This Is How Mutual Funds Work – Did You Know This?

Want to save for a rainy day and don’t know where to keep the extra money? Though investment avenues are multifarious, but more versatile are the reasons for which a person plans to save. Some want to just keep aside a portion of money and use it in the future when a big corpus is … Continue reading “This Is How Mutual Funds Work – Did You Know This?”

Want to save for a rainy day and don’t know where to keep the extra money? Though investment avenues are multifarious, but more versatile are the reasons for which a person plans to save. Some want to just keep aside a portion of money and use it in the future when a big corpus is created (which is nothing more than sum total of amount saved every year), while others want their money to return to them after increasing.

Age old habit of keeping money in savings account in banks has somewhat lost many of its takers; reasons are many to quote. Interest rates have slashed down in recent times, one of the most popular reasons to begin with. In addition to these, newer investment options have popped up in recent times and performed beyond expectations. So, investing in mutual fund has proved to be an enticing option for those investors who are profit-oriented in thinking, and who doesn’t want extra money.

If you observe closely, people have been saving since times immemorial. Mutual fund companies have just given a systematic garb to the people’s savings habits. When mutual funds were not around, a group of people used to pool together a specific amount from each member, and by the way of lottery they used to declare the beneficiary of the collected money for the month. (This system is still functional at informal level!)

Now let’s take a look at the mutual funds that are somewhat analogous to this practice of pooling money. Companies dealing in mutual funds not only collect money from the investors, but also look for premises such as stocks of the companies, debt instruments, and other assets that are considered profit-yielding options. Money invested by the individual investors and pooled together by the fund managers is used for – infrastructural developments, to carry out an ambitious infrastructural project of a company or for bringing some technological innovation – that is of great use to the inhabitants of the country. All these reasons give way to the possibility of earning returns from the money that investors give to their fund managers, from savings point of view.

Investment made in mutual funds grows due to power of compounding and averaging of return-cost ratio. By giving your money to the fund manager to invest, you are handing him over the responsibility of managing your corpus. Thus, he re-invests returns made by your money at a constant rate every year and other returns generated in the form of interest, dividends etc. also keep appending. That is why, there is an appreciable increase registered in the amount you invested at the end of the investment period. This is the main principle behind the working of a mutual fund.

Past performance figures reveal that investors putting their trust in mutual fund investments were able to earn 15-20% returns, on an average. At times, it has grown to as high as 30-40% too. Since there is an intelligent mix of market-oriented and debt-based options in a typical mutual fund, the risk also is comparatively less, as compared to pure equity-based instruments like, stocks.

Thus, by savings in mutual funds, an investor meets a variety of purposes:

1. He is able to earn extra from his own savings
2. He is indirectly contributing to the economic development of the country
3. He is creating extra income for himself to meet the unforeseen expenses
4. And last but not the least, he is securing his future too.

Costs involved in investing in mutual funds comprise of transaction costs, asset management cost, holding fees and other implied taxes. Thus, the amount that is actually invested is your money minus all the taxes. Mutual funds perform in spite of all these costs, such is the power of compounding. To make more out of your money, it is advisable to keep the money for the long term. So, if you are looking for the investment option that is yielding like a stock but safer than it, then mutual funds prove to be the smartest choice.

Check Your Mutual Fund Performance

Mutual fund performance depends a great deal on the fund manager. If an experienced and expert manager manages the fund, it will certainly perform well. The role of a manager is very important since the investment strategies are designed by him. The manager needs to prepare for contingencies and unforeseen market fluctuations. In recessionary times like this, it is very crucial to invest strategically. Thorough analysis and research are required on the part of the manager. The manager is paid fees, which are a certain percentage of the total net asset value of the fund. The manager’s earnings are directly proportional to the mutual fund performance. A manager is expected to have expert knowledge and credentials for his past performance. It is a very responsible position and requires a complete understanding of the stock and other financial markets. Typically, a mutual fund invests in stocks, bonds, money market instruments, government securities and so on. Thus, it is imperative that the manager has knowledge about all the financial markets.

How Does A Mutual Funds Work?

A mutual fund is a plan wherein money is pooled from several investors and invested in various financial markets. The money is not placed in one company but rather is diversified into different financial markets. This diversification helps in reducing the risk of losses. The risk is spread across different companies, so even if one company fails to perform, there are others that can compensate for the losses. Mutual fund holdings are in the form of units, and their price in the market is called the net asset value, or NAV. When an investor purchases a mutual fund, he or she receives a certain number of units in the fund. The number of units will always remain the same; however, the NAV may fluctuate according to the mutual fund performance and market conditions. Mutual funds are subject to market risk, but the risk is less than for other openly traded financial instruments. They are loaded with several beneficial features like liquidity, economies of scale, professional management and diversification of investment, among others.

