How to Invest in Mutual Funds

The COVID-19 induced market volatility has put Exchange Traded Funds (ETFs) through their first real test since the 2008 Global Financial Crisis.

How did they perform? Remarkably. 🔥

Sector-equity funds have risen in popularity, collecting $3 billion of inflows in July alone. Specifically, investors have targeted tech mutual funds, as they offer exposure to the technology sector, and health, which the government increased its spending on throughout the pandemic. Both sectors could benefit from e-commerce, social distancing policies, remote working, and the research put into a coronavirus vaccine.

Despite original concerns of abandonment, the sustainability sector is up too. However, certain sectors were hit hard due to weak demand or government-imposed lockdowns, including natural resources and real estate. Actively managed funds in particular underperformed some passive benchmarks.

As a whole, ETFs are in high demand, and have proven their strength and resilience throughout the pandemic. More investors are looking to them to help diversify from regular equities, catch lucrative opportunities, and hedge positions & rebalance portfolios.

It’s no wonder then that you want to know how to invest in mutual funds. In this guide we’ll take you through a clear action plan to help get you started. First, we’ll outline exactly what you need to know before investing.

What is a Mutual Fund? 🤔

A mutual fund is an investment fund that pools money from investors to buy assets (otherwise known as securities) like stocks and bonds.

Professionals manage the holdings in the portfolio; people invest in shares depending on how the underlying securities perform in the fund.

Mutual fund investors buy shares in a company that buys shares in other companies (or in securities, or government bonds). Investors in mutual funds don’t own stock in the companies the fund buys, but they do benefits from the profits or get hit with the losses in the funds holdings at an equal amount – this is why it’s called “mutual” funds.

The difference between stocks and bonds is usually met with “why choose?” because of their conjoined benefit of creating a diverse portfolio.

How Do Mutual Funds Work? 📈

The fees and performance of a mutual fund are the same across all mutual fund categories, and are dependent on whether it is actively or passively managed.

Funds that are passively managed choose investment based on a set strategy. The performance of a specific market index is matched, and therefore little investment skill or management is needed. This ensures that passively managed mutual funds have lower fees.

There are two popular mutual funds for passive investors: 

The first involves Exchange-traded funds (ETFs): These are similar to individual stocks in that they can be traded, and they offer the added benefit of diversification. There are typically lower fees associated with these than more traditional mutual funds, but costs for might be too high for active traders.

Investors generally ask whether investing in individual stocks is still valuable when compared to funds, and while funds are falling out of favor, there are still some benefits to them. ETFs are on the verge of overtaking the crown from mutual funds for the first time ever. Mutual funds have been crowned as the kings of passive income, however, as index-tracking ETFs hit a record $8.66tn they are suspected to overtake the first place.

Another example of people moving from mutual funds to ETFs can be seen in what the Kaderli family has done, once they retired they had invested a lot of their pension fund into mutual funds and were quite happy in doing so. However, they have realised the fleeting power of mutual funds and have swapped to ETFs.

Index funds: These  track a market index like the Nasdaq or S&P 500. They are stocks comprised of a particular index, which means the risk mirrors the market, and so do the returns.

Actively managed funds have a manager or team making decisions about how to invest the fund’s money. Often they try to outperform the market or a benchmark index, but studies have shown passive investing strategies often deliver better returns.

Mutual Fund Fees 💰

There are two basic types of fees associated with mutual funds: Sales commissions and expense ratios. These are known as sales loads.

The expense ratios are made up of the cost of all ongoing expenses like operational costs and fund administration. These will be charged annually as a percentage of your overall assets.

As mentioned, passively managed funds are associated with lower expenses in comparison to actively managed accounts, because there are less overhead costs, and require less financial professionals. For this reason, comparing and contrasting is your best bet. 

Sales loads are the other big expense. These are commissions that you pay when you buy the share, and when you redeem it. These are paid to financial professionals, such as a broker, to buy the shares.

Mutual funds come in one of four structure types that will affect which fees you will pay:

Open-End Funds 💲

The majority of mutual funds are open-ended, meaning the number of shares or investors is unlimited. The NAV (Net asset value) per share rises and falls in relation to the fund value

The NAV per share rises and falls with the value of the fund.

Closed-End Funds 💸

There is a limited number of shares offered with closed-end funds during an IPO. There are significantly less closed-end funds available in comparison to open-end funds.

You can easily determine whether a fund carries commissions by “loads.”

