Why Should You Invest In Mutual Funds?

Why Should You Invest In Mutual Funds?

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Mutual funds are one of the most common investments. In 2020, 45.7% of US households owned mutual funds. If you have a professionally managed retirement account, you are likely already invested in mutual funds.

If you want to take advantage of these common financial instruments, it will pay to understand what they are and why they are so popular. Let’s go over how mutual funds work and the exact reasons why so many people invest in them.

What Is A Mutual Fund?

What Is A Mutual Fund?

A mutual fund is an investment vehicle. It’s a pool of money that many different investors contribute to. So, different investors can combine their money and share in the return on investment. The risk is thus split between many individuals, and so are the rewards.

There are many different mutual funds and they can contain any number of individual securities. Mutual funds typically contain:

  • Stocks
  • Bonds
  • Money market securities
  • Commodities
  • Other securities

The idea is that a professional money manager chooses which individual securities go into the mutual fund. The managers will receive some form of compensation for their professional services. Investors normally pay for this in the form of annual fees known as “expense ratios”. Other mutual funds also charge commissions.

You, the investor, benefit from the manager’s expertise. You don’t need to individually scrutinize securities, as you’ve outsourced this job by investing in a mutual fund. Mutual fund returns are determined by the abilities of money managers.

Types Of Mutual Funds

Most mutual funds are dedicated to a specific kind of security or even a specific industry. For example, there are stock funds, which are mutual funds that contain a mixed bag of stocks. Likewise, there are bond funds, money market funds, and so forth.

The next way mutual funds are separated is by their goal. For example, there are several different kinds of stock funds including:

  • Growth Funds: These funds contain stocks that typically won’t pay out a dividend, but which are deemed likely to achieve above-average gains.
  • Index Funds: These funds track a specified market index. For example, some of these mutual funds track the S&P 500.
  • Sector Funds: These funds include stocks in a specific industry segment. For example, gold mutual funds only include stocks in companies that mine and trade in gold.

Top-Level Financial Instruments

Top-Level Financial Instruments

The main advantages of mutual funds are their consistency and ease of use.

Mutual funds are popular for their hands-off approach. At the same time, you can choose to invest in a fund that focuses on an industry or index of your choice. This offers you a well-regulated investment that helps you achieve your own financial goals.

Dividend Investing

Dividend investors can choose mutual funds that provide the highest possible dividend payments. Mutual fund dividends can be produced through dividends from stocks or interest on bonds. Mutual funds will normally account for managerial expenses and then divide the profits among the shareholders (mutual fund investors).

Capital Gains

Mutual funds contain individual securities which may increase in value over time. When a money manager sells a security at more than it was purchased for, the whole fund experiences mutual fund capital gain. Many mutual funds distribute these capital gains annually after accounting for expenses.

Net Asset Value (NAV)

NAV represents a mutual fund’s per-share market value. Some mutual fund managers seek to maximize NAV. A higher NAV means a higher value for your investment.

Balance

These are the three ways in which mutual funds produce money for investors. All mutual funds carry some risk, as they are all financial instruments comprised of multiple securities. But mutual funds are widely embraced for the balance they offer between stability and potential profits.

Mutual funds are instruments that people invest in for a wide range of purposes. The returns they produce are normally higher than less risky options, but lower than high-risk strategies such as concentrated or momentum-based direct investment. This means that the average investor can benefit from professional expertise and moderate-risk, moderate-reward investments.

Long Term Investment Opportunities

Long Term Investment Opportunities

Because of their design and pace, mutual funds are typically embraced as a long-term investment option.

One of the most common uses for mutual funds is retirement planning. Mutual funds are a common instrument in retirement accounts due to their normally steady returns. While there are no guarantees, mutual funds normally exceed inflation rates and foster a decent nest egg for retirement. According to data collected from Morningstar, the average 15-year return for a mutual fund in 2020 was 5.89%.

The benefits of mutual funds include the combination of steady returns and hands-off investing. This makes mutual funds an appropriate addition to many kinds of long-term portfolios. Retirement, education savings, and savings for making a down payment are common purposes for mutual fund investment.

Reliable savings

Mutual funds can also be used to build up your savings. If you have a savings goal, mutual funds can help you get there. This is especially true for long-term savings goals.

If you are already regularly depositing money into a savings account, you could mix it up and invest a portion of that money into a mutual fund. Savings accounts are a great safe way to hold onto your money while saving, but they don’t normally produce anything apart from a very small annualized interest rate that doesn’t even come close to the inflation rate. As a diversification tool, mutual funds can be incorporated into a savings plan.

