Are mutual funds a good investment?

Are Mutual Funds a good investment?

The Mutual Fund Industry is one of the world’s largest and fastest growing financial services industries. In 2020, the net worth of mutual funds registered in the United States stood at $23.9 trillion, compared to $11.3 trillion in 2010 and $6.97 trillion in 2000. The growth of the mutual fund industry presents an alternative investment route to investors who do not want to directly invest in equity or debt based instruments.

What is a mutual fund?

A mutual fund is a type of investment fund that pools money from investors and invests it in securities such as stocks, bonds and other instruments to generate a return for the investors. Mutual funds come in many different forms such as index funds and ETFs. They also vary by the mode and investment goals.

For instance

• Growth funds only invest in growth stocks. Aiming to achieve high returns by identifying fast growing companies.
• Equity funds only invest in the stock market.
• Bond funds only invest into bonds and are thus deemed safer than other funds.
• Balanced funds are funds that invest into a variety of stocks, bonds and other instruments to achieve wider diversification.

The rate of return on mutual funds varies in line with their investment goals and objectives. Active mutual funds try to beat the market return and therefore have a slightly higher risk rate. Passive funds on the other hand follow a benchmark market and produce returns that are on par with the market returns.

Good for Portfolio Diversification

Diversification is one of the key strategies to minimize the risk that your portfolio is exposed to. How much you want to diversify, ultimately depends on your risk profile. On average investing into around 20 different companies is considered a good level of diversification.

Anyone who has directly invested in stocks, will know the time and due diligence required to scope out 20 different companies to invest into. Most individual investors do not have the time nor the analytical expertise to analyse 20 different companies before investment and track them afterwards.

Investors can therefore simply diversify their portfolio by investing in mutual funds. It has been seen that the diversification that can be achieved by investing into mutual funds is far greater than any investor can achieve on their own by directly investing into equity or debt based instruments because mutual funds have investments into 20 to 30 different companies at any given time.

Furthermore, these investments are well diversified by industries and sectors. Minimising the market risk to the lowest possible levels. It is virtually impossible for individual investors to achieve this level of diversification on their own.

Run by Professional Fund Managers

Mutual funds are managed by professional investment managers, who are responsible for investing the money in the best possible manner. It is the job and role of the fund manager to identify profitable investments that are in line with the risk profile and investment objectives of the fund to generate a good rate of return.

Since these fund managers are professionally qualified, with years of experience under their belt. They have a better understanding of the market compared to any individual investor. Which is why investing in mutual funds is a safer investment option as compared to investing on your own.

Researching prospect companies, analysing them and the market are time consuming tasks. Many people spend their careers trying to understand the markets and still end up losing money. It is, therefore, better for individual investors to trust a professionally qualified fund manager instead of taking the longer and riskier road.

Reduced Frictional Cost

The investment comes with its costs. In the case of equity investment, these costs come in the form of charges and capital gains tax on the sale of securities. Frequent buying and selling of equities can end up pushing the frictional costs of trading up by a significant amount for individual investors. This frictional cost can offset any capital gains made through investment.

Since mutual funds are pools of investment. The frictional costs are divided among all investors, which ends up reducing the frictional cost that has to be borne by individual investors in the fund.

Perfect for Passive Investment

Since the investors do not have to make investment decisions, this makes mutual funds a very easy mode of investment for passive investors. Investors simply have to carry out initial due diligence to search and select the fund that meets their investment criteria. Once they have invested in a fund, the fund manager takes over.

It is important to understand that it is the job of the fund manager to create the best possible return for the investors.

How to make money from mutual funds?

Investors can make money through three different ways from a mutual fund.

• Dividend payouts: The equity stock owned by the mutual funds received annual or interim dividends against the shares. This dividend is distributed to the fund investors in proportion to their investments. Investors have the option of receiving this dividend in their accounts or reinvesting it into the fund.

• Capital gains/losses: The equities owned by the fund either appreciate or depreciate in value. Any gains or losses made through trading of these securities are passed on to the investors.

• Net Asset Value: The NAV of a mutual fund is its net worth. It is calculated by adding together the total worth of all investments of the fund, divided by the number of shares. The NAV of a mutual fund goes up and down over time. If the underlying assets appreciate, then the NAV goes up. If the underlying assets depreciate, the NAV goes down. Any increase or decrease in the NAV from the date of purchase of the share of the fund, can be realized by the investor by selling the share of the fund.

Investor Takeaway

Mutual funds are a good alternative investment opportunity for investors who don’t have the expertise to make complicated investment decisions on their own. Not just amateur investors but a lot of professional investors prefer mutual funds because it is simply more efficient to invest in mutual funds than investing individually in stocks and bonds.

Investment in mutual funds minimises the risk for investors, as the funds are managed by professionally qualified fund managers. The rapid pace of investment into mutual funds is a testament to the confidence shown by investors.

Mutual funds offer a variety of different investment opportunities for investors, which makes them particularly attractive. Investors can choose a mutual fund that goes along with their investment goals and philosophy to achieve the desired rate of return.