A mutual funds house operates and manages the fund. Each fund house will have different types of funds, and you can choose the one that best suits your needs. There are three broad categories of funds: open-ended funds, close-ended funds and unit investment trusts. Open-ended funds are usually equity-oriented and a little risky as compared to close-ended funds. Depending on your risk appetite, you can choose a fund for investment purposes. Age, too, plays an important role in deciding the risk factor. If you are in your twenties or thirties, then a high risk/high return fund may be suitable. However, if you are in an age group of forty plus, then a low risk/moderate return fund will suit your needs. Whatever type of fund you choose, it is the mutual fund performance that will decide your earnings.

What is a Mutual Fund?

Mutual funds are investments vehicles which allow you to be broadly diversified by owning a large array of stocks or a particular investment instrument. Funds are managed by a single individual or a team of managers. Their job is to maximize your investment within the fund’s investment criteria. The decision made by the fund manager(s) will determine whether you see a financial gain or loss on your investment. Mutual fund managers are responsible for researching investments, as well as buying and selling securities. Mutual fund companies pool money from thousands of investors. Each of those investors becomes a shareholder in that fund.

Types of Mutual funds

There are literally thousands of mutual funds available for you to choose. Virtually every type of asset class is available at your fingertips. There are hundreds of sites which provide information on mutual funds. Morningstar.com is one of the largest and most comprehensive sites available. Popular types of mutual funds:

General Stock mutual funds-These types of funds can invest in a wide variety of stocks. These can range from large cap to small cap international stocks.

Emerging market mutual funds-These funds specialize in investing in small developing and emerging nations. Within these types of funds, you can find mutual funds that invest in a particular country such as Vietnam or India.

Sector funds-Do you think semiconductor stocks will do well in future? Do you think that the price of gold will continues to rise? Sector funds may be an ideal investment. Your manager can only invest in stocks in the particular sector you’ve chosen. If you chose a telecom sector fund and that particular segment of the market sees dramatic results, your telecom sector mutual fund should see similar gains. Sector funds have become extremely popular in the last several years. The thought process behind purchasing a sector fund is to obtain diversity while focusing on a single sector of the market you believe will outperform the market as a whole. You are also hiring a manager who is supposed to be an expert in the particular sector you’ve invested in. Generally sector funds have higher expenses than general funds.

Bond funds-Do you believe the bond market will outperform the stock market? Yes, bond funds are available and there is a wide variety to choose. There are short term Us Government bond funds, municipal bond funds, international bond funds, high yield (junk bond) funds..well you get the point.

Hybrid funds o further enhance your portfolio choices, you can elect to purchase a hybrid fund. Also known as balanced funds, these mutual funds typically invest anywhere from 50-70 percent in stocks and the reminder in bonds and cash. The managers of these funds typically have discretion how the fund will be balanced.

Index Funds-Index funds are generally passively managed funds designed to closely match their corresponding index. Index funds do not allow their fund manager the latitude of selecting or become overweight a particular stock or sector within the fund. It is their job to match the corresponding index The only time a mutual fund would sell a stock in a passively managed fun is if the corresponding was reconfigured. For example, when Microsoft was added to the S&P 500 Index, those mutual funds who mirrored the S&P 500 Index, were forced to purchase Microsoft so they would stay in lock step. Index mutual funds have three distinct advantages over actively managed funds.

1) Low turnover-This will minimize your tax burden at the end of the year. After all, it’s not how much money you make, it’s how much money you keep.

2) Low expenses-Low expense ratios let you keep more of your money. An index fund may be 5 times cheaper or more to manage than that of their actively managed funds

3) Over a ten year time period index funds have a huge advantage of those of active managed funds. If you are a large cap investor, you stand a 73% chance of receiving higher returns over an actively managed large cap mutual fund.

Drawbacks to index funds

With their advantages over actively managed mutual funds, index funds do have a drawback. Since every fund has management expenses, you stand to NEVER beat the index you are trying to meet or outperform. If you want large cap exposure and decide to purchase Vanguard’s Index 500 mutual fund, you will lag the S&P. If Vanguard’s expense ratio was.2% and the S&P 500 return was 10% for the year, your return will be 9.8%.

While expenses are a drawback, you simply cannot acquire diversification for free. Everything comes with a price and investing is no different.

There are vast universes of investment choices available which can enhance your return. While it is difficult to beat the S&P 500, with the correct combination of index funds and proper asset allocation, it is possible to achieve superior returns. This takes know how, experience and nerves not to sell out when the market corrects. A good financial planner will be able to provide you all of these required skills.