How Do Mutual Funds Work? Like Pizza Slices

What are mutual funds?

Mutual funds pool together small amounts from multiple investors and invest the piled-up funds in professionally managed assets.

If you’re still lost, the concept is not as complex as you might have thought. Let’s get started with a simple illustration; using pizza.

The pizza house

You are at the pizza house, and would really like to have some pizza but the attendant slams your dreams down as she says smugly, “The smallest box is NGN4,000. Cash or card?” You don’t have 4,000 to spend on pizza at the moment as your wallet won’t cooperate with your cravings.

Now what?

Seeing everyone else leave with their boxes of pizza makes you even more hungry. Without thinking too much of it, you send a message to your friends. “If you each send me NGN400, we can all have a slice of pizza.” Soon, you’re back at the counter waiting for your box of pizza.

Why is this beautiful?

With all your friends contributing, your craving and your wallet would finally get to cooperate and you and your friends can each have some pizza for the amount you have available. Although you don’t have the full amount needed to get a box, by pooling the amounts you and your friends have you still get a slice.

How does this tie back to mutual funds?

Mutual funds work just like pizza slices do. No jokes! Think of it as crowdfunding to get a box of pizza. That makes it possible for everyone to have a slice without paying the full amount. In essence, mutual funds break down large investments into smaller units that everyone can purchase.

What are the common types of mutual funds?

Just as there are various pizza types, we have mutual funds for the varying tastes of investors. Below we explain the 5 common types of mutual funds.

• Equity Funds: This type of mutual fund invests in equities (another name for stocks). Simply, a fund manager brings together cash from multiple investors and uses the bulk amount to buy carefully selected stocks.
• Fixed Income Funds: Fixed income refers to instruments such as bonds. When a mutual fund invests in bonds or similar instruments, it’s a fixed-income fund.
• Money Market Funds: Ever heard of treasury bills? They are the major instruments that make up what is known as the money market. Funds that invest in them are money market funds.
• Balanced Funds: Extra servings? You get that with a balanced fund. This type of fund can spread your money between the money market and stocks for example.
• Halal Funds: These are special funds that go after investments which practise profit sharing. Such investments don’t charge interest rates. Rather, they earn returns from the direct profits of the ventures invested in.

What are the best mutual funds to invest with?

A choice to invest starts with understanding what matches your personality. Just as some people choose spicy pizza and some don’t, it doesn’t get any different with mutual funds. Making the right choice starts with understanding your risk appetite. With that, it’s easier to find a fund you’ll love.

Your risk appetite is a measure of how you can risk losing as an investor.

Investors are commonly categorised into three risk types:

• Low-risk investors: These are very cautious about the protection of their capital. Regardless of the returns, they don’t want to risk their capital. For such people, they do better with money market funds which are low-risk.
• Medium-risk investors: People who fall under this category, can take on more risk than low-risk investors. However, they are still a bit cautious about how much of their capital can be placed on the line. They usually find a perfect match in fixed-income funds.
• High-risk investors: We call these ones the brave. They’re open to risking their capital for higher returns. So the ups and downs of the stock market, for instance, don’t scare them. It is the very reason why they love equity or stock funds.

Regardless of the category, you fall under, no rule restricts you from investing with any type of fund.

How do mutual funds earn returns?

Breathe. We are about to mention some complex terms, but no worries. We’ll break them down into simple bits. A mutual fund, depending on the type, earns returns in one of these two ways:

• Periodic distribution
• Capital appreciation

What is the periodic distribution of mutual funds?

When you buy units of a mutual fund, you are placing money in the hands of a fund manager to invest on your behalf. As time goes by, it is expected that your investments earn returns. Now, here’s where it gets a little complex.

How does periodic distribution work for money market funds?

Assume the interest rate on a money market fund is 10% per annum. If you invest ₦10,000 every week you’ll earn 10% per annum on your balance each day. That is 10% divided by 365, which gives us 0.0003%. In essence, 0.0003% will be paid on your available balance each day. The fund manager accumulates these returns and pays you after an agreed period; every quarter for instance.

Now, you can choose to sell the units you own in a money market fund anytime. But the returns earned so far will only be paid at the agreed time. For example, if your fund manager promises to pay quarterly and you sell in the second month, you can only access the returns earned in the third month.

What does capital appreciation mean for mutual funds?

Let’s keep this really simple. If you buy a phone today for ₦200,000 and sell the same phone at ₦300,000; you have gained ₦100,000. In other words, you gained 50% from that sale. This is a simple analogy of how you gain with mutual funds that aren’t money-market-focused.

You buy a unit today at a price and gain as the price of a unit increases. At any point, you can choose to sell your units to cash out your gains. On the other hand, you can choose to wait for the fund manager to distribute the gains. Let’s go back to our earlier phone example.

Distribution, in this case, would mean waiting on the fund manager to deduct the ₦100,000 gained and pay it to you without selling your units. If this still seems confusing, please drop a comment. We are always willing to break things down further.

How do you get a slice of mutual funds?

1. Visit a fund manager
2. Fill a couple of forms
3. Pay and verify your investments

or

Access multiple fund managers and start investing in 5 minutes. No long forms.