We have established that we all have to save a part of what we have today for our future benefit. In other words, it is important that we invest.
The first step to successful investing is figuring out your financial goals and risk tolerance, either on your own or with the help of a financial professional. Once you know what you are saving for, when you will need the money and how much risk you can tolerate, you can more easily make a good choice.
The second step, and just as crucial, is deciding what you are going to invest in. There are many investment outlets out there but choosing one which minimizes our risk and maximizes our return is the major challenge that most of us face. There is one investment channel that presents a solution to these issues particularly when you have limited funds to invest and do not have the time or knowledge to manage your investments yourself. This is a mutual fund. A mutual fund is a company that pools money from many investors and invests in stocks, bonds, short-term money market instruments, other securities or assets, or some combination of these investments.
There are two broad types of mutual funds; Open-ended funds and dosed funds. Closed funds sell a fixed number of shares at one time (in initial public offering) that later trade on a secondary market. Mutual funds are generaly open ended funds and our focus here will be on open-ended funds.
DISTINGUISHING CHARACTERISTICS OF MUTUAL FUNDS
Mutual funds are different from other types of investments in the following ways: Investors purchase mutual fund units from the fund itself. Mutual fund units are "redeemable," meaning investors can sell their units back to the fund. Mutual funds generally create and sell new units to accommodate new investors. Mutual funds are typically managed by "Fund Managers" who are registered with the Securities and Exchange Commission (SEC).
CATEGORIES OF MUTUAL FUNDS
There are three main categories of mutual funds -money market funds, bond funds (also called "fixed income" funds), and stock funds (also called "equity" funds). Each type has different features and different risks and rewards. Generally, the higher the potential return, the higher the risk of loss. Money Market Funds Money market funds are relatively low risk. By law, they can invest in only certain high-quality, short-term investments issued by the Federal Government, corporations, and State and Local governments.
Money market funds pay dividends that generally reflect short-term interest rates, and historically the returns for money market funds have been lower than for either bond or stock funds. That is why "inflation risk" - the risk that inflation will outpace and erode Investment returns over time - can be a potential concern for investors in money market funds. Bond Funds Bond funds generally have higher risks than money market funds, largely because they pursue strategies aimed at producing higher yields. Unlike money market funds, SEC rules do not restrict bond funds to high-quality or short-term investments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards. Stock Funds Although a stock funds value can rise and fall quickly (and dramatically) over the short term, historically stocks have performed better over the long term than other types of investments including corporate bonds, government bonds, and treasury securities. Overall "market risk" poses the greatest potential danger for investors in stock funds. Stock prices can fluctuate for a broad range of reasons - such as the overall strength of the economy or demand for particular products or services. Having discussed the categories of funds that are available, it is pertinent to note that Allah has informed us in Q2:275;2:278 - 279 that we are not permitted to deal in any transactions that have interest implications.
Both the money market and bond funds invest in instruments that receive interest income which prohibits us Muslims from investing in them. Investments in stocks on the capital market are however permissible to us since we share both the risks and returns made by the companies that we invest in. The stocks that Islamic investment funds invest in have to pass through the Shariah screens before fundamental analysis to determine if they are permissible or not. The first screen is the qualitative screen, which eliminates stocks based on the primary activity they are involved in. As such, an Islamic fund will not invest in breweries, banking, insurance, alcohol, adult entertainment, arms, hotels, tobacco, etc. The second screen is the quantitative screen which involves the exclusion of stocks that do not meet OIC (Organisation of Islamic Conference) Fiqh Academy guidelines for eligible investments through the use of financial ratios.
Types of Stock Funds
Growth funds - these funds focus on stocks that may not pay a regular dividend but have the potential for large capital gains.
Income funds invest in stocks that pay regular dividends.
Sector funds may specialize in a particular industry segment, such as technology or consumer products stocks.
Ethical funds only make socially responsible investments; an example of this class of funds is the Lotus Capital Ethical Fund.
Advantages and Disadvantages of Mutual Funds
Advantages
Professional Management. Professional fund managers research, select, and monitor the performance of the securities the Fund purchases. They also ensure you receive your benefits such as dividends, bonuses and rights.
Diversification - this is an investment strategy that can be neatly summed up as "Dont put all your eggs in one basket". Spreading your investments across a wide range of companies and industry sectors can help lower your risk if a company or sector fails. Some investors find it easier to achieve diversification through ownership of mutual funds rather than through ownership of individual stocks or bonds which can be costly.
Affordability - Mutual funds accommodate investors who dont have a lot of money to invest because initial purchases, subsequent monthly purchases, or both are usually low.
Liquidity - Mutual fund investors can readily redeem their units at the current Net Asset Value (NAV).
All these advantages mentioned are risk limiting factors.
Disadvantages
As beneficial as it is to invest in mutual funds, investing in them also comes with certain disadvantages and it is important for these to be pointed out. Investors in mutual funds typically pay sales charges, annual fees, and other expenses regardless of how the fund performs, the investors also lack control over the make up of the funds portfolio.
How Funds Can Earn Money for You
You can earn money from your investment in mutual funds in three ways:
Dividend Payments - A fund may earn income in the form of dividends and interest on the securities in its portfolio. The fund then pays its shareholders nearly all of the income (minus disclosed expenses) it has earned in the form of dividends.
Capital Gains Distributions - The price of the securities a fund owns may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, most funds distribute these capital gains (minus any capital losses ) to investors.
Increased Net Asset Value (NAV) If the market value of a funds portfolio increases after deduction of expenses and liabilities, then the value (NAY) of the fund and its shares increases. The higher NAV reflects the higher value of your investment.
Factors to Consider Before Investing in a Fund
Degrees of Risk
All funds carry some level of risk. You may lose some or all of the money you invest i.e. your principal, because the securities held by a fund go up and down in value. Dividend or interest payments may also fluctuate as market conditions changes. Before you invest, be sure to read a funds prospectus and shareholder reports to learn about its investment strategy and the potential risks. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals.
Fees and Expenses
As with any business, running a mutual fund involves costs - including shareholder transaction costs, investment advisory fees, and marketing and distribution expenses. Funds pass along these costs to investors by imposing fees and expenses. It is important that you understand these charges because they lower your returns.
Other Factors to Consider "If you decide to invest in mutual funds, be sure to obtain as much information about the fund before you invest. "Dont make assumptions about the soundness of the fund based solely on its past performance or its name. Past performance is not a reliable indicator of future performance. Dont be dazzled by one years high returns but look for a trend of stable consistent performance. "Mutual funds are not guaranteed or insured by NDIC or any government agency. "All mutual funds have costs that lower your investment return. Shop around before you buy. "Make sure the Fund Manager is SEC registered and check their track record and experience. "Remember that stockbrokers are not fund managers. "Mutual funds can be the easiest, most efficient, safe and profitable way to wealth creation. Conclusion Creating wealth is of great importance but equally important is the way we come about that wealth. It is necessary for us to be informed about the kinds of funds that are available in the market so that we are sure that the funds we decide to invest in do not violate our values and religious beliefs.
This article was culled from the publications of Deen Communication Limited