Although Mutual Funds and their purpose may seem complicated to beginner investors, they can provide a simple, yet powerful tool to beginner and experienced investor portfolios alike. If mutual funds are so important, it begs the question what are mutual funds and what are their most prominent pros and cons?
In this article, we will cover the basics of mutual funds, their inner workings, and whether or not mutual funds could be a beneficial addition to your portfolio.
What is a Mutual Fund?
Mutual funds at their core are simply a business like any other, except instead of focusing on providing key goods and services to customers, mutual funds are businesses designed for investment. They are a collection of a multitude of assets that in return provide owners with ample opportunity for diversification and returns.
Just like a company, mutual funds are run by a group of professionals, in this case professional money managers, that will manage a collection of assets for individual investors in an attempt to produce capital gains and income. Nevertheless, not all mutual funds are alike and depending on their allocations mutual funds can be made up of differing securities, bonds, and other equities.
How are Mutual Funds Valued?
Overall, investors have ownership of a proportion of a mutual fund's assets and the overall price, return, and value of a mutual fund's shares is determined by an aggregation of its vast ownership of varying securities and their respective underlying performance.
Additionally, mutual fund shares are calculated using the NAV, or Net Asset Value per share. This calculation is made at the end of trading by dividing the total value of assets in the fund by its outstanding shares. Mutual fund shares can be purchased and sold at these calculated values that update at the close.
The Pros of Mutual Funds
Mutual funds can be a powerful tool for investors looking to diversify their holding across vast and varying asset classes.
The first and most apparent pro to mutual funds is their ease of access for investors. Most 401k and retirement funds are placed in mutual funds and they are often readily available for purchase through most brokerage firms.
Additionally, these funds provide investors with immediate diversification and professional money management, providing value for investors that are uncomfortable with, or don’t have the time to research, investing in individual securities.
Furthermore, mutual funds are often highly liquid and are abundant, allowing investors access to a plethora of different combinations of equites, bonds, securities both in U.S. markets and abroad. Some brokerage firms and investors use mutual funds to gain exposure to foreign or developing markets with which they have little knowledge or access.
Mutual funds also have the benefit of investing in some restricted IPOs and other assets that may be out of reach for most investors, due to the cost of capital required.
The Cons of Mutual Funds
Although mutual funds can provide investors with a multitude of benefits, there are also a few cons that prevent some investors from adding them to their portfolios.
The most popular qualm investors have with mutual funds is their tendency to charge high fees and expenses to their clientele.
Mutual funds, like other businesses charge for their services and investors often have to stomach these fees in exchange for the diversification and other benefits the funds can provide, although some brokerage firms are now providing select lists of specialized commission-free funds.
Furthermore, investors that invest in mutual funds could find themselves frustrated with the transparency of some funds and additionally struggle to compare and contrast different options. Mutual funds can be quite difficult to compare, due to their varying fees, costs, and other differing assortments of assets and fund strategies.
Lastly, although mutual funds provide many performance benefits, they also can be a detriment to investor returns, due to sometimes over diversified portfolios and their high cash balances that could be utilized for further returns in the hands of individual investors.
Selecting the Best Mutual Funds
Although seemingly daunting, the task of choosing the best, or perhaps your first, mutual fund can be essential for any investor looking to diversify their portfolio. Mutual funds are essentially a collection of investor capital that is used to acquire and manage a predetermined group or class of assets. These funds differ in size, strategy, as well as the type of assets they own. With so many options on the table, choosing the right mutual fund can come down to individual risk tolerance, timeline, and purpose.
Types of Mutual Funds
Despite the fact that all mutual funds share core similarities, most funds differ in their purpose and approach to selecting and managing assets. For example, some funds focus on tracking popular benchmarks, such as the S&P 500, while others are intended to collect income for their investors by acquiring a collection of high yielding investments. Nevertheless, not all funds of the same function are equal, many funds differ in fees and whether or not they are actively or passively managed.
Active vs Passive Funds
Passive Mutual funds in general have lower fees, as they are largely designed to replicate the performance of individual sectors or benchmarks, while actively managed funds often charge higher fees with the potential for greater alpha, or market outperformance.
However, active funds do not always outperform their passive peers. Many studies have shown that active managers often fail to surpass the returns of general benchmarks and that even the best performing managers have their share of bad years.
Choosing the Best Mutual Fund for You
The most important factor to consider when choosing mutual funds are your own individual circumstances. Determining a purpose for your investment can turn selecting mutual funds into a similar process as buying a car.
Although some cars may be flashier and can help you outperform other vehicles, they are often much costlier and less reliable over the long-term. The same can be said about actively managed mutual funds. Although these products may yield higher returns, their performances can differ greatly over the years, compared to their less expensive, more predictable alternatives.
Furthermore, just as when purchasing a new car, investors must decide which vehicle to buy based on practicality and risk tolerance. For investors looking to earn a steady income, some bond or dividend funds may provide a more reliable, steady solution than funds that seek to track highly volatile, emerging markets.
Comparing and Tracking Mutual Funds
Once you have decided on the type of mutual fund that best suits your needs, investors can use resources such as Quotemedia to evaluate a fund’s holdings, performance, and fees. Furthermore, investors can use Quotemedia and other resources to compare funds offered by differing brokerage firms with some funds being offered free of charge on select platforms.
Additionally, tracking the performance of your mutual funds can allow you to make changes when necessary, especially in regards to the performance of active fund managers. Even with a more passive investment, such as a mutual fund, routine investor attention can help ensure the success of any investor portfolio, 401k, or IRA.
The Importance of Mutual Funds
Despite having some cons, mutual funds can be a powerful tool for individual investors, due to their immense benefits. Furthermore most retirement funds automatically place investors’ money into an assortment of such funds.
Knowing where your money is going and how it is being managed by these funds is extremely important and can make the difference in your retirement, whether it be in the form of increased returns, or simply building up supplemental income to allow increased financial freedom and opportunities.
Due to the complexity of some funds and their somewhat intricate differences, it can be difficult to determine which, if any mutual funds are right for you. We at Wall Street Survivor want to promote financial literacy and education as much as possible.
If you decide that mutual funds could be for you, we recommend checking out our Comparing Mutual Funds Starter Guide.