Funds for Beginners (part 1)

Funds for beginners – that will be the topic of today’s article.

In this article, we will discuss almost every financial term related to funds such as mutual funds, fund platforms, and other important aspects. By getting to know about these terms, you will get a clear picture of what funds mean and how you can invest in them.

Nothing written here should be considered formal tax, financial, legal or any other kind of advice advice, and is written for entertainment purposes only, in other words isn’t a solicitation to invest.

For any questions, or if you are looking to invest as an expat, you can contact me using  this form, or use the WhatsApp function below.

Fund definition: 

To begin with, let us know what a fund means (general definition). A fund is a certain amount of money that is available at present. 

A fund can be anything such as a government setting some money aside for developmental activities or a person setting some money aside for dealing with emergencies.

Individuals, Governments, Business Entities, etc., use funds to deal with expenses or keep some money aside as a rainy-day fund for coping with any unexpected expenses.

Some of the general types of funds (excluding investments) include Emergency Funds, College Funds, Trust Funds, and Retirement Funds. Let us discuss each of these funds individually.

Emergency Funds – Emergency funds could be said as personal savings kept aside by individuals for dealing with financial difficulties like job loss, medical emergency, long-term illness, or a huge expense. 

The general idea while creating an emergency fund is that it should have an income that is equivalent to at least three months of the net salary (the more the merrier).

College Funds – College funds are the savings plans that come with tax benefits and are set up by the families for saving funds toward the expenses related to their children’s college education.

Trust Funds – Trust funds are a type of legal arrangement, where money is allocated by an individual (grantor) by appointing a trustee.

This trustee must take care of the valuable assets for the benefit of a listed beneficiary for a specific period. 

Upon completion of this period, all the funds or a portion of those funds are to be passed over to the beneficiary or beneficiaries.

Retirement Funds – As the name suggests, Retirement Funds allow individuals to save money towards their retirement. 

People who have contributed money for their retirement funds would generally receive income monthly, or else, they receive pensions from those specific retirement funds.

Having known about the common terms related to funds, now let us see the different types of funds related to investments.

Types of Funds (Investments):

Mutual Funds: 

When it comes to investments, the first and foremost thing that pops into our minds is ‘Mutual Funds’. So, what exactly do mutual funds mean?

Well, for beginners, mutual funds are a type of investment. These types of investment vehicles are created by entities known as asset management companies or fund houses.

These entities combine/pool the funds gathered from various individuals and institutions, who have the same type of investment goals. 

A financial expert known by the name of ‘Fund Manager’ takes care of the pooled funds as an investment. 

This means the fund manager would invest those funds in financial instruments such as stocks, bonds, etc., which are considered to follow all the instructions for being considered as a legal investment.

Mutual funds could be considered as an efficient investment opportunity for individual investors who want to get broad exposure to a portfolio that is managed by financial experts. 

Adding to that, people can diversify their portfolios with the help of investing in mutual funds. By doing so, the asset allocation would comprise many instruments. 

People would be assigned fund units depending on the money they invest. In that way, every individual investor would experience gains or losses based on the amount they invest. 

The primary objective of a fund manager is to obtain robust returns to investors by investing in securities that are the same as the fund’s objectives. 

In any given case, the overall performance of mutual funds is based on the underlying assets in the respective fund unit.

More on Mutual Funds – Unlike traditional stocks, mutual funds do not invest in a specific share. Rather than that, a mutual fund strategy would comprise of investing in several investment options so that investors can be offered the best possible returns. 

One important thing is that investors are not required to do their research to pick the best-performing stocks. Even if these investors wanted to do so, they can’t.

The fund manager, along with a team of financial analysts as well as market researchers do all the necessary processes and come up with the top-performing investment options that are expected to have more profits.

As we mentioned earlier, people would be allocated fund units that are proportional to the money they’ve invested. The profits that an investor can obtain would usually be based on the fund units held by them. 

Every individual fund unit has access to all the securities that are included in the portfolio by the fund manager. Unlike shares, fund units do not provide investors with any sort of voting rights regarding any company in the portfolio.

Investors won’t have to worry about the risk involved with investing in the mutual funds because the fund manager decreases the risk by investing the pooled money across various instruments. 

