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Monday, September 20, 2021

What are Mutual Funds and How They Work – Complete Guide 2021

A mutual fund pools cash to buy stocks, bonds, or other assets, providing investors with a cheap way to diversify and reap market benefits.

What are Mutual Funds (in simple terms)

Mutual funds ( Mutual Fund ) are basically open-ended investment funds in which the management company manages the investors’ cash deposits, investing them in various asset classes, for example, stocks, futures, industry business, real estate, bonds.

Rather than requiring investors to perform the Herculean task of collecting individual stocks or assets, mutual funds allow average investors to simply choose the types of funds that suit them. The average mutual fund has hundreds of assets in its portfolio, which can be diversified across a broad profile or specific type.

The first mutual funds ( investment funds ), as a prototype of modern companies, appeared in the Dutch Republic during the financial crisis of the 1770s. Businessman Abram van Ketvich (Abraham van Ketwich) created a fund Eendragt Maakt Magt ( «Unity creates strength”) in 1772 with the aim to provide investors the opportunity to diversify.

In the US in the 1890s , the first closed-end mutual funds appeared, which were not very profitable, since their shares were worth more than the assets in the portfolio.

The first open-ended fund, the Massachusetts Investors Trust, was established on March 21, 1924, and is still in existence today and is managed by MFS Investment Management .

Already in 1929, open-ended funds accounted for 5% of the total assets in the stock market and reached a capitalization of $ 27 billion.

The ensuing Great Depression and its exit pushed to develop and increase the number of funds and referrals in order to protect investors from all kinds of risks.

In the 1960s, Boston-based Fidelity Investments began creating mutual funds for the general public, not just the wealthy or companies in the financial industry. The introduction of funds into free exchange trading amid high interest rates in the late 1970s dramatically accelerated the growth of the industry. The first retail index fund, the  First Index Investment Trust, was formed in 1976 by the Vanguard group led by John Bogle and is now called the Vanguard 500 Index Fund and is one of the largest mutual funds in the world.

Beginning in the 1980s, the mutual fund industry began a period of growth that has continued largely without interruption throughout the day.

The combined size of funds in the USA, Canada and Australia is in the order of $ 17 trillion.

In Russia and the CIS, an analogue of mutual funds is a mutual fund ( mutual investment fund ), however, there is a significant difference in the stages and time of development, as well as in the methods of investment. Also for over 140 years, mutual funds have excelled in number, experience and quality.

The ban on the stock market in 1917 in Russia made it impossible for many years of quality experience in asset management. Only in 1997, the Troika Dialog management company followed the example of the Americans and founded the first mutual funds in the Russian Federation.

On the Russian market, in comparison with the US market, there is a negligible number of management companies. And this is mainly due to the fact that the stock market in our country appeared only at the end of the 20th century.

According to the Investment Company Institute ( Investment Company About enterprise | Institute ), at the end of 2019 the assets of mutual funds around the world amounted to 54.9 trillion dollars.

In the United States, mutual funds play an important role. At the end of 2019, 23% of families’ financial assets were held in mutual funds. Their role in retirement savings is even more significant, since mutual funds account for about half of the assets in individual retirement accounts, which are opened from the first salary of a person. Almost every pensioner receives income generated by the stock exchange.

Brief summary

  • A mutual fund is a type of investment vehicle made up of a portfolio of stocks, bonds, or other securities.
  • Mutual funds provide small or individual investors with access to diversified, professionally managed portfolios at low cost.
  • Funds charge annual fees and, in some cases, commissions that can affect overall returns.
  • The vast majority of money in employer-funded retirement plans in the United States goes into mutual funds.

How mutual funds work

Unlike stocks, investment funds do not give owners voting rights. A mutual fund share is an investment in different stocks (or other securities) instead of a single holding.

That’s why the price of an investment fund called the ” net asset value ” ( net asset of value, the NAV ), sometimes expressed as NAVPS – net asset of value The per this content share ( net asset value per share ).

The NAV of a fund is determined by dividing the total value of the securities in the portfolio by the total number of shares outstanding. The repurchased shares are owned by all shareholders, institutional investors, and officers or insiders. Investment fund shares can usually be purchased or redeemed as needed at the fund’s present value (NAV), which, unlike the share price, does not fluctuate during market hours, but is calculated at the end of each trading day.

There are several different types of mutual funds that you should be aware of:

Closed-end mutual funds

They issue a fixed number of shares to investors and are usually traded on major exchanges as corporate shares. Closed-end funds often invest in a specific sector, a specific industry, or a specific country.

Open-ended investment funds

We are ready to issue and redeem shares on an ongoing basis. Shareholders buy shares at net asset value (NAV) and can sell them at the current market price.

