Business

How do mutual funds work?

The Sterling Report

With Eugene Stanley

Sunday, February 23, 2014    

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WITH gut-wrenching volatility pervading global capital markets, investors are eager to find a stable yet rewarding safe haven for their funds. For the conservative investor, managed investment products such as mutual funds and exchange traded funds are attractive investment options. Today we'll take a closer look at the former. A mutual fund is essentially a vehicle that pools funds from different investors and invests the money in different types of instruments. The type of instruments selected is dependent upon the investment policy (i.e. goals and objectives) of the particular mutual fund.

Types of mutual funds

Most mutual funds fall into one of three main categories — money market funds, bond funds (also called "fixed income" funds), and stock funds (also called "equity" funds). Each type has different features and different risks and rewards. Generally, the higher the potential return, the higher the risk of loss.

Money market funds are usually restricted to high quality or short-term investments and therefore carry lower risks, compared to other mutual funds (and most other investments). Investor losses are rare and money market funds pay dividends that generally reflect short-term interest rates, and historically the returns for money market funds have been lower than for either bond or stock funds. As a result, "inflation risk" — the risk that inflation will outpace and erode investment returns over time — is a potential concern for investors in money market funds.

Bond funds generally have higher risks than money market funds, largely because they typically pursue strategies aimed at producing higher yields. As the name suggests, a bond fund invests in fixed income instruments issued by corporations or Governments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards.

Equity funds are made up of investments in common stocks and the fund's value can rise and fall quickly over the short term. Overall "market risk" poses the greatest potential danger for investors in stocks funds. Stock prices can fluctuate for a broad range of reasons - such as the overall strength of the economy or demand for particular products or services. Not all stock funds are the same. They are typically differentiated by their objectives: Growth funds focus on stocks that may not pay a regular dividend but have the potential for large capital gains; Income funds invest in stocks that pay regular dividends; Index funds aim to achieve the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, by investing in all - or perhaps a representative sample - of the companies included in an index; Sector funds may specialise in a particular industry segment, such as technology or consumer products stocks.

Advantages and disadvantages

Every investment has advantages and disadvantages, so it's important to remember that features that matter to one investor may not be important to you. Whether any particular feature is an advantage for you will depend on your unique circumstances. For some investors, mutual funds provide an attractive investment choice because they generally offer professional management -- professional money managers research, select, and monitor the performance of the securities the fund purchases.

They also provide diversification. Spreading investments across a wide range of companies and industry sectors, for example, can help lower your risk if a company or sector fails. Some investors find it easier to achieve diversification through ownership of mutual funds rather than through ownership of individual stocks or bonds.

Mutual funds are affordable, and some mutual funds accommodate investors who don't have a lot of money to invest by setting relatively low dollar amounts for initial purchases, subsequent monthly purchases, or both.

What's more, mutual fund investors can readily redeem their shares at the current Net Asset Value (NAV) at any time minus any fees and charges assessed on redemption.

But mutual funds also have features that some investors might view as unfavourable, such as:

* Costs despite negative returns — Investors must pay sales charges, annual fees, and other expenses regardless of how the fund performs;

* Lack of control — Investors typically cannot ascertain the exact make-up of a fund's portfolio at any given time, nor can they directly influence which securities the fund manager buys and sells or the timing of those trades; and

* Price uncertainty - With an individual stock or bond, you can obtain real-time (or close to real-time) pricing information with relative ease by checking financial websites or by calling your broker. You can also monitor how the price of a stock or bond changes from hour to hour. By contrast, with a mutual fund, the price at which you purchase or redeem shares will typically depend on the fund's NAV, which the fund might not calculate until the end of the business day.

Before you invest in any given fund, decide whether the investment strategy and risks of the fund are a good fit for you. The first step to successful investing is figuring out your financial goals and risk tolerance - either on your own or with the help of a financial professional. Once you know what you're saving for, when you'll need the money, and how much risk you can tolerate, you can more easily narrow your choices.

Eugene Stanley is Vice President - Fixed Income and Foreign Exchange Trading at Sterling Asset Management. Sterling provides medium to long-term financial advice and investments in US and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm. You may visit us on Facebook or follow us on Twitter and for more information please visit our website www.sterling.com.jm

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