Hence, we can clearly say that investing in mutual funds is a good way for you to diversify your investment portfolio. 

The cost of the fund unit in a mutual fund scheme is called the ‘Net Asset Value (NAV)’. Based on this price, you can either buy or sell fund units of the respective mutual fund scheme.

The price for the NAV of a mutual fund is obtained by dividing the total worth of assets in the portfolio while subtracting liabilities. The mutual fund units in a particular scheme are bought/sold according to the existing NAV.

There are different types of mutual funds, among which, we’ll discuss the three major types of mutual funds now.

Types of Mutual Funds:

1. Equity Funds:

If you are new to the investment field, you might not be familiar with equity funds, yet learning about them is very essential for becoming a good investor. By learning what they are and how they work, you can reap more benefits when you make an investment in them.

Also known as Stock funds, equity funds are mutual funds that consist of investments primarily related to stocks, instead of other securities like bonds. Equity funds can be managed actively, or they can be passive (index funds).

An equity fund can either be an open-end fund similar to a mutual fund or an ‘ETF’ (Exchange Traded Fund) or it can be something more like a ‘Unit Investment Trust’.

Note – We will discuss ETFs in a few moments, meanwhile, you must know about UITs. Unit Investment Trust is an investment company/investment fund, which offers a fixed portfolio containing investment vehicles such as stocks, bonds. These are provided as redeemable units and are only available for a specific period. People can benefit from the capital gains and/or they can earn dividend income by investing in a UIT.

Equity funds use the pooled funds for buying part ownership in the company, which is a publicly-traded stock in most cases. That’s why the name equity became a part of equity funds.

The fund may choose the stocks in equity funds, which depends on the primary objective, investment goals, and investment strategy which are known to vary.

For example, let us take a fund named ‘Fund X’, which follows the strategy and style of growth investment. For that, Fund X would invest in small-cap stocks, which are known to be having a lot of risks. This is because small-cap stocks are highly volatile compared to large-cap stocks. 

Why? Well, imagine there is a small company that sells packaged food and then there is Apple (the tech giant). The small company’s stocks are small-cap stocks, which means the company has a market cap of $300 million. There is no need to say anything about Apple’s market cap (2.11 trillion).

Of these two companies, which one would you consider to be the one to stop their business if they had any financial difficulties? Yes, of course, the small company. 

That’s why small-cap stocks are more volatile compared to large-cap stocks as the companies of large-cap stocks are the big players in their respective industries and can deal with most possible problems (financially).

Therefore, when you invest in Fund X, you would have to deal with the risk of volatility. The common factor for all equity funds is capital appreciation (or the term you recognize is capital gains). 

The investors could only profit from the equity funds when there has been an increase in their investment value. On the contrary, investments such as bond funds are created in such a way that they accrue income to the investor.

Equity funds could be categorized on the basis of three different aspects, which are given below.

• Stock funds that concentrate on market capitalization
• Stock funds that concentrate on geography
• Stock funds that concentrate on the specific investment style.

Equity funds concentrating on market cap – Market capitalization is an important aspect while determining a business’s value depending on the share price as well as the number of outstanding shares. 

These types of equity funds can be further classified based on their companies’ capitalization ranges, which are as follows.

• Mega-cap equity funds (≥$200 billion)
• Large-cap equity funds ($10 billion to $200 billion)
• Mid-cap equity funds ($2 billion to $10 billion)
• Small-cap equity funds ($300 million to $2 billion)
• Micro-cap equity funds ($50 million to $300 million)

Equity funds concentrating on Geography – These types of funds use the pooled funds to make an investment in more than one region of the world. Like the funds concentrating on market cap, the equity funds concentrating on geography are also classified into further groups, which are as follows.

• Global equity funds

Global equity funds, which are also known as worldwide equity funds used the pooled funds for investing in companies all over the world, along with those operating in countries such as the United States. 

Differences between domestic and international assets are avoided wherever the portfolio manager or the investment strategy implies it to be so. To be precise, some funds invest in stocks in U.S. firms as much as they invest in domestic equity funds.

• International equity funds

International equity funds strictly invest in the stocks of the companies that are located outside the country of residence (overseas only).

