Introduction to Mutual Funds

Meaning Of Mutual Fund

Investing has become a big topic over recent months, and especially mutual funds have been shifted into the public spotlight. There seems to be a lot of confusion about these funds though, as many people do not seem to know what exactly mutual funds are or what they do. We will try our best to give you some insight and answer these questions.

Usually, when people talk about these funds, they are referring to a professionally managed collective investment scheme that is an amassment of money from a variety of investors which is invested into a verity of investment securities such as stocks, bonds, or commodities (mostly precious metals). Now, the big question is what mutual fund is?

Mutual funds are those professionally managed investment pools that, in a way, show the performance of several varied securities like stocks, bonds, and shares. An advisory firm usually organizes them to offer the fund's shareholders a specific investment goal.

With this, investors can buy shares of a mutual fund, for instance, the stock of a company. Anyone buying shares in the fund become a part owner and want to take part often because of those investment goals. To manage the company, the shareholders choose a board of directors to oversee the operations of the business and the portfolio.

Most of the time, the value of these mutual funds are calculated once a day, and that is based on what the fund's current net asset value is. For instance, a real estate mutual funds are one that invests in the real estate securities from around the world.

The real estate mutual funds usually tend to concentrate the investing strategy on the real estate investments trusts and real estate companies. These real estate investments trusts are mostly companies that purchase and manage real estate with help from the funds that were collected from the investors.

Mutual funds raise the money by selling shares of the fund to the public, much like any other company can sell its stock to the public. Funds then take the money they receive from the sale of their shares (along with any money made from previous investments) and use it to purchase various investment vehicles such as stocks, bonds, and money market instruments.

Most investors pick mutual funds based on recent fund performance, the suggestion of a friend, and the praise bestowed on them by a financial magazine or fund rating agency. While using these methods can lead one to select a quality fund, they can also lead you in the wrong direction and wondering what happened to that "great pick."

The history is a good indicator, though not a guarantee that a fund will do well. If you are investing long-term, the history will be of more importance than in a short-term situation as they say lightning rarely strikes the same place twice.

History of Mutual Funds

The first "pooling of money" for investments was done in 1774. After the 1772-1773 financial crisis, a Dutch merchant Adriaan van Ketwich invited investors to come together to form an investment trust. The goal of the trust was to lower risks involved in investing by providing diversification to the small investors. The funds invested in various European countries such as Austria, Denmark, and Spain. The investments were mainly in bonds, and equity formed a small portion. The trust was named Eendragt Maakt Magt, which meant "Unity Creates Strength."

The fund had many features that attracted investors:

• It had an embedded lottery.

• There was an assured 4% dividend, which was slightly less than the average rates prevalent at that time. Thus the interest income exceeded the required payouts, and the difference was converted to a cash reserve.

• The cash reserve was utilized to retire a few shares annually at 10% premium, and hence the remaining shares earned a higher interest. Thus the cash reserve kept increasing over time - further accelerating share redemption.

• The trust was to be dissolved at the end of 25 years, and the capital was to be divided among the remaining investors.

However, a war with England led to many bonds defaulting. Due to the decrease in investment income, share redemption was suspended in 1782, and later the interest payments were lowered too. The fund was no longer attractive for investors and faded away.

After evolving in Europe for a few years, the idea of mutual funds reached the US at the end of the nineteenth century. In the year 1893, the first closed-end fund was formed. It was named the "The Boston Personal Property Trust."

The Alexander Fund in Philadelphia was the first step towards open-end funds. It was established in 1907 and had new issues every six months. Investors were allowed to make redemptions.

The first true open-end fund was the Massachusetts Investors' Trust of Boston. Formed in the year 1924, it went public in 1928. 1928 also saw the emergence of first balanced fund - The Wellington Fund that invested in both stocks and bonds.

The concept of Index based funds was given by William Fouse and John McQuown of the Wells Fargo Bank in 1971. Based on their concept, John Bogle launched the first retail Index Fund in 1976. It was called the First Index Investment Trust. It is now known as the Vanguard 500 Index Fund. It crossed 100 billion dollars in assets in November 2000 and became the World's largest fund.

