Mutual
funds are a fantastic way to diversify your portfolio. And these funds come in
different sizes and shapes. It’s not surprising that there exist several types
of mutual funds.
However,
many investors, especially the beginners, only have a vague idea of what mutual
funds are exactly like. That’s why we got this list for you.
Along
with that, we’re also going to tell you the risks, advantages, and other
whatnots of investing in mutual funds.
Let’s
first get into a breakdown.
What
are Mutual Funds?
Mutual
funds are pooled investments managed by professionals. And these funds are
becoming more and more in demand nowadays. That’s primarily because a lot of us
are more conscious about our retirement plans, savings for college, and other
financial goals.
According
to statistics, over $4 trillion people have their mutual funds investments—in
America alone. That’s a huge number already, and it’s growing daily. Across the
globe there are nearly $28 trillion people invested in mutual funds.
Along
with the growth in the number of investors and funds, the strategies and types
of mutual funds expand.
How
Can You Earn from Mutual Funds?
Even
though there multiple types of mutual funds, you can money using them in three
ways:
·
You
can earn from dividends on stocks or interest on bonds. Using distribution, a
fund gives you almost all of the income it generates throughout the year. Additionally, you have the option to receive the distribution through paychecks
or reinvest the earnings to obtain more shares.
·
Whenever
the fund sells some securities that have higher prices, your fund already has
capital gains. You could also get these gains through distribution.
·
If
the fund chooses not to sell the fund holdings with the increased price, you
can sell your mutual fund shares in the market.
The
Types of Mutual Funds
Here
are the different types of mutual funds that you can choose to invest in:
Equity
Funds
Equity
funds invest in stocks. The primary goal of this mutual fund is to have growth
that’s faster than other types of mutual funds, such as the money market or
fixed-income funds.
This
means that you might have to suffer higher risks—which mean losing some money.
In addition, you also have at hand sub-types of equity funds.
There
are those that invest in growth stocks. These funds do not typically pay
dividends. There are equity funds that specialize in income funds. Income
funds, on the other hand, hold stocks that pay huge dividends. Other types of
equity funds invest in value stocks, small-cap stocks, mid-cap stocks,
large-cap stocks, or even combination of them.
Read further: Breaking Down Risk Management
Read further: Breaking Down Risk Management
Money
Market Funds
Money
market funds specialize in short-term fixed income securities. And these
securities include government bonds, bankers’ acceptances, certificates of
deposits, commercial papers, and treasury bills.
If
you’re averse to risk, money market funds are the safer option for you.
However, you would also have to settle for lower potential return compared with
other types of mutual funds.
See also How much Risk Can You Tolerate?
See also How much Risk Can You Tolerate?
Fixed-income
Funds
If
you want a fund that targets investments with a fixed rate of return, this is
the fund that’s right for you. Fixed-income funds typically aim for government
bonds, high-yield corporate bonds, and investment-grade corporate bonds.
The
goal is to earn money into the fund on a regular basis. The earnings normally
come from the interest.
As
you can expect, aiming for high-yielding investments in this fund, like
high-yield corporate bonds, requires you to withstand riskier situations. If
you don’t like that, you can instead choose investment-grade and government
bonds.
Balanced
Funds
If
you’re into investing in equities but you also want to throw fixed-income
securities in the mix, balanced funds are for you.
What
these funds do is balancing the goal of earning higher returns and the risk of
losing some cash. These funds generally follow a formula in order to split
money across different types of investments. Balanced funds normally sport
higher risk than pure fixed-income funds. But they are also typically less
risky than equity funds.
Nonetheless,
these funds can be either aggressive or conservative. Aggressive funds sport
more equities than bonds, while conservative funds have more bonds than
equities.
Specialty
Funds
As
the name suggests, these funds invest in specialized industries. Among these
industries are commodities, real estates, and social-responsibility investing.
To
illustrate, a fund that is “socially responsible” invests in companies
supporting environmental campaigns, human rights, and diversity.
It
goes without saying that these funds try to avoid companies associated with the
military, gambling, weapons, tobacco, alcohol, and other such stuff.
Index
Funds
Index funds are perhaps the most popular among the types of mutual funds. These
funds’ goal is to follow and track the performance of a specific index like the
S&P/TSX Composite Index.
Since
it tracks the index, the fund’s value will inadvertently go up when the index
goes up. It will go down as the index goes down.
Index
funds are usually cheaper than actively managed mutual funds. That’s because
the portfolio manager does not do a lot of research. He or she also doesn’t
have to come up with investment decisions.
There
are two types of management approach you can use in this fund:
·
Active management – your portfolio manager
will buy and sell investments. The goal is to beat the return of the overall
market and/or another identified benchmark.
·
Passive management – in this approach, the
manager will only have to buy a portfolio of securities. And these securities
track the performance of a benchmarked index. You only have to adjust the
holdings if there are changes in the component of an index.
Funds
of Funds
These
funds are much like balanced funds, but it sports higher MER than other types
of mutual funds. This fund can make your diversification easier, as well as
your asset allocation.
A
Word of Warning
Before
you jump right in and start investing in a mutual fund, make sure you
understand the fund’s inner workings.
