What Exactly Is A Mutual Fund?

Nowadays, plenty of banks and financial institutions offer mutual funds.

You have probably heard of people making money by investing in mutual funds, but you’ve also heard people losing money from them. Some describe them as a fixed monthly savings plan, while others describe them as an account that gives a high yearly return.

So, what exactly is a mutual fund? What is the truth, and what isn’t?

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Like Group Buying, For Securities

In a nutshell, a mutual fund is like group buying, but for securities like stocks and bonds of all kinds. The banks and financial institutions act as a middleman by buying a mixture of stocks and bonds by bulk to make up the fund’s portfolio.

The portfolio is managed by a team of professional fund managers who do extensive research on the stocks and bonds and purchase and sell them accordingly depending on the market conditions and their individual performances.

The components of each fund’s portfolio is different and is dictated by the fund’s prospectus. A fund’s prospectus would state what type of fund it is, what type of stocks or bonds would be in it and what percentage of the total fund’s value would they make up.

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Hedging Your Risks

One of the main reasons to choose mutual funds is so that you could hedge your risks by buying into a professionally managed portfolio rather than picking the stocks or bond units yourself from the open market.

On a good year in the stock market, you could stand to make more than 100% on your portfolio if you were to buy them directly on the stock market, but you could also lose more than half of your money.

If you were to buy them through a mutual fund, an equity mutual fund that is performing well on a good year could make up to 40% of what you’ve invested. On a bad year, however, you could also lose up to 40% (note that different funds have different performances due to their prospectus and variety in portfolio make-up).

Trusting Fund Managers

By investing through a mutual fund, you are also putting your trust in the team of professional fund managers who manage the fund’s portfolio, monitor the day-to-day market conditions and make the necessary adjustments for you.

Providing Liquidity

Investing through a mutual fund also provides you with liquidity as you can buy or sell your units in a mutual fund anytime you want at the day’s unit price (which reflects the fund’s performance).

Prospectus

Before investing into a mutual fund, it is important for us to first check out the fund’s prospectus. This is because the fund’s prospectus would determine the make-up of the fund’s portfolio, whether it is equity-heavy, bond-heavy, which regions would the fund be investing in and which types of industries or companies would the fund be investing in.

For example, if you would like to invest in Chinese stocks in the China’s stock market, then it would make sense for you to invest in a China-equity fund. If you are interested in growth stocks, then a growth focused equity fund. If you’re interested in corporate bonds, then a bond-fund and so on. They would all have different prospectuses, different fund performances and most importantly, different risk profiles.

Read Also: What Is A Diversified Investment Portfolio?

Fund Performance

Before choosing your fund, it is also important to look at the fund’s performance over the years. That would give you a better idea of what to expect of the fund at its best and at its worst, how much you stand to gain on a good year and how much you stand to lose on a bad year based on its performance over the past 5-10 years or so.

Units

The average performance of the portfolio of securities in a particular fund would be reflected in the unit price of the fund. To invest in the fund, you buy units in the fund, which you can sell at the day’s fund unit price to exit the fund.

Administration Charges

It is also important to note that an administration fee would usually be charged every year for the management of the fund by the fund managers. The amount is usually a low percentage of the value of your total stake in the fund. The first time you buy into a fund, there is also usually extra   commission charges on the total amount of money that you put into the fund.

Because of that, it is important to make sure that you are taking a long enough view to make back the initial charges that you have paid when buying into the fund before selling your units.

Pros And Cons

The benefits of buying into a mutual fund is so that you will not have to worry about which stocks to pick and the daily management of your portfolio. You could choose your general risk appetite and general direction of what you would like your portfolio to consist of based on the fund’s prospectus and leave the rest to the fund managers.

The downside to that, however, is that your potential earnings would be averaged-out across the portfolio and would be lower than if you had picked the right stocks from the open market yourself. You would also have to pay yearly administration charges and commissions when you buy into the fund.

Should You Invest In One?

This would depend on how much work you are prepared to do and how confident you are in your investing and portfolio management skills.

If you are extremely confident in your investing and portfolio management skills, then it would make sense for you to buy stocks or bonds from the market directly.

However, if you would prefer to leave it to the professionals and don’t mind paying a small portion of what you’re investing to them as commissions and administrative charges, then investing in a mutual fund would be a good idea.

Read Also: 13 Things You Need To Know To Start Investing In The Malaysian Stock Market

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