Investing in mutual funds is an investment strategy managed by a fund manager. But what exactly is a mutual fund? And how can you invest in it? In this article by BUX, you’ll discover everything about it.
Mutual funds: meaning in short
A mutual fund is a fund where the money of multiple investors is pooled and managed by a fund manager. The manager invests the money in stocks, bonds, and other financial products. There are actively managed and passively managed funds. Actively managed funds try to beat the market, while passive funds track an index. Choosing the right fund requires a careful comparison of costs, risk, and return. Investing involves risks.
What is a mutual fund?
A mutual fund is a collective pot in which the money of multiple investors is pooled together. That money is managed by a fund administrator or fund manager. This is an expert who actively or passively invests on your behalf in stocks, bonds, and other financial products in specific regions, sectors, or themes. You can see such a fund as a basket of different investments, giving you a broadly diversified portfolio with a relatively small amount. Another name for a mutual fund is ‘managed investing’ or ‘fund investing’.
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How does a mutual fund work?
When you invest in a mutual fund, you buy a piece of that fund, also called a participation (or unit). Then the fund manager gets to work. They determine the composition of the fund, so as an investor, you have no direct influence on the choices made. The fund manager uses the collected money to invest in various financial instruments, such as different stocks of hundreds of companies.
Every day, the net asset value (intrinsic value) of the fund is calculated. This is the total value of all investments divided by the number of outstanding participations. If the value of the underlying investments rises, the value of your investment also rises.
Active vs. passive funds
The fund manager can manage the fund in two ways:
- Active investing: With active investing, the fund manager tries to ‘beat’ the market by choosing carefully selected investments in the fund. This takes more time and expertise, which is why management fees are often higher. Also, you can usually only enter or exit once a day, because the value of the fund is calculated at the end of the day.
- Passive investing: With passive investing, the fund follows a certain index, such as the AEX. This means the fund manager does not actively adjust the composition of the fund but simply copies the index. Passive investing is often cheaper than active investing because the management fees are lower.
4 different types of mutual funds
There are different types of mutual funds, each with its own characteristics. Below you will find the most important types of funds you can consider.
1. Equity funds
An equity fund invests in various stocks of publicly traded companies in a certain region, sector, or theme. This type of fund offers the chance of a higher return, but also more fluctuations. It can be a smart move if you dare to take some risk and invest for the long term.
2. Bond funds
A bond fund invests in bonds from governments and companies. The risk with these funds is usually lower because governments must meet obligations. But a bond fund also carries risks.
3. Mixed funds
A mixed fund combines the best of two worlds: stocks and bonds (or other products) in one portfolio. This combination ensures a spread of risk because there are different investment products in one fund.
4. Hedge funds
A hedge fund uses advanced investment strategies and financial instruments to make an above-average profit. They are often intended for experienced investors and have higher costs due to active management.
Open-end vs. closed-end mutual funds
Not every fund works the same way. There are two main forms: open-end and closed-end mutual funds. The difference has to do with how new participations are issued.
1. Open-end mutual fund
An open-end mutual fund is flexible. New investors can buy new participations, and existing investors can exit whenever they want. The price is determined by the intrinsic value of the fund (Net Asset Value (NAV)) on the next trading day. This is the market value of the fund’s assets divided by the number of outstanding participations.
Characteristics:
- The price of a share lies close to the intrinsic value.
- Many of these funds are not directly listed on the stock exchange but are traded via a fund house at the NAV.
- The fund is often traded once a day.
2. Closed-end mutual fund
A closed-end mutual fund has a fixed number of participations throughout the entire duration of the fund. You can only buy or sell via the stock exchange, depending on supply and demand. So only when someone offers a participation. As a result, the price can deviate from the intrinsic value.
Characteristics:
- The price of a share can deviate significantly from the intrinsic value.
- The fund is traded on the stock exchange. You cannot exit via the fund house; you must sell the participations on the exchange.
- The price of a share depends on supply and demand.
Advantages of mutual funds
Disadvantages of mutual funds
Professional management
A fund manager and specialists manage the fund, so you benefit from their knowledge.
No influence
You have less control over specific investments. It is also difficult to find out exactly what you are investing in.
Highly diversified investing
You can invest in a diversified way across multiple companies with a relatively low investment.
Tradable once a day
You can only trade in open-end mutual funds once a day. The price is also adjusted once a day or longer.
Different markets and sectors
You have access to diverse markets and sectors.
Negative return
There can be a negative return, despite the expertise of the manager.
Lower transaction costs than with individual stocks
A fund usually has lower transaction costs than when you buy individual stocks.
High management costs
The costs for managing the fund are often higher than with ETFs. Active investing costs more than passive investing.
The difference between mutual funds and ETFs
ETFs and mutual funds are similar, because both work with a basket of different investment products. The biggest difference lies in the way they are managed.
- Mutual funds are generally actively managed. The fund manager tries to beat the market through carefully selected investments. This takes more time and expertise, which makes the costs higher. Moreover, you can usually only enter or exit once a day.
ETFs are usually passively managed, which means they track an index. This keeps costs low, and you can trade the fund throughout the day on the stock exchange. This makes ETFs flexible and accessible. However, because ETFs are passively managed, changes such as company acquisitions or adjustments in the index can entail risks.
Read more: Investing in ETFs
The risks of investing in funds
Just as with other investment products, a mutual fund carries risks. In general: the higher the potential return (for which there is no guarantee), the higher the risk, and the greater the chance that you could lose your investment. A risk indicator in the Key Information Document (KID) helps you understand how risky a fund is. On a scale of one to seven, one means a low risk and seven a high risk. This is based on the volatility of the investments within the fund.
4 possible risks
- Market risk: A market falls in value, often if the fund is dependent on one market. Volatility can also be higher.
- Emerging markets risk: Fund investments in emerging markets bring extra risks, such as political or economic instability.
- Concentration risk: The risk you run if you do not diversify enough. This happens if the fund invests too much in one asset. If the investment performs poorly, the chance of large losses is higher.
- Liquidity risk: Some mutual funds are difficult to trade quickly. For example, due to the ability of the manager to buy or sell positions. Or by buying or selling units in the fund yourself.
The costs of investing in mutual funds
Because a fund manager manages the fund for you, management, administration, and transaction costs come into play. These costs and other information are set out in the Key Information Document (KID). How high these management costs are differs per mutual fund, usually between 0.5% and 2%. They are incorporated into the price.
Comparing mutual funds, how do you do that?
Choosing the right mutual fund requires careful comparison. When comparing mutual funds, pay attention to the following factors:
- Costs: What costs will you incur to enter the mutual fund?
- Risk: Check the risk indicator and investment category. How risky is the fund and does it fit your risk appetite?
- Return: What are the historical performances of the fund? Note, past performance is no guarantee of future results.
- Management style: Are you investing in an actively managed fund or do you choose passive investing?
Is investing in funds a good idea?
It can be a good idea to invest in funds. It is, for example, a smart choice if you strive for broad diversification to limit risks. But also if you do not have the time or expertise to delve into companies, sectors, and market conditions. Additionally, investing in funds can be a good move if you want to invest in certain categories, sectors, or regions. But also if you want to get started with relatively small amounts and achieve diversification.
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Investing involves risks. You can lose your investment.
All views, opinions, and analyses in this article should not be interpreted as personal investment advice. Individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
