Mutual Funds Explained

What is a Mutual Fund? 

A mutual fund is an investing method that utilises the power of pooled funds from multiple investors, to invest in multiple asset classes, such as stocks, bonds and real estate.

Mutual funds are run by professional fund managers that are structuring the portfolio’s assets in order to beat the returns gained from the market. Mutual funds give investors the opportunity to invest proportionally in a professionally managed fund.

Because investors pool their money together for the fund managers to purchase the underlying assets, they are proportionally investing in the performance of the fund. So they will share the performance of the fund proportionally with other investors, whether it is positive or negative performance.

Usually mutual funds will inform investors of their annual goal to outperform the market by a certain percentage, maybe 2%. Investors will then use this target to measure performance.

Because a mutual fund is actually trying to outperform the market, these professional fund managers are actively managing your money. That means they will be buying and selling assets as they see fit, in order to try and beat the market returns. 

Mutual Funds will charge you a fee for the service of their fund managers. This is due to the active management of your funds, and the managers expectations that they will outperform the market.

Mutual Funds, Index Funds & ETF's Explained

How does a Mutual Fund Work?

A mutual fund uses the investors money to invest in its chosen asset classes, bear in mind this can be a mixture of assets. The mutual funds goal is to make money from wisely investing the funds.

They can make money from dividend payments received through stocks or interest received from bonds. This money then gets paid out to the investors proportionally as a distribution.

Another way they can make money is through capital gains of an underlying asset. For example if the fund invested in Tesla stock and after its 600% run up they sold their ownership. That would be a capital gain for the fund and they would pass the gain onto the investors.

A mutual fund’s price is measured by its NAV or Net Asset Value. This is calculated by dividing the total value of all the funds investments by the number of shares outstanding. If the underlying assets increase in value then the NAV also increases and so does the funds performance.

This NAV is only calculated once per day after market close. Mutual funds are not very liquid and are also not bought or sold on a stock market exchange.

Mutual funds offer up a nice amount of diversification, at a fraction of the cost if you were to own the companies individually.

As mentioned previously there are fees involved with a mutual fund and these fees can include: 

  • Administration fees
  • Management Fees
  • Performance Fees

Mutual funds generally have really large minimum investment requirements, often starting at $5,000. Which can put them out of reach for most Investors, however Australian company Spaceship Voyager enables access for as little as $1 investment.

Pro’s & Cons

Pros:

  • Diversification
  • Dividend reinvestment
  • Safety from oneself, takes you out of the equation

Cons:

  • Fees
  • Underperformance of Market
  • High barrier of entry
  • Not very liquid
  • Inefficient Tax implications
Index Fund
Index Fund

What is an Index Fund?

An index is just a way to track the performance of a group of assets in a standardised way. An index fund is a type of mutual fund that is designed to track the performance of an underlying index, such as the S&P 500. 

As an index fund is designed to track the performance of the underlying index, it doesn’t require a professional manager to actively manage the fund. Therefore Index funds are often regarded as a passive form of investing. This means that fees are significantly lower for index funds. 

Index funds have been rated as one of the best ways to invest by the greatest investor of all time, Warren Buffett. He suggests them as they offer up a great level of diversification, extremely low fees and great performance.

How does it Work?

The portfolio of the index fund is structured to mimic the construction of the underlying index. The idea behind this is simple, if it mimics the structure of the index, it should also mimic the indexes performance too. 

An index fund that tracks the S&P 500 index will be structured so spread the investment out over the 500 companies that make up the index.  This offers great diversification at a very low cost.

Because the fund is passively managed it also keeps fess down significantly. This is because nobody is trying to pick individual stocks or time the market for greater returns. This also lowers the amount of risk involved through human error.

The value of the index fund is calculated the same way as a mutual fund. The key thing to be aware of here is how each company is weighted within the index. For example Apple makes up over 7% of the S&P 500 index. This means a move either way for Apple is likely to impact the value of the entire Index.

This value is also only updated once a day after the market is closed. They are therefore not very liquid.

Index funds are similar to Mutual funds in that they often require a large minimum investment to get started, often around $5,000. But are significantly cheaper than mutual funds.

Pros & Cons

Pros:

  • Low fees
  • Diversification
  • Great performance
  • Passive
  • Low risk

Cons:

  • No potential for extremely high returns
  • Lack of flexibility
  • High barrier to entry
ETF's Explained
ETF’s

What is an ETF?

An Exchange Traded Fund (ETF) is a basket of securities that trade on an exchange, just like a stock. An ETF often tracks an underlying set of assets through an index. The index can be made up of any type of financial security, such as stocks, bonds or commodities.

It is extremely similar to an index fund, with some small but significant differences. An index fund’s value is updated daily and is not very liquid. Whereas an ETF is traded like a stock, so it’s value is updated frequently like a stocks value is.

This means an ETF is extremely liquid and has a lot of fluctuation in its price. There are multiple types of ETFs to invest in on the stock market, so it is important to know what the ETF is tracking.

A very common ETF is the SPDR S&P 500 ETF (SPY), this tracks the performance of the S&P 500.   

How does it Work?

ETF’s are structured around the sole purpose of tracking the performance of the underlying index. It is not designed to outperform the market, and therefore is a very passive investment option.

The price of the ETF is determined by the value of the index it is tracking, which is determined by the underlying assets of that index. This is updated frequently, as it is traded on the stock exchange.

ETF’s have very low minimum investments and with the implementation of fractional investing you can now invest in ETF’s for as little as $5. This really smashes the barrier to entry and makes them very appealing for investors.

As they are a passive investment option too, the fees are very low, and yet still produce great performances. They also provide diversification versus buying individual companies.

Pros & Cons

Pros:

  • Easy to trade
  • Low barrier of entry
  • Good performance
  • Low fees

Cons:

Mutual Funds
Mutual Funds

What should you use?

Selecting which one to use comes down to your individual situation. It takes into account the goals you have in mind and your funds available.

Because Superannuation is a mutual fund, you could look into maximising the tax benefits of your Superannuation. So one thing to consider with superannuation is you won’t be able to access these funds until you retire.

You need to ask yourself if you have the required amount to start investing in Index Funds or not? If you do then it will come down to whether you want to be involved in the process or not. Should you not wish to be involved then you should consider using Index Funds as your investing strategy.

So if you would like to be involved in the process, or don’t have the minimum investment amount then you should consider using ETF’s as your investing strategy.

Let me know whether you use any of these funds to invest with? Please feel free to share on social media too.

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