Pension plan vs mutual fund

Pension plan vs mutual fund

Mutual funds are often thought about alongside retirement plans. In fact, you’re far from alone if you first heard about mutual plans from a financial advisor during a talk about retirement planning.

While it needn’t necessarily be the case, you may be wondering which is better: a regular pension plan or a self-directed mutual fund investment.

Pension Plan Investments

Most employer-sponsored pension plans contain low-risk securities. For example, government securities are common pension plan investments. Government-backed debt securities often come with guaranteed returns. For example, US Treasury Bonds are guaranteed by the government.

Some pension plan managers have a higher risk appetite. But pension plans that you don’t direct will normally be safer. Pension plans tend to favor fixed income investments like US Treasury securities. Other common investments include blue-chip stocks and passive real estate securities like REITs.

Self-Directed Investment

If you have the time to educate yourself on mutual funds and the individual securities they contain, it can make sense to open a self-directed IRA or another self-directed account. In this case, you would have complete control over your investments and could invest in any mutual fund you choose.

If you’re risk-averse, it makes sense to pay attention to what pension plans invest in. But you will need to investigate mutual funds to make sure they invest in a way that lines up with your risk appetite and long-term financial goals. In doing so, you must consider mutual fund taxes. Mutual funds taxability varies widely by jurisdiction, so you must also consider the tax obligations and any applicable deductions (capital losses, etc.)

When you start exploring mutual funds, you will quickly notice they vary greatly in terms of securities and overall risk appetite. That’s why it’s normally considered riskier. However, your bank’s financial advisors would likely be happy to walk you through your options. You should still educate yourself before speaking to them. Making the right choice for you when it comes to mutual funds requires you to understand:

  • Risk capacity
  • Risk tolerance
  • Asset allocation (difference between asset classes)
  • The different types of mutual funds
    • Debt funds
    • Equity schemes
    • Growth schemes
    • ETFs

It’s always recommended that you speak with a certified financial advisor before making a mutual fund investment.

How to save tax by investing in mutual funds

How to save tax by investing in mutual funds

Among the advantages of investing in mutual funds, that they can easily be used for tax-efficient long-term savings and investment strategies. A long-term capital gain on mutual funds will normally be taxed at a lower rate than a short-term capital gain. Your mutual fund tax rate will normally be the same as other capital gains rates.

Mutual funds are often used for retirement planning. In addition to the high annual returns they normally produce, you can take advantage of immediate tax savings. Mutual fund investment through a retirement account like America’s IRA or Canada’s RRSP enables you to claim tax deductions for the year the investment was made. For example, if you invest in a retirement account in 2020, you can deduct the investment on your 2020 tax filing in 2021.

Tax-sheltered retirement accounts provide ongoing tax relief. Your mutual fund investments are immediately tax-deductible. Then the profits you make on those investments are also tax-advantaged.

Traditional IRA

With a traditional IRA, mutual fund yields are not taxed while in the account. Once you withdraw the funds in retirement, you will pay regular income tax on your withdrawals. This is a double-edged sword, as long-term capital gains taxes are normally lower than income taxes. However, retirement income is normally smaller than the income you’d produce from full-time employment. This makes mutual fund investment in a traditional IRA a great way to defer taxes.

Roth IRA

If you prefer, you can pay your taxes on mutual fund profits now, then deposit them into a Roth IRA. Roth IRAs are filled with after-tax funds. So, you can pay capital gains taxes and then withdraw your savings in retirement tax-free.

Other Options

You can explore other options available to you. Americans have access to other non-employer-sponsored retirement accounts or employer-sponsored plans where you still maintain control over the investments and their risks.

If you reside in a different country, you can likely take advantage of tax-advantaged mutual fund growth. For example, the UK offers similar benefits in a SIPP, and in Canada, you can do the same with an RRSP.

Mutual fund dividends

Mutual fund dividends come from funds that invest in dividend-paying or interest-paying securities. These gains are then passed onto mutual fund investors.

Mutual fund money managers often focus on maximizing dividends from the fund’s investments. Many of these funds aggregate dividends from several individual stocks that are either reinvested or directly paid out to shareholders. If you share their appreciation for monthly dividend paying mutual funds, you have many options to choose from.

Several index funds focus on stocks that pay higher than average dividends. One example is The Vanguard High Dividend Yield Index Admiral Shares (VHYAX). This index invests in company stocks that pay high dividends. This fund features a low minimum investment of $3,000 and a very low expense ratio of 0.08%.

High dividend mutual funds are naturally appealing to many investors. If your priority is constant income, these are the funds you will want to focus on.

