Although it is technically possible to trade mutual funds to
earn a living if you have enough capital to invest and if you can employ a
highly active trading strategy, mutual funds are not created for short-term
investors.
The Basic of Mutual Funds
Mutual funds have maintained their popularity as a choice
for investors due to the wide variety of funds available. There’s also the
diversification they offer, quite automatically.
Mutual funds pool the investments of a number of
shareholders and invest in a plethora of securities. And these securities could
be stocks, bonds, and short-term debt, depending on the stated goals of the
fund.
Funds that are more heavily invested in stocks or low-rated
debt instruments are best suited for investors who are okay with the considerable
amount of risks in exchange for the chance to achieve stellar gains.
Meanwhile, there are funds that invest only in highly rated
corporate or government bonds. They are in general better for investors who
have lower risk tolerance.
Redemption of Mutual Funds
Not like stocks or ETFs, mutual funds are not traded on the open
market. Rather, investors must redeem shares directly with the fund, or through
an authorized broker.
The value of a mutual fund share, which is called the net
asset value (NAV), is in the fund’s portfolio. The share price does not
fluctuate throughout the day like that of exchange-traded securities.
Since mutual fund shares cannot simply be bought and sold
between investors, the fund itself must find the money to cover shareholder redemptions.
Since mutual fund capital is normally wrapped up in the portfolio, share
redemption normally requires the liquidation of assets.
Short-Term Trading
When a mutual fund liquidates its holdings for any reason,
it can generate a capital gains distribution for all shareholders. Because mutual
funds are required to pass along all gains to shareholders to avoid paying
taxes on the income, any kind of sale of assets that ends up in profit prompts
a distribution.
Every distribution increases the tax liability of all
shareholders, not just the shareholder redeeming shares, making short-term mutual
fund trading particularly a burden to the remaining long-term investors.
Additionally, excessive trading causes a mutual fund’s
expense ratio to increase because of the additional trading and administrative fees
incurred. Short-term mutual fund trading hikes the costs for buy-and-hold investors,
which are mutual funds’ key customers, across the board.
Dividend Funds
If you’re set on investing in mutual funds, you can still
generate annual income by investing in dividend funds and using a buy-and-hold
strategy corresponding with the security’s purpose.
Dividend funds are those that invest in dividend-yielding
stocks or interest-bearing debt instruments. Dividend equity funds only invest
in stocks with solid track records of paying solid dividends every year.
In a similar fashion dividend debt funds generate annual
income from the guaranteed coupon payments carried by the bonds, notes, or
bills in their portfolios. Some balanced funds include both types of assets.
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