Load funds

The term “ burden ” refers to the commission paid by an investor who buys shares in a mutual fund. When a fee is charged at the time of purchase, it is called external loading. Conversely, internal burdens are fees that are assessed when the investor ultimately sells the fund. There are no-load Funds when these fees are not withheld.

What are mutual funds?

Most of the funds on the market (55%) are engaged in the purchase of shares.

Equity funds

They can invest in large, mid or small cap companies. Because funds invest in stocks, they are viewed as high risk, but they also offer the potential for higher returns.

Long-term earnings can be about 10-12% per annum.

Generally, the smaller the market capitalization, the more risky the investment, since the fund’s return is more volatile.

Not all equity funds are created equal. Here are some examples :

  • Growth funds target stocks, which may not pay regular dividends, but have the potential to generate above-average financial returns.
  • Income Funds invest in stocks that regularly pay dividends.
  • Index funds track a specific market index, such as the Standard & Poor’s 500 Index.
  • Industry funds specialize in a specific industry segment.

Target date funds

Contain a set of stocks, bonds and other investments. Over time, the composition gradually changes in accordance with the fund’s strategy. Target date funds, sometimes called lifecycle funds, are for individuals with specific retirement dates.

Value Added Funds

These are equity funds that invest in companies with low P / E ratios that are not well received by investors due to bad quarterly reports or bad deals.

On the other hand, undervalued stocks generate high dividends, thereby generating dividend income and long-term growth.

Fixed Income Funds (Bond Funds)

Invest in corporate, municipal, mortgage-backed or high-yield bond funds, thereby exposing themselves to a lower risk than equity funds.

According to ICI statistics, about 22% of all US mutual funds are bond funds.

The maturity of funds can be short, medium or long term, and funds are actively managed and traded for the highest possible return.

Compared to stocks, you can get in the long term from 3 to 8% per annum.

Money market funds

Consist of safe (risk-free short-term debt instruments), mainly government treasury bills. By law, they can only invest in certain high quality short-term securities issued by US corporations and federal, state and local governments. This is a safe place to park your money. You won’t get substantial profits, but you won’t have to worry about losing your principal.

While money market funds invest in ultra-safe assets, some money market funds suffered losses during the 2008 financial crisis after the fund’s stock price, usually $ 1, fell below that level.

According to ICI statistics , about 15% of all US mutual funds are monetary funds.

Index Funds

Another group that has become extremely popular in the last few years comes under the nickname “index funds.” For example, an index fund manager buys stocks that match a major market index, such as the S&P 500 or the Dow Jones . This strategy requires less research from analysts and consultants, therefore less cost.

Balanced Funds / Hybrid Funds

Balanced funds invest in a hybrid of asset classes, be it stocks, bonds, money market instruments or alternative investments. The aim is to reduce the risk of exposure to different asset classes.

This type of fund is also known as an asset allocation fund. According to ICI, hybrid funds account for 8% of the mutual fund market.

International / Global Funds

An international fund ( or foreign fund ) only invests in assets located outside your home country. Global funds, meanwhile, can invest anywhere in the world, including in their own country.

It is difficult to classify these funds as riskier or safer than domestic investments, but they tend to be more volatile and have unique territorial and political risks.

On the other hand, they can, as part of a well-balanced portfolio, actually reduce risk by increasing diversification, since income in foreign countries may not be related to income at home. While the world economies are becoming more interconnected, it is likely that another economy is superior to your country’s economy somewhere.

Specialized / Sectoral Funds

This classification of mutual funds is a more comprehensive category, which consists of funds that have proven to be popular, but do not necessarily belong to the more rigid categories that we have described so far. These types of mutual funds move away from broad diversification in order to focus on a specific segment of the economy or target strategy.

Sectoral funds are targeted strategic funds that target specific sectors of the economy such as finance, technology, healthcare, etc. Therefore, sectoral funds can be extremely volatile. There is a high probability of large profits, but the sector could also collapse (for example, the financial sector in 2008 and 2009).

Regional funds

Regional funds allow you to focus on a specific geographic area of ​​the world. This could mean focusing on a wider region (say Latin America) or a single country (for example, only Brazil).

The advantage of these funds is that they make it easier to buy stocks in foreign countries that can otherwise be difficult and expensive. As with sectoral funds, you must accept the high risk of loss that arises if a region is going through a severe recession.

Social funds

Social funds only invest in companies that meet the criteria of certain guidelines or beliefs. For example, some social funds do not invest in “ sinful ” industries such as tobacco, alcoholic beverages, weapons, or nuclear power.

