Mutual funds offer an efficient means to invest in diverse companies, industries and investment types. Investing in individual stocks or bonds of a single company can expose investors to unacceptable levels of risk. Mutual funds allow investors to spread this risk by investing in hundreds or even thousands of securities.
There are two main types of mutual funds. The first is the open-ended mutual fund, which can issue new shares to buying investors. The proceeds from the sale of these shares are used to purchase additional securities and expand the fund. When investors want to sell their investments within an open-ended mutual fund, the fund will buy back or redeem existing shares. This may require the sale of securities to raise cash, and the size of the fund may decline. Open-ended mutual funds can be purchased from a mutual fund company, sponsor, or through a broker that sells shares on behalf of a mutual fund company and earns a sales commission.
The second type of mutual fund is the closed-ended mutual fund, which has a limited number of outstanding shares. Money is raised, and shares are issued when the fund is launched; but new shares are rarely issued thereafter. Moreover, the mutual fund company will not repurchase or redeem shares until the fund is closed and liquidated. The shares of closed-ended funds are usually traded on stock exchanges, and like stocks, buying and selling takes place between parties brought together by a broker or market maker.
Risk
Mutual fund investors can lose money if the fund’s portfolio underperforms, resulting in a decline in the fund’s net asset value (NAV). Additionally, if an investor sells mutual fund units for less than what they purchased them for, they will realise a loss. Investing in mutual funds comes with certain risks and investors may experience losses in various scenarios:
- Market risk: Mutual funds invest in a diversified portfolio of securities, such as stocks, bonds or a combination of both. The performance of the fund is subject to market fluctuations, and if the underlying securities in the portfolio underperform, the fund’s net asset value (NAV) can decline. Market risk arises from factors such as economic conditions, interest rates, geopolitical events, and investor sentiment.
- Investment style risk: Different mutual funds follow various investment styles, such as growth, value or income-oriented strategies. If the chosen investment style does not perform well during a particular market cycle, the fund’s returns may suffer. It is important for investors to understand the investment approach of the fund and align it with their investment objectives.
- Managerial risk: Mutual funds are managed by professional fund managers who make investment decisions on behalf of the investors. The performance of the fund largely depends on the skill and expertise of the fund manager. If the manager’s investment strategy or decisions do not yield favourable results, it can impact the fund’s returns and potentially lead to losses.
- Expenses and fees: Mutual funds charge fees for managing the fund, including management fees, administrative expenses and sales charges (load fees). These fees are deducted from the fund’s assets and can reduce the overall returns for investors. High expense ratios can erode the fund’s performance and potentially result in losses for investors, especially if the fund’s returns do not adequately compensate for the fees.
- Redemption risk: Mutual funds allow investors to buy and sell fund units on any business day. However, if a large number of investors decide to redeem their units during a market downturn or volatile period, it can put pressure on the fund’s liquidity. In such cases, the fund may need to sell securities at unfavourable prices to meet redemption requests, which can impact the fund’s NAV and potentially lead to losses for remaining investors.
It is important for investors to conduct thorough research, evaluate the fund’s historical performance, consider their risk tolerance, and diversify their investments across different mutual funds or asset classes. Additionally, understanding the fund’s investment objectives, strategy, and expenses can help investors make informed decisions and manage the risks associated with investing in mutual funds.
