Mutual funds are still one of the most popular investment types in the U.S. With a significant number of households adding more money to mutual funds in their investment portfolios. Today, there are tens of thousands of mutual funds options that investors can choose from, making these securities more attractive for trade. Investors who trade mutual funds enjoy a wide range of benefits, including professional management and versatility. However, due to their unique structure, mutual funds pose various risks and pitfalls, which can be quite costly if not well managed. This guide provides you with a highlight of the basics of mutual funds trading, and tips on how to best trade these unique securities.
The Definition of Mutual Funds
A mutual fund is an investment vehicle that pools together money from multiple investors to invest in a collection of securities, including bonds, short-term debt, and stocks. This collection of securities is known as the company’s portfolio, in which investors hold shares. The amount of investment made by each investor represents their share of ownership in the mutual fund. One outstanding feature of mutual funds is that they are managed by professionals.
Types of Mutual Funds
While there are tens of thousands of options to choose from, there are four major categories of mutual funds under which these options fall.
These funds invest in stocks from various publicly traded companies. Although they are more exposed to volatility than other mutual funds, equity funds have very high growth potential. Equity funds are categorised into broader options, including large-cap funds, small-cap funds, value stocks, mid-cap funds, growth stocks, and income funds.
Bond funds, also known as fixed-income funds, are a type of mutual funds that invest in securities that pay a fixed-rate return on the investment. They buy investments, such as government and corporate bonds. Since bond funds aim at producing high yields, they are exposed to higher risks.
Money Market Funds
These are also fixed-income funds that come with relatively lower risks compared to equity and bond funds. Money market funds invest in high-quality, short-term assets issued by corporations, governments, and banks. Examples of debt securities held by money market funds include commercial papers, Treasury Bills, and certificates of deposits. With the potential of high returns, money market funds are considered to be a safer investment as far as mutual funds are concerned.
Balanced funds, popularly known as asset allocation funds, invest in a combination of bonds and equities. The investment is typically made in a fixed ratio of these securities, such as 40% fixed-income assets and 60% stocks. Balanced funds tend to be less risky compared to equity funds, but riskier than fixed-income funds. This type of mutual fund is categorised into conservative and aggressive funds. Conservative funds are the type that invests in fewer equities compared to bonds. Aggressive funds, on the other hand, invest in more equities relative to fixed-income securities.
How to Trade Mutual Funds
When you decide to invest in mutual funds, here is the step by step guide to follow.
Step One: Decide on Passive and Active Funds
The initial and most fundamental decision to make when trading mutual funds is choosing between actively managed funds and passive funds. Actively managed funds involve a team of professional managers who research in their effort to beat a given market index when investing their funds. Active funds are quite expensive in the long run due to high management fees. Research also proves that it is quite difficult for active managers to beat a market index.
Passive funds, on the other hand, consist of fund managers who aim at achieving a match with the market gains through the index fund format. Passive funds are not only cheap, but they also produce consistent yields in the long run.
Step Two: Settle on Your Budget
As the general rule goes, only invest an amount that you are ready to lose. You must also never invest money that you will not in the short term. When calculating your budget, consider the following;
What is your minimum deposit to open a trading account?
Depending on the brokerage company you choose, you might be required to deposit a minimum amount of £500 up to £3000. Some brokerage firms do not have a minimum deposit requirement.
What brokerage charges and operating fees do you need?
Evaluate your trading platform for fees and charges as these will have an effect on your trading value.
What funds are right for you?
The good thing with mutual funds is that they are highly affordable. You can, therefore, initiate your investment with the lowest investment possible. However, not every investment is right for you. If you are a beginner or one who is approaching retirement, then conservative investments might be your ideal choice. On the other hand, young investors and experienced traders can take on riskier funds with a larger investment.
Step Three: Decide on Your Trading Platform
You will need a trading account to invest in mutual funds. The modern investor is going for the online brokerage accounts, following the wide range of mutual fund selection and companies that come with online trading platforms. Different brokers come with varying options, features, and fees, which is why you should choose your broker wisely.
The following are factors to consider when choosing your broker.
Cost – Watch out for the fees surcharged on the funds themselves and the brokerage account.
Ease of Use – The easier it is to use the broker’s trading app or website, the better the trading experience.
Tools – Successful traders do not make investments based on their emotions. You will require extensive research before you put your money into an investment, which is why research tools are essential. Check out for educational and support tools, such as graphs, calculators, and Demo accounts.
Fund Choices – The best broker is one who provides a wide range of mutual fund options from which you can make your choice. Some brokers also feature other types of assets, such as exchange-traded funds (ETFs) that enhance your portfolio diversification.
Step Four: Evaluate the Trading Fees
Generally, every platform will charge you some account operating and fund management fees. These trading fees have a long-run impact on an investor’s total returns. Therefore, it is crucial that you evaluate these fees before settling on your broker. Often, it is not possible to identify these costs upfront. Scrutinizing the trading platform extensively will enable you to find out the fees that would eat up on your monthly or annual returns.
