How to Invest in Funds
Are fund shares a good investment? The short answer is, yes. However, as with any investment, research and forethought will increase your chances of a high return. In this article, we'll take a look at the basics of investing in funds.
Miguel Cervantes is often lauded as the Shakespeare of Spain. In his canonical novel, Don Quixote, he wrote, “It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.”
Contemporary investors would likely reduce this aphorism to one word—diversification. Diversification is the financial manifestation of not putting all of your eggs in one basket. It is the opposite of dropping your savings into the current trending meme stock and hoping fortune favors you.
Savvy investors will seek to reduce risk or volatility by investing in a variety of assets. Recall the tremendous drop in value of travel and leisure related stocks during the global lockdowns of March 2020. For anyone with all their investments in airlines, it must have been a turbulent time. However, for investors with stakes in the travel and medical industries, it would have been a time for opportunity.
This kind of diversification allows you to adapt your portfolio to various market forces so that you can reap benefits from one investment, while holding out for better days on the others. Yet, the problem for hobby investors is that they often don't have the time to do their due diligence on various sectors, companies, and assets. The solution? Funds.
What is a Fund?
An investment fund is a financial vehicle that allows many individual investors to pool their money together in order to invest in various financial assets and instruments. Since these funds are held in common, they are often referred to as mutual funds.
Mutual funds offer a great opportunity for diversification because they are managed by professionals who are responsible for allocating the fund’s collective assets with the goal of maximizing capital gains. Each individual investor’s gains or losses are proportional to the size of their investment in the fund.
While funds are typically less risky than buying individual shares, money managers don’t win 100% of the time. Additionally, there are various types of funds, each with their own risk profile. For example, an index fund that broadly tracks the S&P 500® will likely come with less risk exposure than an exchange-traded fund (ETF) tracking growth tech stocks.
How Can I Buy and Sell Fund Shares?
To buy and sell fund shares you will have to set up an investment account if you don’t already have one. Unlike purchasing single shares, mutual funds typically require higher investment minimums.
Furthermore, shares of mutual funds can only be purchased at the end of the trading day and the share price does not fluctuate throughout the day. The fund will instead calculate the net asset value (NAV) after market close (4 p.m. ET).
The NAV represents the per share or unit price based on the net value of the fund after liabilities are subtracted. Therefore, if you have a $1,000 investment and the NAV posts a $50 per share value, you will obtain 20 shares.
Mutual funds typically charge fees that act as commission charges to pay brokers as well as an annual expense ratio based on a percentage of your investment. Fees will vary depending on your broker, so it would be wise to familiarize yourself with their terms of agreement before investing.
When you're ready to sell, you will do so through an authorized broker or the fund company. Your capital gains upon closing are based on the number of shares you have, multiplied by the NAV, minus fees.
Note that ETFs trade like stocks and do not require high investment minimums. Additionally, it’s possible to purchase fractional shares of a mutual fund, lowering your cost basis.
Types of Investment Funds
Each type of investment fund listed below operates with pools of capital provided by numerous individual investors in order to purchase securities and earn capital gains. Additionally, each is managed by a fund manager. Individual investors do not make investment decisions.
Now that we understand what places them all beneath the same umbrella, let’s dive into the details of each.
Most investment funds fall under the category of open-end mutual funds which are typically priced daily and issue new shares as new investors are added to the pool.
In contrast, closed-end funds are traded much like stocks, meaning that they operate with a fixed number of shares and trade on an exchange.
Exchange traded-funds, or ETFs, are relatively new financial instruments. They were developed in the 90s with the goal of providing individual investors with access to passive, indexed funds. ETFs trade on exchanges and can be traded through business hours. Some mutual funds even have ETF analogues.
Money Market Funds
Money market funds set themselves apart from other mutual funds by investing in things like cash, debt-based securities with a short-term maturity, cash equivalent securities, and other highly liquid, near term instruments. They are designed to be low risk and highly liquid.
Hedge FundsUnlike mutual funds and ETFs, hedge funds are only made available to accredited investors. Since they face less federal regulation, they are able to invest in a broader range of asset classes and implement strategies that would otherwise be ineffective.
The difference between mutual funds and money market/hedge funds should appear obvious from the descriptions above. However, new investors often have a more difficult time parsing the nuances between mutual funds and ETFs.
Difference Between Mutual Funds and ETFs
Of course, both ETFs and mutual funds represent professionally managed baskets of securities, but they differ in some important ways. For example:
- 1 ETF share can be purchased at market price, which may be as low as $50, while mutual funds typically require minimum initial investments that are not based on a flat dollar amount, rather than the fund’s share price.
- ETFs offer more control because they have real-time pricing along with more complex order types. In contrast, the price of a mutual fund share is typically calculated at the end of the trading day, and you will pay the same price as everyone else that day.
- Mutual funds offer automatic investments and withdrawals based on your particular preferences, while ETFs do not.
Luckily, you don’t have to choose between investing in either or. Diversification of asset classes is just as important as diversification of individual stocks.