NAV. If the market value of a fund’s portfolio increases, after deducting expenses, then the value of the fund and its shares increases. The higher NAV reflects the higher value of your investment.1
All funds carry some level of risk. With mutual funds, you may lose some or all of the money you invest because the securities held by a fund can go down in value. Dividends or interest payments may also change as market conditions change.1
TIP: A fund’s past performance is not as important as you might think because past performance does not predict future returns. But past performance can tell you how volatile or stable a fund has been over a period of time. The more volatile the fund, the higher the investment risk.1
Additional Information and Resources
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The information contained herein is general in nature, is provided for informational purposes only, and should not be construed as investment advice. The above links to articles are provided for your information strictly as a courtesy, and do not constitute an endorsement for the presented strategies or opinions. We make no representation as to their accuracy or applicability to your personal circumstances. Diversification does not assure a gain or protect against a loss in declining markets. Before investing in any investment strategy, it is recommended that you consult with an investment advisor to discuss your individual investment objectives and financial situation.
Securities offered through The O.N. Equity Sales Company, Member FINRA/SIPC, One Financial Way Cincinnati, Ohio 45242 (513) 794-6794. Investment Advisory services offered through O.N. Investment Management Company.