• Regional equity funds/Country equity funds

Regional equity funds invest in the stocks of the companies located in the country of residence. However, a slight variation exists between the country equity funds and regional equity funds.

For example, if a fund invests in stocks native to India could be mentioned as a country equity fund. At the same time, if the fund invests in Asia, then it would be referred to as a regional equity fund.

Equity funds concentrating on a specific investment style – When it comes to equity funds concentrating on a specific investment style, there happen to four different types of methodologies.

• Sector-specific/Industry-specific equity funds

These funds follow a strategy where investments are made in the top-performing stocks belonging to a particular industry or a sector in a top-down manner.

This can be quite satisfactory for the investors who are interested in investing their money in some specific types of businesses. This might not be considered a bad idea because certain industries have been known to provide higher returns to investors.

• Equity income funds

Equity income funds make use of a bottom-up strategy by acquiring ownership of businesses that are known to pay more dividends. In simple words, these funds tend to concentrate more on the income rather than the capital gains.

• Growth funds

Instead of focusing on income like the equity income funds, growth funds focus on the growth strategy. These funds invest in stocks that are known for their efficiency in offering profits, having growth, and would continue to be that way in the future as well.

A good example of growth funds would be the funds that invest in stocks related to the tech sector.

• Value funds

Funds investing in stocks by adopting the value strategy are known as value funds. These funds are known to invest in stocks that are currently undervalued and are expected to grow effectively in the future.

Investing in Equity funds: 

If you want to invest in equity funds, then you would have to be attentive to some of the important aspects before continuing to do it. Let us take a look at things to do before investing in fund offerings and how can you be able to invest in equity funds.

Things to consider – after becoming confident on investing in equity funds, you would generally be checking the fund offerings from major providers for the following.

• An equity fund should be less expensive based on the expense ratio and the lack of sales load.

• Less turnover or no turnover at all in the underlying fund portfolio.

• An investment strategy that complies with your financial and investment goals.

• Diversified portfolio

• Portfolio managers should invest most of their assets in the same investments as you, which makes them perform well and acquire more profits.

• The fund’s investment pattern should be clear for you, which lets you understand the types of assets acquired by the fund, the reason for acquiring those assets, and the reason for selling them.

• A stable portfolio management history.

You can also check for the fund rankings online, which is even more helpful. After successfully narrowing your list of investments, make sure you read the mutual fund prospectus and additional information.

By reading those, you will become informed about the mutual fund plan and how it plans on using your invested money. This process can become a bit complicated, and therefore we suggest you take the help of a professional investment planner (such as us).

How to invest – coming to the process of investing in equity funds, you have different options.

You can open an account with a reputed mutual fund provider such as Vanguard, Fidelity, etc.

You can create a brokerage account and purchase the shares of an equity fund using it.

You can buy the shares of an equity fund with the help of a 401(k) or 403(b) plan offered at your employment.

You can open a Roth IRA or a Traditional IRA at a brokerage account and make use of it for buying the shares of an equity fund. 

Finally, you can acquire the help offered by us, and by doing so, we will also assist you with all your investments by charging very little compared to what other investment planners and financial advisors charge. Click here.

Equity funds and ETFs distribute all the dividends (if there is any) to their respective shareholders every year and therefore, you must check your total returns instead of just the share price. 

Usually, most mutual fund companies and brokerages allow you to reinvest your dividend income automatically. This is usually done in whole or done partially, which allows you to have more shares.

In general, most mutual funds require an amount of at least $1,000, or else you can pay an amount as low as $100 monthly as an automatic investment. Some ETFs copy the equity mutual funds and you can trade with them for lower fees.

2. Fixed Income Funds (Bond Funds):

‘Fixed Income Funds’, which are also called ‘Bond Funds’ are another type of mutual funds where the pooled funds are used by corporate entities or government institutions for clearing their debts.

In return for the invested money, the investors are provided with income in the form of dividend payments. Usually, bond funds are considered a key aspect of a portfolio as they increase the total returns of an investor when other investments such as stock funds decrease in value. 

How do they work – even if you are a person having a very little amount of knowledge related to investments or are an advanced investor, it is very important for you to know how bond funds work.

