Amutual fund is an investment vehicle comprised of a pool of funds collected from a number of investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other similar types of assets.

The fund is managed by a professional investment manager who buys and sells securities to facilitate effective growth of the fund. Mutual funds can be “open-ended” or “closed-ended”.

“Open-ended” mutual funds are those that do not limit the number of shares the funds can issue and will continue to issue shares to accommodate new investments regardless of the volume of the current investors in the fund.

Open-ended funds also buy back shares when investors wish to liquidate their holdings.

With closed-ended funds, only a certain number of shares can be issued for a particular fund, and they can only be sold back to the fund when the fund itself terminates. However, shares in closed-ended funds can be sold to other investors on the secondary market.

Types of mutual funds

Most mutual funds fall into one of three main categories: money market funds, bond or fixed-income funds, and stock or 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 mutual 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.

Losses to investors are usually 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.

Consequently, inflation risk is a major concern for money market fund investors as rising inflation will erode investment returns over time. Bond mutual funds generally have higher risks than money market funds, largely because they typically employ strategies aimed at producing higher yields.

Bond funds can vary significantly in their risks and rewards dynamics due to the many different types of bonds. Credit, interest rate and pre-payment risks are some of the risks associated with bond funds.

Credit risk is the possibility that a bond issuer may fail to repay its debts as they become due. However, credit risk can be mitigated by investing in highly rated securities. Interest rate risk is the risk that the market value of the bonds will decrease when interest rates rise regardless of credit quality.

Funds that invest in longerterm bonds tend to have higher interest rate risk. Reinvestment risk is the possibility that repaid proceeds from a bond may be re-invested at a lower rate of return. For example, the proceeds from a high-paying coupon bond that has been “called” may have to be reinvested in lower coupon bonds if interest rates have been falling.

Equity mutual funds are made up of investments in common stocks, and the fund’s value appreciates or falls over time as stock prices change. Stock prices can fluctuate for a number of reasons, such as the overall strength of the economy or demand for particular products or services.

Stock funds differ and may be growth-oriented, focusing on stocks that may not pay a regular dividend but have the potential for large capital gains.

They can be income funds that are invested in stocks that pay regular dividends or they can be index funds which try to mimic the returns of a particular market index, such as the S&P 500 index, by investing in a representative sample of the companies included in an index.

Sector funds are another type of equity funds and these may specialise in a particular industry segment, such as commodities or financial stocks.

Advantages and disadvantages of mutual funds

Every investment has positives and negatives attached.

It is therefore instructive to remember that features that are important to one investor may not be to another. Whether any particular feature is an advantage for someone will depend on that person’s unique circumstances.

For some investors, mutual funds provide an attractive investment choice because they generally offer: professional management as professionals select, and monitor the performance of the securities the fund purchases; diversification in the spreading of investments across a wide range of companies and industry sectors, for example, which can help to lower the 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.

Affordability is another advantage as some mutual funds accommodate investors who don’t have a lot of money to invest by setting relatively low dollar amounts for initial purchases; and liquidity in that mutual fund so investors can readily redeem their shares at the current Net Asset Value (NAV) at any time minus any fees and charges assessed on redemption.

Among the disadvantages of mutual funds are: costs despite negative returns as investors are obliged to pay fees (such as sales charges, annual fees) regardless of how the fund performs; lack of control as 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; price uncertainty where unlike with an individual stock or bond where real-time pricing is available with relative ease, the price at which you can purchase or redeem shares in a mutual fund will typically depend on the fund’s NAV, which the fund may 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 U.S. and other world market currencies to the corporate, individual and institutional investor.

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