• Load funds pay a commission to the broker that sold the fund, as well as the NAV share price.
• No-load funds, do not charge a sales commission for the purchase or sale of the fund shares. This is the ideal option, and they can be accessed through brokers like E-Trade and TD Ameritrade.

How to Define Goals and Risk Tolerance ⚠️

Before you choose a fund to invest in it’s important to identify your investment goals. Think about whether you have long term goals, or if you would like a more current income, for example.

Additionally, consider your risk tolerance. Can you accept significant swings in the value of your portfolio, or would you prefer to play it safer. Of course, the more risk you take on, the more you can potentially win, or lose.

Finally, look at your time horizon. Think about aspects like how long you’re happy to hold the investment for, and whether you anticipate any liquidity issues any time soon. The sales charges that come with mutual funds can eat into your return over the short term.

Therefore, an investment horizon of five years minimum is necessary to offset the impact of the charges.

Style and Fund Type 💵

The aim of growth funds, mainly, is capital appreciation. If you’re aiming for long-term returns and have a high risk tolerance, you could go with a long-term capital appreciation fund. These could offer greater returns due to the increased risk associated, and should be held for no less than five years.

However, financial planners now advise not to just forget about the mutual funds during this period, as investors would have done before, but to review your portfolio once every quarter or a minimum of once every six months to optimize returns.

Generally, there are no dividend fees associated with growth and capital appreciation. If you would like current income, you should consider an income fund. These funds are usually significantly less volatile.

Bond funds can be used to diversify holdings in your stock portfolio as they typically have a low or negative correlation with the stock market. However, bond funds also carry risk including;

• Interest rate risk: the sensitivity of the price of the bond to interest rate changes
• Credit risk: the potential that the credit issuer will have its credit rating lowered, which impacts the bond price.
• Default risk: the potential for the bond issuer to default on debt obligations.

However, bond funds are a good option for diversifying even a portion of your portfolio, despite the risks.

Size of the Fund 🏦

Typically, the fund size does not negatively impact its ability to reach the investment objectives set. However, it is possible for the fund to get too big. An example of this is the Fidelity Magellan Fund.

In 1999, it rose to $100 billion in assets and restructured the investment process to accommodate large investment inflows. Instead of buying smaller and mid-cap stocks, the focus was shifted towards large stocks. This hindered the performance of the stocks.

Look at the Key Factors 🏦

Instead of looking at the past to help make your decision, take into account the factors that will influence its results going forward. With this in mind, we can look to Morningstar.inc, a top investment research firm.

Morningstar has recently brought in an updated grading system based on performance, process, people, and price. The rating system looks at the expense ratio, the fund’s investment strategy, the longevity of its managers, among some others. Each fund is graded into neutral, bronze, silver, and gold.

One factor that needs to be taken into consideration, is fees. Lower fees consistently correlate with a strong performance. This is a key reason why index funds are so popular.

Mutual Funds in a Recession 📉

The ripple effects of a COVID-19-induced market sell-off has caused a fast and hard decline in the economy. This has resulted in some uncertainty around how to treat mutual funds, but don’t let your emotions get in the way.

Studies show sectors like pharma performed as the government increased its spending on healthcare and US FDA approvals quickened. In an anti-China wave, chemical stocks gained while highly valued banks in the private sector fell due to fears NPAs would rise as a result of the pandemic.

However, one thing is certain when it comes to investing during the pandemic – the quantity of investments has significantly increased due to stimulus checks being used for investing.

Overall, though actively managed funds were expected to outperform the downturn, they underperformed several passive benchmarks, instead. From 19th February to April 30th we saw mutual funds underperform their passive benchmarks. 

When measured against the S&P, we see 1.74% of mutual funds underperform the S&P 500 with a -5.6 underperformance on average over the ten-week period, or an annual underperformance of -29.1%. While some did expect investing based on social goals to be abandoned, sustainable investing is up, and performing well. This shows that sustainability is now seen as a necessity rather than a luxury good.

Mutual funds are typically known for buying and holding, so it’s normal to hold your mutual fund during a bear market. Of course, it’s normal to want to protect your mutual fund when faced with uncertainty from volatile conditions, but some think it might be wise to sell now and return when the market is lower. This is a risky move and could lead you down a path of irreversible losses.

Actions to Take During Volatility 💳

You can’t control how volatile a market is, so focus on what you can control – the level of risk your portfolio is exposed to.

We also have a lot of control over our spending. This will have the biggest impact on how successful your strategy is. Keep track of what you’re spending, now is a great time to look at it. Estimating amounts can be difficult, but move in the right direction.