In simple words, Bonds are the loans offered to entities in return for interest payments on the invested amount. The returns on bonds are affected by the interest rates that fluctuate based on international and national economic swings.

Bond funds came into existence for allowing investors to pool their invested money and use it for investing in bonds. These are managed by a professional manager, who tries to generate the highest possible returns.

To invest in bond funds, you must get familiar with the process of how bonds operate.

To begin with, when you buy a bond, you are considered the lender. The government/corporate entity that issued the bond must pay you the borrowed money along with interest. 

One should not compare this income with dividends, instead, it should be considered as interest that is paid to a bank when a loan has been obtained. This means you are the lender like a bank, and you receive interest on your money.

For instance, a bond pays interest known as a ‘coupon’ to the bondholder at an agreed-upon interest rate for a specific period known as a ‘term’. 

If it is held until the maturity period, the entity that issued the bond doesn’t default and the investors would receive all their interest payments along with the principal amount by the end of the term.

This process reduces the risk involved with the investment and therefore considered to be a form of fixed-income investment.

You should always try to understand bond risks along with the relationship between bond prices and interest rates. The interest paid by an entity to the bondholders primarily depends on the term, the credit rating of the entity issuing the bond, and the existential interest rates for such loans during that time.

The general interest rates in the market and bond interest rates vary a lot. The interest rates for a bond are the interest payments or the yields of that respective bond. 

In general, bonds come with the risk of default. Hence, a bond having a longer term would provide a higher interest rate. This is because longer terms tend to be riskier and bond buyers should find bonds as an attractive investment that compensates them for the risk of default.

At the same time, when an entity issues many bonds, the risk of default increases. In such cases, we can observe the fact that a company is increasing the amount of debt it keeps. 

This scenario is something like a person having a lot of debts being forced to pay more interest on future loans from which they are at risk of default.

Just like a person requires a credit score/credit history for securing a loan, an entity would be required to have a good credit rating for issuing bonds. 

Based on the credit rating of an entity issuing the bond, one can be able to estimate the entity’s ability to repay the amount to the investors. An entity having a higher credit rating issues bonds with lower interest rates and vice versa.

Bonds have a face value, which is called ‘Par Value’. When you invest in a bond, you may end up paying more or less than the par value based on the existential interest rates. These prices are affected by the market interest rates as well.

During recessions, the past performance of bonds makes it clear that the bond prices go up as the interest rates go down. 

Anyhow, when there is an increase in the bond prices, the profits offered by them decrease (when purchased at the higher price). 

These types of correlations make investors search for other strategies to create returns on investments or restrict the inherent risks in their portfolios.

When there is an increase in the prevailing interest rates, the price of already existing bonds decreases because investors usually want a discount for the older (and lower) interest payments. 

Because of this reason, the prices of bonds move in the reverse direction of interest rates, and bond fund prices are impacted by the interest rates.

Variation between bonds and bond prices – Mutual funds invest in various investment instruments, by using the money pooled from the other investors to invest in different types of securities. 

Bond funds invest only in the fixed securities such as Treasuries, municipal bonds, corporate bonds, or foreign government and corporate bonds. 

As discussed before, these types of entities issue bonds for raising capital (money) to meet with their expenses such as funding projects or to fund internal and ongoing operations.

Bond mutual funds (Bond funds) are the type of mutual funds that invest in bonds. Just like other mutual funds hold securities, bond funds are investment vehicles that hold tens or hundreds of individual bonds.

A bond fund manager or a team of managers conducts extensive research on the fixed income markets for attaining the bonds depending on the overall investment goals of the bond fund. 

These managers would then buy and sell bonds according to the economic and market activity. Managers would also be necessitated to sell funds so that they can deal with the money-related needs when an investor redeems money (withdrawals). 

This leads to a situation where the bond fund managers can’t possibly hold their bonds until maturity.

Bond funds may lose value – This makes it clear for us that a bond mutual fund can either gain or lose value because the fund managers would be required to sell the underlying bonds in the fund prior to maturity in most cases.

If there is a decrease in the bond prices after the bond was purchased, the bond’s value decreases by the time of sale of those bonds.

Bond fund managers usually buy and sell the underlying bonds on a constant basis held in the respective fund. Therefore, when there is a change in the price of bonds, there would be a change in the complete value of the fund.

