Everyone wants to invest their money, but at the same time, they want to avoid the risks and hassles associated with picking individual assets. Mutual Funds offer the advantages of a diversified portfolio without the time required to manage one.

If you have never invested your money in mutual funds before, here in this article are some of the basics for the investors to know. This is going to help them understand how any mutual fund really works.

WHAT PRECISELY ARE MUTUAL FUNDS?

A Mutual fund gathers money from a bunch of different investors in order to invest in a large group of assets. Some of the mutual funds focus on a single asset class, like stocks and bonds, whereas others invest in a variety.

But in contrast to the stock market, where the investors purchase shares from one another, mutual funds shares are purchased directly from the fund (or a broker that purchases them directly from the fund). The Mutual Funds generally create new shares to be sold to new investors; so there is no fixed amount as in case of stocks. Since the purchase of shares is made directly from the mutual fund, they are redeemable and can be sold back to the fund at any time.

The value of each share is calculated as the fund’s per-share Net Asset Value (NAV); funds may charge additional purchase fees. When you sell back your shares, you will be paid the per-share NAV, minus any redemption fees.

Some Mutual Funds do provide numerous classes of shares, each having its different fee structures. However, these classes will all be investing in the same portfolio of securities. 

TYPES OF MUTUAL FUNDS

Broadly speaking, there are four kinds of mutual funds in the market:

1. MONEY MARKET FUNDS

The Money Market Funds offer the lowest returns as they carry the lowest risk. This kind of Mutual Funds are legally required to invest in high-quality, short-term investments that are issued by the U.S. government or U.S. corporations. Money Market Funds tend to keep their NAV around $1.00 per share.

2. BOND (FIXED-INCOME) FUNDS

The Bond (fixed-income) funds possess more risk than money market funds. Also they are not legally restricted to certain qualities of investments. There are a variety of bonds, so you should study each mutual fund individually in order to decide the amount of risk associated with it.

3. STOCK (EQUITY) FUNDS

Equity funds carry the highest risk along with the highest potential returns. The market fluctuations can drastically affect the returns of equity funds. There are many kinds of equity funds, like growth funds, income funds, index funds, and sector funds. Each one of these groups tries to maintain a portfolio of stocks with certain characteristics. 

4. HYBRID FUNDS

As the name suggests, the hybrid funds invest in a mix of stocks, bonds, and other securities. Many of the hybrid funds are funds of funds; they invest in a group of other mutual funds.

ACTIVE vs. PASSIVE

Irrespective of the category a mutual fund falls into, its fees and performance will be affected by whether it is actively or passively managed.

The passively managed mutual funds invest as per a pre-determined strategy. They attempt to match the performance of a certain market index, and hence need little investment skill. As these funds need little management, they will carry lower fees than actively managed funds.

The actively managed mutual funds tend to outperform market indices and possess the potential for greater return than passively managed funds. As a result, they have greater fees and risk as well.

THE BENEFITS AND DOWNSIDES TO MUTUAL FUNDS

The two major benefits of investing your hard earned money into mutual funds are:

1. Diversification

Diversification is an important principle of investing. If a certain company fails, and all your money was invested in that one company, then you have lost your money. But, if a specific company fails out of the diversified portfolio, then you have only lost a small amount. Mutual funds offer access to a diversified portfolio, without the hassle to monitor dozens of assets daily.

2. Simplicity

It is the key role performed by Mutual Funds. If you come across a mutual fund with a good track record, you have a relatively small role to play. Some investors dislike the lack of control linked with a mutual fund; as they don’t know the exact make-up of the fund’s portfolio and have no control over its purchases. But this can be a relief to the investors who do not have time to track and manage a large portfolio.

However, the major disadvantage associated with mutual funds is that the fees will be incurred no matter how the fund performs. The investors need to pay sales charges, annual fees with other expenses & that too with no guarantee of results. 

HOW DO INVESTORS EARN MONEY BY INVESTING INTO MUTUAL FUNDS?

When an investor invests in a particular mutual fund, distributions come from three sources:  

1. DIVIDED PAYMENTS

When a mutual fund acquires dividends or interest on the securities in its portfolio, it distributes a proportional amount of that income to its investors.

2. CAPITAL GAIN

When a mutual fund sells a security that has gone high up in value, this is a capital gain. Similarly, when a mutual fund sells a security that has gone down in value, this is a capital loss. Majority of the funds distribute any net capital gains to investors annually.

3. NET ASSET VALUE

When the Net Asset Value (NAV) of a particular mutual fund increases, it increases the value of your shares. This is similar to when the value of a stock increases. You don’t get any immediate distributions, but the value of your investment increases, and you will make more money when you decide to sell it.

While buying shares in mutual funds, you can opt to collect your distributions directly, or you can reinvest them in the fund.