Wrap
your head around the goals of the funds. Check if the goals are in conjunction
with your own goals. In addition, determine your risk tolerance. The risks
found in different types of mutual funds also vary a lot, so determining how
much risk you can take is very crucial if you want to work the fund in your
favor.
Digging
Deeper into the Types of Mutual Funds
Mutual
Fund Schemes
Those
are just the overview of each type of mutual funds. Now, we’re about to dig
deeper.
If
you want to achieve your short-term goals (those goals that fall under five
years), then you can try and invest in debt schemes. Of course, you have to
choose a debt scheme that will suit your goals and situation perfectly.
Liquid
Funds
These
funds invest in, as the name suggests, highly liquid money market securities.
These are ideally the securities with residual maturity, which should not last
over 91 days. You can let your money simmer in them for couple days or a few
months.
Ultra-Short-Term
Funds
These
funds primarily invest in very short-term debt securities. They also invest in
some longer-term debt securities. You can let your money stay here for a few
months to a year.
Short-Term
Funds
These
usually invest in debt securities with one to three years of average maturity.
You can expect these funds to perform well when the short term interest rates
are high. You ought to park your money here for a few years.
Dynamic
Bond Funds
Dynamic
bond funds invest in a plethora of debt and money market securities, all with
different maturities. These funds have a portfolio that’s actively managed
which changes along with the interest rate outlook of the fund manager. If
you’re the type that likes to pass on the task of calling on interest rates,
this is the fund for you.
Income
Funds
Income
funds pour money in government bonds, money market instruments, and corporate
bonds that have long maturities. These funds are very vulnerable to interest
rate changes, so they are mainly suitable for investors who have high risk
tolerance and who are planning to stay invested for the long haul. A little
tip: it’s very ideal to invest in these funds when interest rates are almost
certainly going to fall.
Fixed
Maturity Funds
Fixed
maturity funds are closed-ended debt mutual funds, and they work in a similar
manner with fixed deposits. These funds invest in debt instruments with less
than or equal maturity date with the scheme. They have to redeem your
securities on or before the maturity. Additionally, they have to pay investors
before the maturity date.
Gilt
Funds
Gilt
funds specialize in government securities. You can be free from the most usual
risks because the government is the one that issues the bonds. On the flip
side, these funds are quite easily shaken when changes in interest rates take
place. They are also vulnerable to other economic factors. You should be
looking to invest for a long time if you plan to use this fund.
Debt-Oriented
Hybrid Funds
As
the name clearly tells us, debt-oriented hybrid funds specialize in debt, along
with a few equities. In the portfolio, the equity part could provide additional
returns, though it also makes it riskier. You got to have an investment horizon
of more than three years if you plan to invest in these funds.
Kinds
of Equity Funds
As
we indicated above, there are other sub-types of equity funds. Here they are:
Arbitrage
Funds
Arbitrage
funds do not invest in equities. However, they are treated as such or are
considered as equity schemes for taxation purposes. How is that so? These funds
try to utilize the price difference between the cash and derivatives markets in
order to generate returns. Favorable taxes can be used to their advantage
because the investments that are held for a year in them can be qualified for
long term capital gains tax, which is zero. This could be your best option if
you are in the highest tax bracket and you want to let your money simmer for a
short time.
Large-cap
Funds
As
the name suggests, these funds invest in well-established companies with large
market capitalization. This is so because large-cap companies are considered
the safest companies to invest in. Aside from their large capitalization, these
companies are almost always the market moves and market leaders. If you’re
conservative when it comes to equity, large-cap funds are good for you. These
investments carry less risk, with a decent amount of returns.
Midcap
funds
Midcap
funds are those funds that invest in medium-sized companies. These are the
companies with a middle-level market capitalization. They are also the ones who
have probably achieved a part of their full potential. However, they can also
be extremely risky since there is always that possibility that they won’t
achieve or reach their full potential. On the other hand, if they managed to
reach their long-term targets, you stand the chance of being rewarded
generously. If you have a high risk tolerance, this one should be good for you.
Small-cap
Funds
These
funds invest in small companies, and of course that means companies with small
market capitalizations. These are extremely risky companies since we know
little about them. Not all the details of their business are available in
public domain. However, there’s always the chance that they can boom and have a
phenomenal run. Your risk appetite should be stellar high if you plan to invest
in such companies.
Equity-Oriented
Hybrid Funds
These
types of funds invest in a combination of equity, which comprise at least 65
percent of the whole portfolio, and debt. Compared with pure equity funds,
equity-oriented hybrid funds are less volatile, thus less risky, because of the
mixture in the corpus. The debt component can stabilize your portfolio during
times of extreme volatility. If you are quite risk averse and conservative,
this one’s for you.
Diversified
Funds
Diversified
funds, as you may guess, invest across all the types of market capitalizations.
This primarily depends on the market outlook of the fund manager. Now, since
the fund is spread across market caps, you have fewer risks than mid- and
small-cap funds, but a little more risks than large cap funds.
