Mutual funds are investment vehicles that allow investors to buy shares and have them professionally managed. This is quite suitable for those who don’t know much about investing or don’t have time to do it. Also, by investing in these funds, you achieve diversification, because a typical fund invests in multiple companies or assets.
The disadvantages of investing in these financial vehicles relate to various fees, as well as performance. Not every manager performs well enough to justify paying fees.
When it comes to terminology, mutual funds are also known as open-ended funds. This means that the number of outstanding shares in a fund changes based on deposits and withdrawals of clients. This is in contrast to closed-ended funds, where there are a fixed number of shares in the market.
To buy units, investors can open an account directly with a fund. However, this limits investors to only one investment company and resulting limited selection. It is also possible to buy funds from a bank. The drawback is that the advisor there may have a bias toward only certain funds due to bigger commissions paid.
Yet, another way to buy is to open a brokerage account and buy directly from there. This gives an access to a very wide range of funds. The disadvantage is that you might pay a transaction fee, but there are also no-transaction-fee funds, so investors get options to avoid extra charges.
How to diversify investments
There are many investment companies offering funds, so investors have a great selection to choose from. For example, an investor can choose among equity funds. These investors focus on the stock market but differ in their strategies. Some invest in small capitalization companies, others in medium or large companies.
What’s more, some funds invest only domestically, others internationally. Yet there is another difference regarding style. There are funds that focus on growth stocks, while others seek value or income. Some specialized equity funds even focus on an industry, or a particular region, such as Southeast Asia.
There are also fixed-income funds, which specialize in government and corporate funds, money market instruments, and so on. And there’s a combination of both, the so-called blended funds that split investments among stocks and bonds.
By buying blended funds, or funds that invest in different regions or industries, it is possible to achieve diversification. This makes investing less risky.
To diversify even further, investors add commodity and real estate funds to their portfolios. This way, they make investments in multiple asset classes.
In addition to ongoing fund management charges and initial transaction costs, there are other charges, known as loads. These charges usually serve as an extra compensation to the seller of the funds.
The way loads work is that there is a spread between buy and sell price. So, when an investor buys a fund at the ask price, he or she is immediately down by a few percentage points. This specifically applies to Class A shares, which have a load upfront.
Some other shares, such as Class B, only charge a load when an investor sells a fund. This load will decrease over time, though. And it may even reach a no-charge point if an investment is kept long enough.
Finally, for Class C shares, there’s a constant load charged over time. The good news is that there are plenty of no-load mutual funds to choose from. Some investors avoid load funds and opt for only no-load, no-transaction-cost units.
Finding information about funds
Every fund company issues prospectuses detailing information about their funds. These documents are usually long and hard to read at times. So another option is to read the so-called Fact Sheets. These documents summarize the most important information about specific funds.
Performance and style of funds are not the only important things to know. Investors need to check what are the minimum initial, as well as subsequent, investment requirements for each fund. For example, many funds will ask initially for $500-1000, and $100-200 for next deposits. Often, there is a lowering of these minimums for Individual Retirement Accounts (IRAs) or 401(k)s.
Additionally, there are commercial sources that provide fund information. Among them is Morningstar. Although it is a service that charges fees for expanded coverage, there is still some free information provided.
Morningstar, among other services, rates funds. The top 10% of performers have a 5-star rating, while the bottom 10% get only 1-star rating. All other funds are rated between 2 and 4 stars.
The criterion of these ratings, however, is past performance, and the past doesn’t always equal the future. So, this rating agency now provides future outlooks for the funds. The best outlook has a Gold rating. Then, there are Silver, Bronze, Neutral, and Negative outlooks.
About fund manager’s performance
Managers are rated on their performance as well. What really counts is performance based on risk. For example, investors expect higher returns from equity funds than from money market funds. So, the question is whether the manager has performed well enough based on risks taken.
The Information Ratio shows how well the manager has done on a risk-adjusted basis in comparison to his fund’s benchmark, which usually is an index consisting of assets similar to fund’s style. If this ratio is above 0.5, it is considered to be a good performance.
The Sharpe Ratio is another measure of risk-adjusted performance. It is a good way to compare managers. For instance, a manager with a Sharpe Ratio of 1.4 has done better than a manager with a 1.2 score.
Index funds as an alternative
The truth is that many managers don’t beat the market, especially after adjusting for fees. As a result, many investors have turned to Index Funds. These investment vehicles seek to match performance of specific indices such as S&P 500. Effectively, they are passively managed. But the fees are lower.
In recent years, other investment funds such as the Exchange-Traded Funds (ETFs) have become more popular. In many ways, ETFs are similar to Index Funds. However, the difference is that ETFs trade on stock exchanges as regular shares and are more tax efficient.
As we have seen, mutual funds are investment vehicles that allow investors to buy shares and have them professionally managed. They are made of a pool of funds that are collected from various investors to be invested in securities like stocks, bonds, money market and other assets. In order to invest as healthy as possible, you can assign a fund manager to help you in your business, to gain profit with less loss as possible.