The idea is to be competitive while maintaining a healthy conscience. Other such funds invest mainly in green technologies such as solar and wind energy or recycling.

Exchange traded funds (ETFs)

The highlight of a mutual fund is the indexed exchange-traded fund (ETF). These increasingly popular investment vehicles combine investments and use strategies that are compatible with mutual funds, but are structured like investment funds that are traded on stock exchanges and have additional benefits from the features of stocks.

For example, ETFs can be bought and sold at any time during the trading day at the market price. ETF trades can be short (trade down) or leveraged. ETFs carry a lower fee than an equivalent mutual fund. Many ETFs also benefit from the options market, where investors can hedge their positions. Compared to mutual funds, ETFs are generally more efficient and liquid.

Classes of Mutual Fund Shares

Mutual funds can issue different classes of their shares to investors. The most common classes of shares:

  1. Class A shares ( Class A ) – Shares of mutual funds charge an initial load at time of purchase. This is a fee that is charged as a percentage of the total investment and is used to compensate a financial representative who sells securities to you. The external load is deducted from the original investment. For example: if an investor places $ 10,000 in an investment fund with a 2% external burden, then the total sales will be $ 200. The remaining $ 9,800 will be used to purchase the fund’s shares. Promotions may also impose sales commissions. Investors do not pay these fees directly. Instead, they are taken from the assets of the fund. The fund then uses these fees to market and distribute its shares. The fee can be a maximum of 0.25% per year.
  2. Class B Shares ( Class B ) – Shares add background loads. When an investor buys B shares of a mutual fund, the fee is deferred until the fund is sold. This delayed load usually decreases every year. B Shares typically charge a higher sale fee than Class A Shares. For example: B shares of a mutual fund may carry a 5% load if the shares are sold within the first year. However, this internal load of 5% can be reduced by 1% each year until it is eliminated in the 5th year. Some B shares are automatically converted to A shares after a certain period of time, which reduces fees.
  3. Class C Shares ( Class C ) – Class C Shares generally do not impose a burden, but often charge a nominal fee if the shares are sold within one year.

Aggressive funds

An aggressive portfolio of mutual funds is suitable for an investor with a higher level of risk tolerance and time horizon – you will need more than 10 years.

The reason aggressive investors should have a time period of more than 10 years is because they have a high stake in stocks and more risky investments.

If the market experiences a severe downturn, it will take you a long time to offset the decline in value.

Here are examples of allocating 85% of stocks and 15% of a bond portfolio as a mutual fund for an aggressive investor:

  • 30% large cap stock (index);
  • 15% mid-cap shares;
  • 15% small cap stock;
  • 25% foreign or developing shares;
  • 15% bonds for the medium term;

Aggressive portfolios are best suited for investors in their 20s, 30s or 40s. Average yield is 7-10% per annum. In his best year, he can gain 30-40%. In the worst year, it can drop by 20-30%.

Moderate Fund

A moderate portfolio is suitable for an investor with a medium risk level and a time horizon of more than five years. Here is an example of a moderate type of mutual fund portfolio that includes 65% stocks, 30% bonds, and 5% cash or money market funds:

  • 40% large cap stock (index)
  • 10% small cap stock
  • 15% foreign shares
  • 30% medium-term bonds
  • 5% money market

This moderate portfolio can achieve an average annual return of 7-8%. Its best annual growth can be 20-30%, and the largest decline in a year can range from 20-25%.

Conservative mutual fund

A conservative portfolio of mutual funds is suitable for an investor with a low level of risk and time frames ranging from immediate to over three years. Here is an example of a conservative portfolio of mutual funds by fund type with 25% stocks, 45% bonds, and 30% cash and money market funds:

  • 15% large cap stock (index)
  • 5% small cap stock
  • 5% foreign shares
  • 45% medium-term bonds
  • 30% cash / money market

The maximum growth of this portfolio in a calendar year can be 15%, and the worst – from 5 to 10%.

How to buy and sell mutual fund stocks

Investors buy shares of a mutual fund from the fund itself or through a broker and not from other investors. The price that investors pay for a mutual fund is the fund’s net asset value per share plus any fees charged at the time of purchase, such as sales volume.

Funds’ shares are ” redeemable “, meaning that investors can sell shares back to the fund at any time. The foundation usually must send the payment to you within seven days.

Read the prospectus carefully before buying stock in a mutual fund. The prospectus contains information on investment objectives, risks, results and costs.

Understanding fees

As with any business, managing a mutual fund comes with a cost. Funds pass these expenses on to investors by charging commissions and expenses. Fees and expenses vary from fund to fund. The high cost fund must perform better than the low cost fund to bring you the same returns.