If most of your spending is done on your credit or debit card, look at your annual statement as a starting point.

In the short term, if you’re uncomfortable with a volatile market, ignore paying attention to any daily fluctuations. If you are fortunate enough to still have a job then keep contributing towards your 401(k), which in it of itself is is often targeted by new legislation. 

Ultimately, the two components that will impact your investing strategy is your risk tolerance and time horizon. If the valuations of your mutual funds are decreasing, reduce the mutual fund shares you hold in stocks to limit volatility and increase your exposure to bonds. 

The pandemic has left many in a state of shock and vulnerability to the unknown, but emotions can come into play when it comes to how portfolios are managed. Despite the volatility, understanding that a mutual fund is a balanced investment will help ease your worry and keep you on top of your investment goals in the long-term.

How to Invest in Mutual Funds ⭐️

Before we start with the actual steps you need to get your priorities straight, make sure you know what you want from investing in mutual funds. When you have a clear plan you can move on to the first step.

Step 1: Choose Between Passive & Active Management 🥇

Determine whether an active or passive fund is best for you. Active funds are managed by professionals who decide which assets and securities to put into the fund.

The aim of an active fund is to outperform a benchmark index and so they have higher fees than passive funds. Expense ratios can start at 0.6% and go up to 1.5%.

Passively managed funds, also known as index funds aim to track and mirror the benchmark index. These generally come with lower fees than actively managed funds, with expense ratios started at 0.15%. Assets are not traded very often with passive funds unless the benchmark index composition changes.

Step 2: Research Past Results and Evaluate Managers 🥈

As with all investment prospects, make sure you research how the fund performed in the past. Consider asking yourself whether the results were consistent with general market returns and whether the fund was more volatile than major indexes?

With this, conduct a review of the investment literature. Look to the fund’s prospectus to get a better idea of the prospects for the fund and its holdings in the coming years. The discussion of the industry in general and market trends that may affect the performance of the fund. Knowing how to properly research stocks can be tough because it is complicated—so be sure to familiarize yourself before diving in.

Step 3: Decide Your Budget 🥉

When choosing a budget, keep in mind that patience will do wonders for your bank account. As we mention above, investing your money for a minimum of five years is a good rule of thumb to overcome any downturns.

You can take these two things into consideration to help you decide: 

How Much is Necessary to Start? 💶

There is often a minimum deposit requirement that has to be met if you want to open an account with a mutual fund provider. Though there are brokerages that have $0 account minimums, other brokers often require hundreds, if not thousands of dollars to open an account.

How Do I Invest the Money? 💷

As we’ve highlighted a few times now, the main benefit of mutual funds is that they offer an affordable means of diversifying your portfolio.

Step 4: Choose Where to Buy Mutual Funds 🏅

In our modern world, the process of buying stocks has become fairly simple. Investing in mutual funds is a different story because you don’t necessarily have to open an account with a brokerage.

If you’ve opened a tax-advantaged retirement account like a 401(k) for example, or some other form of workplace-related retirement account, you’re probably already a mutual fund investor. Another option is to buy shares straight from the fund provider – companies like BlackRock Funds or Vanguard.

However, for a vast majority of people, your best bet is probably to go open an account with an online broker, where you can access a wide range of funds to choose from. To help you choose the best broker, look out for the following:

Fees 📊

When investing in mutual funds you will come across two types of fees: Brokerage account fees, like account maintenance fees, and fees associated with funds, like expense ratios.

Ease of Use 🥧

Choosing a broker with an easy-to-use website and a great investment app will make a huge difference to your experience. The more difficult it is to use its platforms the easier it will be to mess up. If you decide to invest in stocks, we have a list of the most popular stock trading apps, too.

Choosing a Mutual Fund 👥

Choose your funds wisely, and make sure there is enough variety to choose from. Your workplace retirement plan, for example, might only have a small selection to choose from—but mutual funds are the most common investment of choice for millennials. 

Quite a few brokerages give clients access to thousands of transaction-free funds. You may also choose from other fund types, including ETFs, which will offer the diversity you need along with the flexibility of being traded like an individual stock, and target retirement funds, which reallocate the assets to become less risky as the target date approaches, while still achieving the desired returns.

Market Research and Education🔍

While a bigger selection most certainly is the ideal scenario, this means that you will also need to put in more time researching and identifying the best one. It’s important to choose a brokerage that will assist you in learning more about the fund before you make a decision.

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