Today, let’s take a look at the world of investments, with a focus on explaining how mutual funds work.
But before we dive in, however, let’s take a moment to explore the concept of asset classes and how mutual funds fit into the larger picture of building an investment portfolio.
Asset classes are groups of investments that have similar or different levels of risk and return.
It’s crucial to keep in mind that each asset class has its own unique risk level, potential for returns, liquidity, and diversification benefits.
By using asset allocation strategies that are in line with their financial goals, risk tolerance, and time horizon, investors can effectively manage risk and get the most out of their investments. Before making decisions about investments, it’s important to carefully look at the features and risks of each asset class and get advice from a professional where necessary.
The main asset classes that exist typically include:
-Stocks (equities): Stocks are ownership interests in publicly traded corporations and are riskier investments with larger rewards. They may be common, preferred, or other equity securities.
-Fixed-income bonds: companies and governments issue bonds. You have likely come across Dangote’s bond and the federal government of Nigeria’s bond, and the similarity they have is that they pay interest periodically and return the principal upon maturity. Bonds have lower risk and return than stocks.
-Cash and Cash Equivalents: Cash, savings, money market funds, and short-term government securities are highly liquid investments. These low-risk investments have smaller returns than stocks and bonds.
-Real estate assets include residential, commercial, and industrial buildings as well as REITs that are traded publicly. Investing in real estate can lead to rental income and capital growth, but market conditions and changes in the value of a property can be risky.
-Commodities: Gold, silver, oil, natural gas, wheat, corn, and other raw materials are commodities. Supply and demand determine commodity prices, which are used to hedge against inflation or speculate.
-Alternative investments include hedge funds, private equity, venture capital, and other non-traditional investments. These investments are riskier and require experience.
-Others: Collectibles, cryptocurrencies, and other non-traditional investments are also forms of asset classes.
Now let’s look at how mutual funds tie into these asset classes.
Mutual funds take money from many people and invest it in a wide range of assets, including different kinds of assets. Mutual funds can invest in stocks, bonds, cash and cash equivalents, real estate, commodities, and other investments, depending on their goals and strategies. In short, what constitutes a mutual fund is the investments or asset classes it is invested in. Mutual funds are a popular way to invest because they are diversified, professionally managed, easy to access, affordable, liquid, transparent, and may be tax efficient. With lower investment minimums and simple access to their funds, they give investors the chance to invest in a professionally managed, diversified portfolio.
Mutual funds are also clear about their investments, performance, and fees, and they may have tax benefits. But before investing in mutual funds, it’s important to think carefully about the risks, fees, and investment goals. It’s also a good idea to talk to a financial advisor for personalised advice.
Examples of mutual fund types are listed below.
-Equity (stock) funds: These mutual funds invest in publicly listed stocks. They are higher-risk, higher-return investments. Asset management companies in Nigeria trade in mutual funds that are tied to stocks, and invariably, the stock market’s performance.
-Fixed-Income (Bond) Funds: These mutual funds buy corporate and government bonds, and they can be denominated in naira or USD. They have lower risk and potential returns than equity funds.
-Money Market (Cash and Cash Equivalents) Funds: These mutual funds invest in short-term debt assets like fixed deposits, Treasury bills, and commercial papers and are low-risk and low-return. In Nigeria, money market mutual funds are a good example of this. A number of asset management companies actively promote these funds.
-Real estate funds: These mutual funds invest in real estate properties, or REITs, and can make money from renting them out and from their value going up.
-Commodity Funds: These mutual funds invest in commodities like precious metals, energy, and agricultural goods to hedge against inflation.
-Alternative Investment Funds: These mutual funds may invest in hedge funds, private equity, venture capital, or other non-traditional investments that are riskier but may yield better returns.
Note that mutual funds can also be put into different groups based on the type of investment (value, growth, or blend), the size of the market (large-cap, mid-cap, or small-cap), the location (US, global, or developing markets), or the sector. (e.g., technology, healthcare).
To understand a mutual fund’s investing objectives, strategies, risks, and fees, you may read its prospectus and talk with a registered financial advisor.
So if you are new to investing and mutual funds, a good place to start building your portfolio is in money market mutual funds because they are usually low-risk, and as you build your risk tolerance, you may start to consider mutual funds that invest in other asset classes and then in various asset class investments.
