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What are Mutual Funds: Definition, Pros, Cons, and Common Types

Mutual funds are one of the most popular types of investment for an everyday investor. It is because of its simple investments to understand and they are easy to use.

Today we will discuss to you everything you need to know about mutual funds.

Mutual Funds on iPad Holding by a Man

What are Mutual Funds?

A mutual fund is an investment security that allows investors to pool their money into a one professionally managed investment. It can be invest in stocks, bonds, cash, or a combination of those assets.

Meanwhile, the underlying security types, which is known as holdings, combine to form one mutual fund, is also called a portfolio.

In much simpler terms, mutual funds are like baskets. Now, each basket holds certain types of stocks, bonds, or a blend of both to combine for one mutual fund portfolio.

Mutual funds allow small investors to access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder participates proportionally in the gains or losses of the fund.

These funds invest in a wide amount of securities, and its performance is usually tracked as the change in the total market cap of the fund, which is derived by aggregating performance of the underlying investments.

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Types of Mutual Funds

It does not matter what type of investor you are, there is a mutual fund that will suit your taste.

One important thing for you to understand is that each mutual fund has different risk and reward profiles. In general, the higher the potential return, the higher the risk of potential loss.

Here are the different types of funds that you will see in mutual funds.

Money Market Funds

The money market consists of safe short-term debt instruments, which are mostly government Treasury bills. This is one of the safest places to put your money.

With money market you will not get substantial returns, however, you will not have to worry about losing your principal.

A typical return is a little more than the amount you would earn in regular checking or savings account and a little less than the average certificate of deposit.

Bond Funds

Bond funds are investing and actively trading in various types of bonds. This type of fund is often actively managed and seeks to purchase relatively undervalued bonds in order to sell them at a profit.

These mutual funds are likely to pay higher returns than certificated of deposit and money market investments, but bond funds are not without risks.

Since there are many different kinds of bonds, bond funds can vary dramatically depending on where they invest.

Income Funds

This type of fund is providing current income on a steady basis. These funds are investing primarily in government and high-quality corporate debt, holding these bonds until maturity in order to provide interest streams.

While fund holdings may appreciate, the main objective of this fund is to provide steady flow of cash to investors.

In addition, the audience for this fund consists of conservative investors and retirees. Since they are the one who produce regular income, tax conscious investors may want to avoid this type of fund.

Index Funds

These funds are passively managed funds that pursue to repeat the performance of a broad market index like S&P 500.

Investors might consider an index fund if they know that most of the active portfolio managers cannot beat the market. Because index fund merely replicates the market return it also benefits investors in the form of low fees.

Index funds have been growing in popularity since Vanguard pioneered the way for passive indexing in mutual fund form.

International and Global Funds

An international fund invests only in the assets that are located outside your country. On the other hand, global funds, allows you to invest anywhere around the globe.

However, these funds are hard to classify as risky or safe than other domestic investment. But they have tended to be more volatile and have unique country and political risks.

These funds can also be part of a well-balanced portfolio, it actually lessen risk by increasing diversification since the returns in other countries may be uncorrelated with returns at home.

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Pros and Cons of Mutual Funds

Just like other investing out there in the market, mutual funds have its own pros and cons. The best thing to do now as an investor is to know these advantages and disadvantages of mutual funds.

Learn about the pros that can help you and what are the cons you should be aware of.

Pros

Investing in mutual funds can come with various advantages. You should know and remember these benefits to help you decide on investing in mutual funds.

Diversification

By owning shares in mutual fund instead of having individual stocks or bonds, your risk is spread out across various holdings.

The knowledge behind diversification is not to put all of your things in one basket. You have to spread them across many diverse assets, this can help you minimized the loss in any particular investment.

In other words, the more stock and bonds you have, the less of chances they can hurt your finances.

Meanwhile, large mutual funds usually own hundreds of different stocks in various industries. You have to know that it would not be practical for an investor to build this kind of portfolio with a small amount of money.

Simplicity

Purchasing a mutual fund is straightforward. Several banks and brokerage firms have their own line of in-house mutual funds, and the minimum investment is often small.

Meanwhile, most companies have automatic purchase plans whereby as small as $100 can be invested on a monthly basis.

You should also know that brokers could also buy any other listed mutual fund on behalf of clients.

Professional Management

The main advantage of mutual funds does not have to pick stocks and manage investments. Instead, a professional investment manager will be taking care of all of this using research and skillful trading.

Investors buy funds because they often do not have the time or the expertise to manage their own portfolio. They also do not have access to the identical kind of information that a professional fund has.

Meanwhile, a mutual fund is a relatively cheap way for a small investor to get a full-time manager to make and monitor investments.

Variety

As of today, mutual funds exist with any number of many assets classes or strategies. This allows investors to gain exposure not only with stocks and bonds but also with commodities, foreign assets, and real estate over specialized mutual funds.

You should also know that some mutual funds are structured to profit from a falling market, which is known as bear funds.

Mutual funds offer opportunities for foreign and domestic investment that may be directly accessible to other ordinary investors.

Accessibility

With just $100 an investor can get started investing with mutual funds.

Moreover, the fact that mutual funds hold dozens, hundreds, or even thousands of other securities, an investor can gain access to an entire market of investable securities.

Cons

Investing in mutual funds can also come with various disadvantages. You should also consider the losses you may incur to help you decide if you should invest in mutual funds.

Costs and Fees

Creating, distributing, and running a mutual fund is an expensive undertaking. From the portfolio manager’s salary and investors’ quarterly statements cost money, those costs are passed on to the investors.

Due to the fees vary widely from fund to fund, failing to pay attention to the fees can have negative long-term consequences.

Meanwhile, actively managed funds incur transaction costs that accumulate over each year.

Just remember that every dollar spent on fees is a dollar that is not invested to increase over time.

Taxes

When a fund manager sells a security, a capital-gains tax is triggered. This is why investors who are concerned about the impact of taxes need to keep those fears in mind when you are investing in mutual funds.

In addition, taxes can be mitigated by investing in tax-sensitive funds or by holding non-tax sensitive mutual fund in a tax-deferred account like IRA.

Active Management

Several investors debate whether or not the professionals are any better than you at picking stocks. Management is by no means infallible, and even if the fund losses money, the manager will still get paid.

Actively managed funds incur higher fees, however increasingly passive index funds have gained popularity. These funds track an index such as the S&P 500 and they are much less costly to hold.

Liquidity

Mutual funds let you request that your shares can be converted into cash at any time. But unlike stock that trades throughout the day, many mutual fund redemptions take place only at the end of each trading day.

Crash Drag

Mutual funds require a significant amount of their portfolios to be held in cash to satisfy share redemptions each day.

Meanwhile, if you want to maintain liquidity and the capacity to accommodate withdrawals. Your funds have to keep a larger portion of their portfolio as cash than a typical investor might. Because money earns no return, it is often referred to as a “cash drag.”

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Conclusion

Before you invest in mutual funds or any investments, you should have a background about it.

You have to know the meaning of it, what are the types of mutual funds. You should also know the advantages and disadvantages you will encounter along the way.

Take time to do your research before investing in anything.

If you want to learn new things and learn strategies about the market, BWorldpedia is the site you should visit! We provide profound and useful insights about the market and across a plethora of topics related to it. Also, register an account now with BWorld and start your investment journey.

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