Today mutual funds have come a long way. Nearly one in two households in the US invests in mutual funds. The popularity of mutual funds is also soaring in developing economies. They have become the preferred investment route for many investors, who value the unique combination of diversification, low costs, and simplicity provided by the funds.

Structure of Mutual Funds

The mutual fund industry is highly regulated to imparting operational transparency and protecting the investor's interest. It is usually either a corporation or a business trust.

Like any corporation, a mutual fund is owned by its shareholders. Virtually all mutual funds are externally managed; they do not have employees of their own. Instead, their operations are conducted by affiliated organizations and independent contractors

Understanding The Types Of Mutual Funds

"If you don't act now while it's fresh in your mind, it will probably join the list of things you were always going to do but never guite got around to. Chances are you'll also miss some opportunities." - Paul Clitheroe

Types of Mutual fund

There are many different types of mutual funds for investors to choose from. No matter the type of investor that you are, you should be in a position to know the best options to fit your investment style. In America for instance, surveys indicate that there are more than 10,000 types of mutual funds for investors to choose from. This portrays that there are more mutual funds than stocks. With myriad options available and more to come for investors to choose from, choosing the right ones may turn out to be a daunting task. However, armed with all the necessary information, choosing the right investment option should be an unproblematic task.

It is imperative to understand that different types of mutual funds have different risks and rewards. Generally, the higher the potential return of investment, the higher the risk of loss. Though some may be riskier than others, all of them tend to have some form of risk. While you are investing, it is not possible to evade all the potential risks. Therefore, no matter the type of investment you are making, you have to be prepared for facing some risks only that some investments may be riskier than others.

All mutual funds usually have predetermined investment objectives. These objectives tailor the funds' assets, regions of investments and investment strategies. Generally, there are three main types of mutual funds, and they include; equity funds (stocks), fixed income funds (bonds) and money market funds. Usually, you are likely to come across the variations of these three classes of assets.

Let us have a succinct look at the type's mutual funds available;

1. Equity Funds- These are meant for investors, who are ready to take higher risk to maximize return. These are also called stock funds. They predominantly invest in company stocks; therefore, they are characterized by high risk. It may invest in small, medium or large-cap companies, which is determined by the market capitalization of the company. Again, the portfolio manager may assume the different style of investment, i.e., value, growth or blend.

As the portfolio of these funds reflects the preponderance of company stocks, the return on equity funds largely depends on the stock market conditions. Capital appreciation in the long term is the primary objective of the stock funds.

2. Fixed Income Fund- FIFs are just the opposite of equity funds. Capital appreciation is not the focus of FIF. Here, security of the money invested assumes most of the importance. FIFs may invest in different types of debt instruments like corporate, municipal and government bonds.

They may also invest in unconventional debt instruments like mortgage-backed securities. Retired persons can park their money here. Most of the fixed income funds prefer U.S. government bonds for investment because it has the highest credit quality. Instead of putting money in a fixed deposit, one should consider investing in fixed income funds.

3. Money Market Fund- The objective of an MMF is to give a safe investment option to the investor. Money market funds, primarily, invest in money market instruments. The portfolio of the fund contains cash equivalent short-term liquid assets.

The risk involved is very low for MMFs, and this is reflected in their low return profile. The good thing about these types of funds is that you can expect to get back twice what you would get from a savings account.

Apart from these three primary types, there are some other types of mutual funds.

Sector Fund: It targets a particular industrial sector to invest. For instance, you might fund sector funds that invest in just biotech, oil, and gas, electronics, or banking. Performance of these funds is highly depending on how well that industry is doing. They are more vulnerable to changes in a certain market sector than other funds, but also allow for significant profit from a sector that is doing well.

International Fund: IFs invest in international assets and companies. If you have heard, there are some great opportunities overseas; this might be a fund for you.

Value funds, on the other hand, invest in companies that the fund managers feel are undervalued by the market.

They m ay have had issues with management or a product, or maybe they are great companies, but most investors haven't picked up on them yet. These funds make a profit when their companies improve in either profitability or popularity.

