Beginner's Guide to Mutual Fund Investment

Understanding the Basics of Mutual Funds

At its simplest, a mutual fund is an investment structure that allows people to invest together. You can think of mutual funds like a pool of several investors' money, invested as a single fund. The mutual fund company collects everyone's money into a single sum and invests in a variety of assets (stocks, bonds, commodities, real estate, etc.).

When you invest, say Person A, in a mutual fund, you own "shares" of that fund, representing your ownership in the combined pool of money assets that the fund owns and invests. So, everyone who invests in that mutual fund indirectly owns a smaller part of everything the mutual fund invests in.

A primary reason for the popularity of mutual funds is their diversification. A single investment can provide an investor access to multiple asset classes and reduce the need for individual investors seeking out several investment opportunities. Mutual funds are also liquid, making it easier for the investor to buy or redeem shares or units for cash more quickly than other individual assets, such as real estate.

Types of Mutual Funds

Mutual funds exist in many variations, each directed at different investment objectives and different tolerances for risk. The three principal types are bond funds, stock funds, and balanced funds.

Bond Funds

Bond funds focus on fixed-income securities, including government or corporate bonds, and pay their investors a regular interest rate, creating a steady source of income. The mutual fund collects all interest payments from bonds and pays them to investors.

Stock Funds

Stock funds invest in shares of multiple companies and are heavily dependent on market conditions for the prevailing performance of those companies. Insurance funds employ specific investment strategies to invest based on things like initial public offering (IPO) value, market capitalisation of markets, and brand strength.

Companies are classified based on their market capitalization, or the total market value of shares outstanding.

Large-cap stocks are well-established companies in the billions of dollars. Large-cap companies are comparatively stable and subject to less volatility.

Mid-cap and small-cap stocks are all growing companies and offer more returns, but also more risk.

Balanced Funds

The term balanced funds represents a mixture of bonds and stocks. These types of funds provide a combination of stability with growth potential. A bond is best viewed as a loan from the investor to the company or government, where the investor earns interest every period until the bond matures and receives the principal at maturity.

Bonds are generally viewed as safer investments as they provide predictable returns over a set term. The only major risk to a bond is default by the issuer or committed fraud.

Balanced funds are most popular for conservative investors interested in receiving moderate returns while keeping equity market volatility exposure and lower market risk.

How Mutual Funds Are Traded?

In contrast to individual stocks, mutual funds are only traded once within a day. Investors can purchase or redeem units through the fund’s Net Asset Value (NAV), which the fund ascertains after the market has closed for the day.

To determine the NAV, the fund divides its total assets (the fund’s total holdings less liabilities) by the total number of outstanding units.

It is also important to understand that investors purchase or redeem mutual fund units directly from the fund, as opposed to other investors, as with stocks.

Most mutual funds have a minimum investment amount, although this will vary by fund and by the Asset Management Company (AMC).

Understanding Charges

Mutual funds carry fees and expenses, which is why it's important to know about fees and charges before investing.

Some funds impose load fees, in other words, commissions paid to the distributor/advisor selling the fund.

A front-end load is an amount of money charged when you buy units of the fund.

A back-end load (or deferred sales charge) is an amount of money charged when you sell your fund units within a certain time after you purchased them.

Back-end loads tend to be higher in year one and go down each year until they disappear altogether. For example, a fund may carry a 3% penalty if redeemed in year one, 2% in year two, and no penalty thereafter.

You should also be aware of the expense ratio, in addition to similar to load fees. The expense ratio includes all management and administrative costs. Higher fees are likely to be a drag on returns over the long term, since funds charging higher load fees must now outperform their benchmarks to offset the higher fees.