Equity-Linked
Savings Schemes
These are also called tax-planning mutual
funds. Equity-linked saving schemes are good for you if you are searching for a
good way to save taxes. Your investments in these funds can give you some
chances of having your taxes reduced. You must remember that they come with a
compulsory lock-in period of three years.
Sector
Funds
Sector
funds specialize in a certain sector, or follow the lines of a defined theme. Investments
are focused on one sector or theme, so they can be extremely risky. Timing your
entry and exit from them is very, very crucial. Remember that the wealth of different
sectors chance along with the different cycles of the economy. You must first
gain in-depth knowledge of a particular sector before you can jump in.
Advantage
of Investing in Mutual Funds
Different
types of mutual funds offer different benefits to different investors. However,
you can expect to have the following as the overall advantages of investing in mutual
funds:
Professional
Management
This
is arguably the top advantage of investing in mutual funds. You don’t have to
pick stocks and manage them by yourself. You can have a professional investment
manager to handle everything with thorough and careful trading.
This
benefits investors who have a lot on their hand and who have not the insights
and expertise to manage their portfolios. Some investors, on the other hand,
merely do not have the intimate knowledge over investments that the fund
manager has.
Further,
it’s relatively cheap. So even small investors can avail a fund manager from a mutual
fund to oversee and manage their investments.
Economies
of Scale
Mutual
funds buy and sell tremendous amounts of securities and funds. Because of this,
transaction fees are lower than if you would pay for them. Also, mutual funds
pool money from many modest investors. This enables them to invest in specific
assets or take huger positions than what you can afford.
Diversification
If you
own shares in a mutual fund instead of owning stocks and bonds, you can spread
out your risk across the various holdings. This effectively does the diversification
job for you. You can spread the investments across a large number of a plethora
of assets, so your eggs are not all in one basket. Diversification works because
the losses in some of the assets you own can be minimized by the gains other
assets you hold.
Simplicity
Buying
a mutual fund is very easy and direct. In addition to this, many brokerages and
banks have their own mutual funds, plus the minimum investment cost is pretty
cheap. Many other companies also have automated and systematic plans where you
can invest a predetermined amount of money on a monthly basis.
Variety
As time
goes by, more and more types of mutual funds engage in more and more asset
classes and strategies. This enables you to be exposed not only to stocks and
bonds but also other mandates like commodities, real estate, and foreign assets
via specialized mutual funds. In fact, other mutual funds are calibrated to let
you profit even in a bear or falling market. Those are called bear funds. If you’re
an ordinary investor without investments in mutual funds, you may not have the
opportunities for other foreign and local investments.
Transparency
If you’re
concerned about the safety of your investments, mutual funds may just be the
perfect fund for you. Mutual funds are under the eyes of industry regulators, which
ensure the accountability and fairness given to investors.
Disadvantages
of Investing in Mutual Funds
Just
a mutual funds have its benefits, it also sport some inherent risk and
disadvantages. Here they are:
Active
Management
As we
have mentioned, professional fund managers will handle your investments. Now,
some investors don’t think that these fund managers are any better than
individual investors when it comes to picking stocks. No matter how expert the
manager is, there’s always the big chance that his/her decisions will fail. Of course,
this manager can still get paid even if his/her strategy didn’t work. Actively managed
funds are also subject to fees, though the passive management principle is gaining
huge popularity nowadays.
Costs
and Fees
You will
have to prepare some amount of cash to pay for the fees for creating, distributing,
and running mutual funds. In a way, you will have to shoulder the expenses for
the portfolio manager’s salary to your quarterly statements. Fees and charges
vary in different types of mutual funds, so if you fail to pay attention to
this detail, it could derail your budget plan and capital allocation. And even
if you think that these fees pale in comparison to the gains you could acquire,
they can add up and accumulate year by year.
Liquidity
If you
want to liquidate or convert your funds into cash, the mutual fund will allow
you to do so. However, unlike stocks that trade throughout the day, a huge
number of mutual fund redemptions only happens at the end of each trading day.
Taxes
Whenever
a fund manager decides to sell a security, the capital gains tax will get
triggered. If you are conscious of those taxes, you must keep this simple
detail in mind when investing in mutual funds. You can alleviate this by
investing in funds that are tax-sensitive, or you can hold non-tax sensitive
mutual fund via a tax-deffered account.
Dilution
Although
diversification is the golden rule for many investors, over-diversification can
also cause some losses. Mutual funds can have small holdings in a variety of
companies. Because of this, even if you have high returns from some
investments, those returns won’t really make much difference on your overall
return. If a successful fund grows too enormous, dilution can also happen.
Cash
Drag
Most of mutual funds need to hold a
substantial amount of their portfolio in cash for them to satisfy share
redemptions each day. To maintain liquidity and the ability to serve withdrawals,
mutual funds will have to keep a bigger proportion of their portfolio at cash.
Conclusion
Summing
up, we know that mutual funds are very ideal for several types of investors. Whatever
kind fo investors you are, there will always be type of mutual fund that will
suit you. These types of mutual funds offer varying benefits and risks, so must
dig deeper into each of them. Also, keep in mind that mutual funds in general
also sport inherent risks and disadvantages.
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