Step Five: Manage Your Portfolio
Now that you have your account running, it is time to manage your portfolio for long-lasting benefits. Diversify your portfolio and come up with a plan to manage risks linked to your mutual fund investment. Stick to your plan and avoid the mutual fund success stories. The past performance of a mutual fund does not always guarantee future success.
Mutual Fund Trading Platforms
With the growing trend in the mutual fund industry, there has been increased competition in the brokerage service providers. Here are examples of some of the platforms that investors can use to trade mutual funds.
This is one of the leading mutual funds trading brokers, offering investors with four zero-fee funds. With these funds, investors do not pay management fees. Fidelity Investments was founded in the mid-40s, bringing its total assets under management to over $2.46 trillion. The company does not have a minimum deposit requirement. With Fidelity Investments, investors can enjoy multiple screening and research tools to aid their trading experience.
The Vanguard Group was started in 1975, with its current assets under management valuing at over $5.6 trillion. The platform is popular for its low-cost index funds and no minimum deposit requirement. Vanguard also offers free transactions for the 130 mutual funds featured in the platform.
This platform offers over 4,600 mutual funds that require no transaction fees. E-Trade was started in 1982, assembling over 4.9 million brokerage accounts. The site also features plenty of research tools that help you in making informed investment decisions. You will require a minimum of $500 to open an E-Trade account.
This is one of the most competitive mutual fund brokers in the industry, offering a myriad of mutual fund options. Charles Schwab does not charge sales commissions and there no transaction fees for 4,200 mutual funds. The platform does not have a minimum deposit requirement for account opening.
Ally Invest was started in 2005, offering access to more than 12000 mutual funds. Although the broker is not as popular as most brokerage firms, Ally Invest offers some of the lowest charged commissions in the market. Ally Invest does not have a minimum deposit requirement for account opening.
Benefits of Investing in Mutual Funds
Mutual funds have become quite popular, with most investors adding them to their investment portfolios. Here is a highlight of some of the benefits that come with mutual funds.
Every investor enjoys the professionalism that comes with the management of mutual funds regardless of the management type they choose. These professional managers are full-time experts who have years of experience in trading mutual funds. The managers are involved in the buying, selling, and monitoring of mutual funds at a given fee.
If an investor were to purchase all the securities carried by a single mutual fund, then it would be quite an expensive endeavor. With a mutual fund investment, however, one will require a minimum initial amount to get started. Mutual funds are among the most cost-effective investments for traders across the world.
One mutual fund can hold thousands of investment securities, making it easy for investors to diversify their portfolios. This means that when one security declines in value, then another growing asset would cushion the effects of the losing security.
Securities held in a mutual fund are easy to sell, as long as the markets are open for trade. It is, therefore, easy to access your money whenever you want it, not forgetting that mutual funds have the potential of yielding high returns.
Risks and Pitfalls Associated with Mutual Funds
While mutual funds come with myriad benefits to the investors, they are also linked to specified risks. These risks include the following;
Liquidity Risk – During a lock-in period, mutual funds are exposed to liquidity risks. This means that it becomes difficult to sell a security, following the unavailability of a potential buyer. It is also impossible to access your money without incurring losses in a given investment.
Market Risk – This refers to the potential of losing part or the entire principal amount of a mutual fund investment due to poor market performance. Poor market performance can be as a result of political instability, recession, inflation, pandemics, or natural disasters.
Interest Rate Risk – This refers to the risk of a decline in the value of your mutual fund investment as a result of a rise in the interest rates.
Credit Risk – This is the risk that the issuer of mutual fund security is unable to pay the promised interest. The issuer might also be unable to redeem a security for face value upon maturation.
Currency Risk – This is the risk of losing or experiencing a decline in your mutual fund investment due to a fall in the exchange rate.
Types of Metrics to Use When Considering Mutual Fund Investments
When investing in mutual funds, there are indicators or metrics that you should use to measure the risk or potential of an investment. Here are five metrics that you should consider using;
This is the measure of the performance of a portfolio based on risk adjustment. It compares the returns of a portfolio with a benchmark index, such as the S&P 500. Investments with Alpha above zero are said to offer higher returns relative to the assumed risk amount. Investments with a negative Alpha are said to have underperformed relative to the benchmark. Investments with higher Alpha are considered to be the best.
Beta is the measure of the volatility of a portfolio in relation to a market index. Regression analysis is applied to determine Beta. The market is said to have a Beta of 1.0, with a negative Beta indicating a less investment in respect to the market index. The vice versa is also true.
This metric measures the reliability of Beta. The value ranges from 0 to 1.0, with 1.0 showing perfect reliability and 0 indicating no reliability.
Standard Deviation (SD)
Just like Beta, the standard deviation metric is also a measure of a portfolio’s volatility. However, standard deviation compares the returns of an individual investment to its average returns over a given period. As the returns of an investment deviate from the value of its average returns, standard deviation increases. The higher the SD, the more volatile the portfolio.
This is a measure of the return of an investment relative to a risk-free return. Investors rely on this metric to determine whether the returns of an investment will expose them to more risk.
Mutual funds are remain one of the favored assets of long-term investors. Although their popularity has diminished in recent years due to the rise of ETFs, mutual funds can still provide stable returns and should be considered as part of a balanced investment portfolio.