What are Mutual Funds? Are there pros and cons to be aware of?

“What are mutual funds?” What are they made up of? How would I benefit the most from a mutual fund? Do they have any pros and cons, especially 'cons' to be aware of? And other similar questions!

These are the sort of questions that every shares & stock and/or mutual fund newbie investor asks. And there is nothing wrong with them questions.

In this article, I’ll explain what a mutual fund is using the Ice Cream to break down exactly what this concept means. And then we will look at its pros and cons.

Before we dive in though, please, do me a favour. After reading this article, kindly leave a comment to say whether you have understood mutual funds better or not. It’ll help me know that this was simple to digest. And if you have any questions, feel free to leave them in the comments too.

So what are mutual funds?

Mutual funds are a type of investment that allows you to invest in different types of assets at once while allowing you to be as hands-off as possible with paperwork and other intricacies. It’s a basket of different investments put together to form one asset group. That asset group is called the mutual fund and the professionals who put the different investments together are fund managers.

Who are fund managers?

Fund managers are investment experts who work as professional asset managers to help meet specified investment goals on behalf of investors. They use their expertise and experience to determine what a mutual fund should comprise and how a fund should be invested profitably.

Back to mutual funds, let me break it down with ice cream.

The Ice Cream analogy

Instead of buying 4 cups of ice cream with just one flavour in each, many people prefer to buy a cup with different flavours and toppings in it. These lovers of ice cream never buy strawberry, vanilla, cheesecake or chocolate flavours in 4 different cups. Instead, they buy the biggest cup or cone and then put all their favorite flavours in it with any topping they're craving at the time.

Investing in a mutual fund is like that. It’s a simple way to diversify without the hassle of buying and managing the assets one after the other. A fund manager does the “hard work” of putting different assets together; you then buy shares from the “basket”. Simply put, a fund manager brings together cash from multiple investors, and uses the bulk amount to buy carefully selected assets.

With mutual funds, you’re diversifying in a quick way but only buying one thing.

You’re investing in bits of everything. Just like enjoying different ice cream flavours in one cone!

Understanding the different risk levels

Mutual funds are universally separated into three risk levels: low, medium and high risk. You’re advised to stick to certain types of mutual funds, depending on your risk profile as an investor.

When you invest in equity mutual funds (Aggressive Funds), what you’re investing in are company stocks. So you’re buying a piece of different companies like Google, Apple, Nestle, MTN, Total, etc.

While when you invest in conservative funds (low-risk funds), you’re investing in low-risk instruments like treasury bills, bank deposits, commercial papers, bonds, call cash.

When you then invest in balanced (medium-risk) funds, you’re investing in a mix of both high-risk funds and low-risk funds.

Back to the ice cream flavour analogy. Let’s say regular flavours like strawberry, vanilla and chocolate are conservative. They’re for people who don’t like to explore or try out “new things”. It means that their ice cream cone will only have these flavours that promise you a certain taste back.

But high-risk flavours are flavours like mint, buttered pecan, and cookie dough because they can taste great today and taste really bad tomorrow. So they’re for adventurous people.

Investing in medium risk assets is you then buying a mix of chocolate and buttered pecan in your cone. You’re in the middle, like the people who prefer a little bit of this and a little bit of that. Did someone say trust issues? Ok ok, moving on!

Can you explain the risk levels to me?

Of course!

Aggressive Funds:

They contain a higher mix of stocks and are usually called high-risk funds.

For example, the ARM Aggressive Growth Fund is made up of 79.59% equities and just 20.41% of fixed income instruments. If the percentages were vice versa, this would have been a low-risk fund because it’ll have a higher percentage of conservative instruments.

Anyway, when you go deeper into the assets under the ARM Aggressive Growth Fund, you find that it is spread into the Banking, Consumer Goods and Industrials industries. When you go even deeper again, you find that it has companies like MTNN, NESTLE and DANGCEM in its portfolio.

So when you invest in this specific ARM fund, you get shares in MTN and NESTLE without having filled long forms or stood on queues.

Balanced Funds:

These are usually referred to as medium risk funds and they contain a mix of stocks and low-risk instruments like bonds and money market.

Conservative Funds:

They’re usually called low-risk funds and contain assets like treasury bills, bank deposits, commercial papers, bonds, and money market instruments.

Who are mutual funds for?

Mutual funds are for investors who have money but don’t want to do the stressful work of investing in separate assets and managing the paperwork of buying each, one by one.

They’re great for first-time investors or people who just want a more seamless investing experience where the fund manager is in charge of managing the performance of the fund.

If you’re to create your own mutual fund, you’ll have to personally go buy Google stock, buy Apple stock, buy treasury bills, bonds, then manage the performance of the mix of all these yourself.

By investing in mutual funds, you give your money to a fund manager and ask them to invest it in various financial instruments for you.

What are the pros and cons of mutual funds?

Pros

  • Provides Options: In life, having options is crucial. Typical fund managers would usually have many types of mutual funds available for you to choose from. Each one has a different investment strategy and risk level and anyone can find one that meets their investment needs.
  • Professional Management: Fund managers are the professionals in this case and they know a lot about putting various assets together. You don’t need to worry about buying shares in the nick of time or watching closely on a daily basis to balance your portfolio out. That’s the job of the fund manager.
  • Inexpensive: One of the major goals of fund managers is to give retail investors access to profitable investment opportunities and mutual funds are the major way they get that done. Mutual funds allow you to start investing with what you can afford while you work to grow your assets. They’re one of the most inexpensive ways to invest in a diversified portfolio.
  • Diversification: As stated earlier, you’ll have to do a lot of work to build a diverse portfolio without mutual funds. By investing in one mutual fund, you can easily diversify your investment into different asset types.
  • Easy to convert to cash: If there’s a need for quick cash, you can easily sell your shares in mutual funds. They’re also very easy to buy.
  • Generally low risk: Investing in mutual funds generally comes with less risk of losing all your capital, compared to investing in stocks or cryptocurrency directly. The stock and crypto market is much more volatile, which is why you make much more profit from them if you plan well but can loose all if careless, and so are not really for the faint-hearted. This is unlike mutual funds which is non-volatile, but you make much less profit.

Cons

  • Fund manager fees: Fund managers in Nigeria usually charge between 1% to 2% to manage mutual fund investments and this can be a turn off to some investors. However, when comparing this to the work a new investor will have to do themselves, this is a little price to pay. The middlemen in any sector have to make some profit and it’s no different in investing.
  • Little Control Over Your Portfolio: With mutual funds, you have to rely on fund managers to create the mix that will make up your portfolio and you also rely on them to make informed decisions. You can’t decide to invest more in a particular asset except you buy mutual funds that have more of those kinds of assets.

Now that you have answers to the “What are mutual funds?” question. What should you do next?

I could end this with a lot of aspire to perspire but I’ll be straightforward and say – start investing in mutual funds now to diversify your portfolio.

When you start early, you learn much more than the person who’s sitting on the sidelines. There are insights about investing you can never learn until you actually take action. You can choose from the many options presented by many fund managers right now.

I love the stocks and crypto markets, but I also do some mutual fund investments as well, to diversify portfolio and spread risk. Start with one, and plan to jump into the others as well.

Cheers to your success! 🥂

Author
This article is adapted from, but complately rewritten, from an original by Cowrywise.

1 comment:

  1. Thanks for the post, even though it is a re-write from an original post. It was quite clear and succinct

    ReplyDelete