Choosing the best bond funds – each individual bond fund has a different goal that controls the type of bonds that are held in a fund and the respective fund’s type/category. 

Normally, conservative investors opt for bond funds that purchase bonds with shorter maturity periods and excellent credit quality as they come with a lower amount of risk related to default or low interest rates.

On the contrary, the interest received is lesser compared to bond funds investing in bonds having longer maturity periods and low credit quality. But such bonds have a higher risk involved.

Key points to remember:

• The companies or governments might sometimes fail to pay back their debts, which results in a loss for the investor.

• If the interest rates rise, the value of the bond would decrease and vice versa. The bond value in a bond fund is inversely proportional to the interest rates.

• A bond might be paid off early in some situations. When such situations arise, the bond fund manager might not be able to reinvest the available funds in some other bonds that pay the same returns.

3. Money Market Funds:

In simple words, Money Market Mutual Funds let investors access the benefits and safety with the help of money market securities. Approximately, an amount of more than 15 trillion dollars is invested in money market funds globally.

Money market funds are the type of mutual funds that offer low returns which involves a substantially lower amount of risk. These funds invest only in low-risk debts. Some examples consist of short-term Treasuries, municipal bonds, high-value corporate debts, etc.

As they involve lower risk, the dividends paid to the investors are usually short-term interest rates.

Dissimilar to mutual funds invested in stocks, money market funds make sure that the value of each share is at a dollar. They can do so as they invest in safe and short-term debts.

By doing so, investors need not change the value on the books every day (no need to track the value). Instead, investors who opt for money market funds are paid dividends from the stocks in their portfolios.

The value of a money market fund depends on the yield or the interest rate, which usually varies. The net asset value does sometimes become lesser than a dollar, yet it is very rare. This is known in financial terminology as ‘breaking the buck’ and only happens when the investment has been done poorly.

Types of Money Market Funds – Money markets make investments in three different types of securities with lower risk. 

• Treasury bills

The treasury bills are backed by the respective country’s government

• Certificates of Deposit (CDs)

Certificates of deposit are the loans provided to banks for a short amount of time. Considering their very nature, CDs are said to be very safe and offer a fixed rate of interest to the investors until the loan is repaid. 

• Commercial paper of companies

Commercial paper of companies is a short-term debt offered to reliable, reputational, and large-scale companies. The debt agreement is issued by the company itself to the investors.

It is a simple promise made by the companies saying that the debt would be repaid. No assets would be provided by these companies as collateral for acquiring the loan.

In general, these companies have enough outstanding invoices, which are known as receivables for supporting the loan. These companies just need the money for dealing with the expenses related to their day-to-day operations until their business income comes in. 

It is similar to a payday loan, except that it is for a business. The company assures the investors that it will repay the debt within a period of one year or sooner. 

Money market funds are not known to be the best when it comes to beating inflation. Not only that but most of them are not insured by agencies such as FDIC.

Even though they aren’t insured, money market funds are very safe and allow investors to easily access their money. Additionally, they don’t require any minimum amount to be invested.

If withdrawn earlier, securities such as CDs levy penalties known as early withdrawal charges. Considering the lower interest rates, these funds pay profits that won’t be able to keep up with inflation in most cases.

In such cases, investors who put their money in such funds lose their purchasing power. These can be considered a good investment for the people who don’t take huge risks and want a safer investment vehicle.

The most depressing situation for money market funds – On September 16, 2008, the Reserve Primary Fund with an amount of $62 billion fell in value (broke the buck). This fund was the USA’s oldest money market fund. 

This money market fund invested in the short-term debt of Lehman Brothers. When Lehman Brothers went bankrupt, the NAV of Reserve Primary dropped to an amount of 97 cents. 

Reserve Primary was the first-ever money fund in 14 years to decrease in value. This created a lot of panic among investors and made them withdraw an amount of $172 billion out of money market funds. 

At a certain peak moment, an amount of about $7 billion was withdrawn with a period of one week.

Within a few weeks, the situation became so hard that people who had to deliver the packaged food to grocery stores didn’t even have the money to make it reach the grocery stores. This is an example to state how worse was the situation became.