Open Ended Fund: The fund house may issue and redeem fund units at any point in time depending on the demand for the fund.

Closed Ended Fund: Once issued the number of units cannot be increased later on by the fund managers. However, the units can be traded in a market at a premium or discount.

Index Fund: These funds create their portfolios keeping in mind the weight of different stocks in a benchmark index. Many index funds follow either S&P 500 or S&P CNX Nifty. The return on these funds almost exactly reflects the return of the benchmark index.

Growth Funds: Among the stock funds, the Growth fund is one of the most popular. This type of fund invests in growth stocks; stocks of companies who are developing new products and services, are in good financial order and are expected to grow faster than other similar companies in the market.

Investing In Mutual Funds

Since you have never invested before, investing in mutual funds is a great opportunity and choice. As a first-time investor, you may be worried about choosing the wrong investments and losing money. You have to understand that any investment is a risk. You risk losing any or all of her money, but you could also make quite a bit of money. But more risk you take on, the more likely you will lose the money but also the more money you could make. You have to figure out the amount of risk you want to take.

Why Invest in Mutual Funds?

It is easy to understand why people would invest in mutual funds, but is it a smart play? I would say the majority of investors select mutual funds because

a) It is easy

b) They think the professionals must be able to do better than them

c) The only option in their company's 401K.

Now there isn't anything you can do about a company not offering self-directed accounts, but most investors even given the option would go mutual funds over selecting stocks themselves. To compound the problem, the majority of investors select the top returning mutual funds from the previous year when they select one. If a mutual fund they own is doing bad, they will drop that one and take the highest returning fund in their pool of funds. Statistics prove that this strategy will not beat the S&P 500 over the long haul.

There is no doubt that their plenty of good mutual funds out there; in fact, there are some great ones. The problem is the majority of investors are not in these funds. I've read multiple articles with various stats on how many mutual funds beat the S&P 500 year over year. These numbers generally are between 10 and 20 percent, which is a staggering number if you think about it. Why would you want to park your money in a fund that isn't beating the indexes on a consistent basis? Why not just pick an index fund and avoid the fees.

Does anyone like paying fees? I know I don't and mutual funds charge you fees to run your account. They generally run between 1 and 2 percent, which may not sound like much but it can add up in a hurry. If you started with $10,000 and earned a compounded return rate of 7% in 20 years, it would be $38,697. Now let's say with that same starting figure you earn 8.5% (1.5% increase from above), your new total after 20 years would be $51,120. Now doesn't that extra money in your wallet/purse look nice just by avoiding fees!

If you have a fund that isn't performing well, we can assume the manager of the fund will likely swap in and out of winners and losers he or she is holding. They undoubtedly will not sit on their hands and watch their stock selections circle the drain. This movement in stocks is music to the ears of the brokerage firms that have their account. They are collecting transactions fees for every stock they get in and out of. Who do you think is paying for that?

Okay, this is all fine and excellent, but you don't have the time to pick stocks. It doesn't take as much time as you think with stock screeners and the amount of information on the internet these days. Now there are hundreds of different approaches to investing in stocks, so I won't get into which way is the best. You know your risk tolerance and can select stocks off that. If you don't trust yourself picking stocks, you can select stocks that the dependable investors like Warren Buffett or Carl Icahn select. You can even find several mutual funds that have historically beat the market over the years and look at their top 10 holdings. If they are in these stocks and have traditionally beat the major indexes, then they most likely are pretty good stocks.

The key to making your stock picks work for you is staying diversified. To what level of diversification should you have your portfolio setup? That again depends on your risk tolerance, but keeping your stocks spread out amongst the different sectors is a good way to avoid heavy losses. If you spent a little time researching stocks, you would see it is time well spent in most cases.

I know selecting stocks can be a scary process for a lot of people but at the very least aren't you better off in an index fund with no fees. When I am working on my portfolio, I have my best interest in mind, and I'm not sure that always happens when other people are playing with your money. As an exercise, it might be a good idea to write down stocks you are thinking of buying and track how they are doing compared to your mutual fund. What have you got to lose except the fees?