Even small differences in fees can mean large differences in income over time.

  1. For example, if you invested $ 10,000 in a fund with 10% annualized return and 1.5% annual operating costs , you would have approximately $ 49,725 in 20 years .
  2. If you invest in a fund with the same efficiency and cost of 0.5% , you will receive $ 60,858 in 20 years .

How much can you earn investing in mutual funds

Many experts predict that an average growth of 8% to 10% is normal and achievable. According to Kiplinger magazine , three funds that have performed well over the past 10 years are:

  • Fidelity Contrafund
  • Fidelity Low-Stock Stock Fund
  • T-Rowe Price Small Cap Value

On average, the profitability amounted to 7.9, 9.3 and 9.3 percent, respectively.

Investors typically generate income from a mutual fund in three ways:

  1. Income from dividends on shares and interest on bonds held in the fund’s portfolio. The fund pays almost all of the income it earns in a year to the owners of the funds in the form of a distribution. Funds often give investors a choice: get a distribution check or reinvest profits and get more shares.
  2. If a fund sells securities that have risen in value, the fund receives a capital gain. Most funds also pass this profit on to investors in distribution.
  3. If the fund’s assets increase in value but are not sold by the fund manager, the fund’s shares rise in value. You can then sell your mutual fund shares for a profit in the market.

How much money do you need to invest in mutual funds?

While there are mutual funds without any minimum investment, most mutual funds require a minimum initial investment of $ 500 to $ 3,000 , and institutional-grade funds and hedge funds require a minimum of $ 1 million or more.

These minimum amounts are set by each fund as a means of preventing small short-term transactions from affecting cash flows and day-to-day management of the fund. The minimum of each fund is dictated by the style of the fund and its investment goal.

Criticism of mutual funds

Liquidity, diversification, and professional management make mutual funds attractive to young, start-up and other individual investors who do not want to actively manage their money. However, no asset is perfect, and mutual funds also have drawbacks.

According to the Dow Jones , 66% of large-cap mutual fund managers (large companies) failed to outperform the S&P 500 in 2016 (numbers are even worse for mid-cap and small-cap managers). And when the same study looked at actively managed mutual fund performance for 15 years , over 90% failed to get around the market .

According to a research report by Standard & Poor’s , 92.2% of active large-cap funds, 95.4% of active mid-cap funds, and 93.2% of active small-cap funds lagged behind a simple index fund that simply tracks the S&P 500.

The main reason for failure lies in the fees and charges of mutual funds and the fact that some mutual funds make short-term decisions to buy and sell assets, which means they generate more taxable income than the buy and hold strategy .

Main disadvantages :

  1. Many funds charge huge fees, resulting in lower overall returns. These fees reduce the overall payout of the fund and are charged to mutual fund investors regardless of the fund’s performance. As you can imagine, in those years when the fund is not making money, these fees only increase the losses. Creating, distributing and managing a mutual fund is a costly undertaking. Everything from a portfolio manager’s salary to quarterly investor reports costs money. These costs are passed on to investors. Since commissions vary from fund to fund, ignoring commissions can have negative long-term consequences. Actively managed funds incur transaction costs that accumulate each year.
  2. Over time, the statistics showed profits not higher than the key stock indices, that is, they did not overtake the overall return on the stock market.
  3. Mutual fund shares cannot be bought or sold during normal trading hours, but are valued only once a day.
  4. As with many investments with no guaranteed return, there is always the possibility that the value of your mutual fund will depreciate. Investment mutual funds experience price fluctuations along with the stocks the fund holds.
  5. The US Federal Deposit Insurance Corporation (FDIC) does not invest in mutual funds, as there is no guarantee that any fund will be effective. Investment in funds is not subject to deposit insurance.
  6. To maintain the ability to accept withdrawals, funds usually need to keep most of their portfolio in cash. Having enough cash is great for liquidity, but money that just sits there and doesn’t work for you isn’t very profitable.
  7. Researching and comparing funds can be difficult. Unlike stocks, mutual funds do not give investors the ability to compare price-earnings (P / E) ratios, sales growth, earnings per share (EPS), or other important data. Only index funds that track the same markets tend to be truly comparable.

Conclusion

Before investing, it is wise to know why you are investing. This is called your investment goal. To find out what your investment goal is, ask yourself the following questions:

  • How soon will you need your investment?
  • How much risk are you willing to take to generate income? (More risk – active funds, less risk – passive funds)
  • Save funds or increase?
  • What are the acceptable investment terms?

The answers to these questions will help you determine the investment time frame and risk tolerance, which are fundamental elements in determining your investment goal.

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