Because of this, the treasury department came into action on September 19, 2008, for guaranteeing money market funds. This led to a lot of complications and finally on October 21, the Federal Reserve accepted to buy assets from money market funds that allowed investors to cash out their investments.

4. Hybrid Funds:

Hybrid funds are the type of funds that invest in both equities and bonds. These funds offer decreased risk along with improved profits. To make it clear, investors acquire decent profits with a tailored strategy that is suitable for their investment goals. 

What makes them attractive is their diversification of mutual fund portfolios along with optimum asset allocation. When the investment is in favor of bonds more than stocks, then it is a stable investment and when it favors stocks, then it would be prone to offer more profits.

Diversification is not only an important aspect while investing in stocks and bonds, but people should also make sure the portfolio is diversified regarding the domestic and international assets. 

It would be much beneficial if the money is distributed among equity funds, bond funds, money market funds, and the funds that we are going to be discussing.

Exchange-traded Funds (ETFs):

ETF is an investment vehicle that is like a mutual fund but gets traded on public exchanges. ETFs group assets together and track an underlying benchmark index like S&P 500.

ETFs consist of multiple securities such as stocks, bonds, gold, etc., which makes them similar to mutual funds, mostly like index funds (which we’ll discuss later). The only major difference is that ETFs, like stocks, are traded on an exchange.

This means people can easily trade with ETFs with the help of an exchange. ETFs are very flexible, which makes them an excellent option for investing in broad market indices such as S&P 500, or is separate sectors such as tech, health, robotics, etc.

As easily a person can be able to trade with stocks, they can trade with ETFs as well. For trading with ETFs, a person needs a brokerage account, with the help of which, trades can be done during the trading hours.

When you are trading with ETFs, you must choose the number of shares that you want to purchase or sell, which is the same as stock trading. 

If there is a $1,000 worth ETF that you want to buy, and the value of each share is $100, then you would have to place a buy order for 10 shares by using ETF’s ticker symbol.

Even though ETFs are traded just like stocks, the process of share creation and redemption differs from the process involved with shares. 

The handling procedure, which is the buying and selling of ETFs’ underlying securities is carried out by third parties known as ‘Authorized Participants (APs)’. This handling is done in large fractions of shares known as creation units.

In this way, ETFs won’t involve trading costs and the cost of the fund is correlated to the cost of the underlying index, despite the supply and demand.

Pros and cons – ETFs could be considered an excellent investment opportunity for every investor, nonetheless, they aren’t the best for everyone. Let us look at some of the features of ETFs (both pros and cons).

people making an investment in ETFs get access to tens or hundreds of securities such as stocks, bonds, etc., in a single ETF. 

By holding various investment vehicles in a single fund, the volatility of the fund is reduced compared to buying single security or a few.

In most cases, ETFs are managed passively and because of this, there won’t be any costs related to research or analysis, which results in a reduction of the overall management costs.

The expense ratio of ETFs is comparatively lower than that of mutual funds. For example, most ETFs have costs lower than 0.25%, which means the charges would be around $25 for every $10,000 invested.

Anyhow, there are trading commissions that incur every time an investor buys or sells shares. Even though these commissions are low, the costs can compound when an investor makes frequent trades.

On the other hand, the average expense ratio of mutual funds is around 0.76%, which means investors would be charged around $76 for every $10,000 invested.

Mutual funds that are managed actively, trade within funds and lead to capital gains distribution and is a taxable endeavor. However, the gains on ETFs are also taxed, but their composition makes them tax-efficient compared to mutual funds.

As ETFs are traded throughout the day, investors can place market orders like limit orders and stop-loss orders. For example, when an investor puts a stop-loss order, their ETFs would be sold automatically upon reaching the specific price.

Most ETFs track a specific benchmark or any similar sector in the market such as technology. Such types of ETFs usually have bigger fluctuations in their price than those tracking a broad market index like S&P 500.

As people are provided with the access to make trades easily, they get tempted easily in doing so. This leads to a situation where investors tend to fiddle with the market-timing. 

This is not considered to be a good idea because the potential disadvantages of doing so are more compared to the advantages. Investors will start speculating on the price changes instead of opting for a long-term investment.

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