Average Mutual Fund profitability

As we discussed before, according to data collected from Morningstar, the average 15-year return for a mutual fund in 2020 was 5.89%. However, there is something funny that all the data shows when it comes to mutual fund profitability: generally, the longer the mutual fund investment, the lower the returns. However, there are several exceptions to that as well.

At the time that same study was conducted, year-to-date returns for mutual funds in 2020 averaged 9.51%. The average (mean) 5-year returns were 8.17%. However, even this doesn’t complete the picture.

If you eliminate short-term bonds mutual funds, the average returns rise noticeably. Some kinds of mutual funds also perform abnormally well. This is particularly true of US large-cap stocks, which produced an average return of well over 11.5% no matter which measurement of time you chose. Many mutual funds can boast of steady long-term returns of over 12%.

Mutual fund profitability can be a controversial subject. The figures you get can vary widely and no investments are free of risk. By selectively ignoring certain data, you can easily make mutual funds look much better or worse than they actually are. That’s why understanding individual security types and broader economics is so important.

We cannot set your expectations given the diversity in mutual funds you can choose from. But it’s reasonable to hold mutual funds to a high standard of at least 6% average returns over a period of a year or more. The only exceptions are international stocks mutual funds and short-term bonds mutual funds, which tend to produce much smaller returns.

As always, no mutual fund is without risk and there are no guarantees of any specified returns. No financial professional will offer you any such guarantees. Past performance is not an indication of future results. However, it makes sense to refer to past results as a measure of a mutual fund money manager’s demonstrated level of competence.

Mutual Fund markets overview (North America, Asia, Europe briefly)

Mutual Fund markets overview (North America, Asia, Europe briefly)

There is extensive data available on the state of the mutual fund markets. However, this data is typically provided on a regional basis.

Let’s have a look at the largest mutual fund markets in the world.

North America

North America has one of the most dynamic and trafficked mutual fund markets in the world. The US mutual fund market alone contains more than $21.3 trillion in total net assets (2019). Overall, private research suggests a high reliance on mutual funds on the part of US households as a tool for retirement preparation. Mutual funds are also very well-represented in institutional investment, including business investment. Money market funds are particularly popular as a source of high short-term yields and high liquidity.

Canada shares many similar trends as the US when it comes to mutual funds. However, Canadians suffer from one of the highest average mutual fund fees in the world. Despite that, there are many independent fund companies offering great service at a reasonable cost.

Europe

European mutual funds come in the regulatory forms of UCITS, AIFs, and PEFs. While these regulatory bodies cover the entire EU, individual countries have their own regulations, which makes the European mutual fund market more complex than its North American counterpart.

Regardless, the mutual fund market in Europe is massive, standing at EUR 15.68 trillion for Q1 of 2020. Since then, the total value of the market has diminished significantly as a result of the COVID-19 pandemic.

Overall, when compared with the US mutual fund market, in-depth research reveals a few stark contrasts:

  • European mutual funds lag behind US counterparts for asset size, average fund size, and overall market importance. Mutual funds are less significant to European individuals and institutions.
  • Fewer companies have control of the greater bulk of the mutual fund market in Europe. In individual countries, a few large domestic fund groups offer the majority of mutual funds open to the public.
  • European mutual funds, while lagging in fund sizes and individual asset sizes, outperform their US counterparts, particularly US small-cap mutual funds.

Asia

Mutual funds in Asia are concentrated in a select few markets. Singapore and Hong Kong mutual fund exchanges alone account for the vast majority of mutual fund assets in Asia. However, several large Asian economies have experienced high growth in their mutual fund markets since the 2009 global recession. However, Asia, when looked at in its entirety, is an exception to the trend of explosive growth in the worldwide mutual fund market.

In several Asian economies, notably India, Taiwan, Hong Kong, China, South Korea, and Singapore, mutual funds are embraced as the main method of saving money by larger swathes of the population. However, these are still small sample sizes.

In China, only 5% of the countries’ domestic household savings were held in mutual funds in 2021. The shift to stock funds has been slow but steady in Asia, as middle-class households in economies like India shift away from traditional assets like gold and residential real estate.

Start Trading Mutual Funds On MF Trader

Mutual funds are a balanced investment for many people and households around the world. They offer a fairly high rate of growth while allowing average individuals to profit from the expertise of professional fund managers.

If you want to make the most out of your mutual fund investment opportunities, you can take advantage of cutting edge trading software. Consider using Mutual Funds Trader software by Boston Unisoft Technologies.

Boston Unisoft is a fintech software developer that specializes in innovative financial applications. Our software is used by mutual fund investors, fund houses, and fund owners. Private investors and financial organizations can use MF Trader to invest and resell mutual funds.

Try the MF Trader client interface or contact us to schedule a full platform presentation.

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