All You Need to Know About Mutual Funds & How They Work

If you’ve recently begun exploring the world of investments, then you may have heard that mutual funds are a great option.

However, you’re probably wondering what exactly are mutual funds? How do mutual funds work? Which mutual funds should you invest in? How do you choose the right mutual funds to achieve your investment goals? Well, you’ve come to the right place. Read on to learn all about mutual funds and how they function!

What is a Mutual Fund?

Building a portfolio is complex for novice investors, the time, effort, and knowledge needed to research and analyse various investments can be a huge challenge for most people. Then you need to think about all the trades you'll need to make to build your portfolio plus the ongoing research and thought required to maintain it. When it comes to mutual funds, you can get started with just one fund.

A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund's assets and attempt to produce capital gains or income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Mutual Fund Characteristics

Mutual funds are generally defined by three main characteristics. These are:

  • Passive management: This means that they are not actively managed by the investor themself but managed on behalf of the investor by a professional portfolio manager. As such, the investor only needs to provide the investment dollars and can then be a passive participant in the mutual fund.
  • Open-ended: This means that mutual funds are not limited to a certain number of investors. They allow for the acceptance of additional investment capital from new investors and there is no cap on the number of investors who invest in a mutual fund. 
  • Diversification: This means that within a single fund there is a wide range of investments such as stocks, bonds, or other securities. This allows investors to spread their investments (and risk) across several investments.

Advantages of Mutual Funds

Mutual funds offer five main advantages to investors: diversification, professional management, liquidity, low cost of investment, and multiple investment options

Diversification

As we’ve already seen above, mutual funds can contain stocks, bonds, or other investments. This helps to spread the risks inherent in investing over many different investment options. This diversification makes them more stable than investing in any one stock in the market. For example, if one company in the mutual fund goes bankrupt, it will not be devastating to the entire portfolio because the investor has invested in many different companies.

Professional Management

One of the main reasons mutual funds are easy to invest in is because they're professionally managed. Rather than choosing, buying, and selling stocks or bonds yourself, you have a skilled fund manager doing it for you. Professional management is at the core of how mutual funds work. When you buy shares of funds, you're pooling your money with other investors. Managers use this pool of money to buy the stocks or bonds that end up forming one portfolio.

Liquidity

In finance, liquidity describes the degree to which an asset or security can be bought or sold in the market. For example, a highly liquid asset such as gold can be easily sold. In contrast, a company's shares usually need to be registered with a stock exchange and approved for trading before they can be bought or sold. Further, while you might find a buyer quickly if you want to sell prime real estate, it could take much longer to find a buyer if you want to sell your old car. Accordingly, the term ‘liquidity’ is used to describe how easily an investor can buy and sell securities in the market. A highly liquid security is easy to buy or sell; whereas an illiquid security may present difficulty when you try to buy or sell it. Mutual funds offer liquidity — that is, the ability to sell at any time — making them ideal for investors.

Low Cost of Investment

The reason for the relatively lower cost when compared to other investments is that there are multiple investors, so the investment costs are spread across investors. In addition, low minimum purchases make mutual funds ideal for new investors who may want to test the waters or who can only afford to invest small amounts but still want to grow their wealth.

Multiple Investment Options

Mutual funds are available in many different forms and types. They vary by the type of investments they hold, how much risk they carry, and the fees associated with them. The most common mutual funds include money market funds (geared to safety), bond funds, equity funds, or balanced funds (blend of bonds and equities). There are several other types of funds that will allow you to invest by certain sectors ie Precious Metals or Energy or even in certain countries or geographic regions in the world.

How can you invest in mutual funds?

The most common ways to purchase shares in the mutual fund are directly from the fund company, through an online investment account, or through an Investment Advisor. If you feel comfortable in your knowledge of mutual funds and which one you wish to purchase, an online account may make sense. If you would like some guidance and advice, working with an Investment Advisor is suggested.

How to choose a mutual fund?

Here are some things to consider when choosing a mutual fund:

Investment objective: Choose a mutual fund based on your investment objectives. Are you looking for short term savings, income, or long-term capital growth?

Timelines: Investors need to consider their investment timeline, which can be short term or long term. Short-term investors usually want some guaranteed return and should pursue safer alternatives, while long-term investors can take on more risk to get higher returns.

Cost: Consider what you're paying in management fees and other expenses before investing.

Style: Know the style of investments that you prefer, such as blue chip or aggressive growth stocks

As demonstrated, mutual funds are a popular investment vehicle for a variety of reasons. They offer a simple and cost-effective way to invest in the stock market and are suitable for both new and experienced investors with any amounts of money to invest.

Want to start investing in mutual funds? Then, reach out to us at Innovation Wealth through Credential Securities and Credential Asset Management Inc. today, where our team of expert Wealth Specialists, Wealth Advisors, and Financial Planners can steer you to the path of investment success!

Mutual funds and related financial planning services are offered through Credential Asset Management Inc. Mutual funds and other securities are offered through Credential Securities, a division of Credential Qtrade Securities Inc. Credential Securities is a registered mark owned by Aviso Wealth Inc.

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