The Basics of Investing and Trading

I just launched the alpha version of a new site – www.investmentforbeginners.com . This site is meant to be a resource for those new to the world of investing. Most of the articles published on this blog are available on the new site. The site has plenty of articles on the basics of investing in stocks, bonds, futures, commodities,options and cash equivalent in addition to articles on as financial planning. In due course, I will add several utilities which will aid users in the investment process. Some of the other features in the pipeline are:

• Financial planning tools such as Present Value/ Future Value calculators
• Mortgage schedule and amortization calculators
• Asset Allocation tools

In future, I will post slightly more advanced on this blog while posting more tutorials and articles for beginners on the above mentioned site.  Click here to access the new site.

Cheers,
Ash.

“Expect the best, plan for the worst, and prepare to be surprised.”- Denis Waitley

Why is planning important?
Planning is an essential part of investing. Planning not only brings in an element of discipline into the investing process but also helps investors better understand their own objectives, needs, unique constraints and risk tolerance.Most High Net Worth Individuals (HNIs) have written documents called Investment Policy Statements (IPSs) outlining their investment objectives, risk tolerance and the methods that their portfolio managers should use to achieve those objectives. Strategic Asset Allocation, tax constraints and liquidity constraints are clearly mentioned in an IPS.Prudent individual investors would do well to create such written documents for themselves.  The key steps in creating an investment plan are as follows:

1. Always plan on paper
It helps to have a written plan as opposed to a vague mental note. Not only does this bring clarity but it also becomes useful when you want to refer to your plan in future.

2. Outline your investment objectives
Investors should outline your long term investment objectives in detail. What sort of returns would investor like over the long run? Can the investor bear the requisite risk? Common long term objectives are:

Capital preservation: Capital preservation implies that the investor’s aim is to maintain the purchasing power of his capital, given an inflation rate and to not lose money through risky investments. This is usually the aim of investors with a low risk appetite such as retirees. Good instruments for capital preservation are Treasury bonds, Inflation linked securities such as TIPS, money market instruments and high quality corporate bonds.

Capital appreciation: Investors whose aim is capital appreciation aim to grow their money. This is usually achieved though increases in the value of their investments. Several investors aim to achieve capital appreciation over long time horizons. This is a common objective among investors with moderate to high risk appetite.

Regular Income: Quite a few investors seek regular income payouts from them investments. This income usually comes from interest (bond coupons etc) and dividends. Of course, it is possible for investors to create their own dividend by selling part of their holdings that have appreciated in value.

3. Understand and document your risk tolerance
It is critical for investors to understand both their capacity to take risk and their willingness to take risk. It is important to understand the distinction between the two. Investors can invest in risky assets as part of a diversified portfolio if they are both willing and able to accept risk.The ability to take on risk depends on several factors such as net worth, age, liquidity requirements, long term goals and mental make-up of the investor. More information on assessing the risk tolerance of investors can be found here. Whatever be the risk tolerance of the investors, it should be documented and taken into account while making investing decisions.

4. Outline your needs and constraints
Investors often have special needs and constraints? Investors should document them and take them into account while making investment decisions. Preferences with respect to asset classes or securities are considerations that should be taken into account while planning.

5. Understand your tax implications
Tax management can significantly enhance investment returns. This is especially important for investors with high marginal tax rates (the tax rate on every additional dollar of income earned). Investing in tax exempt accounts or tax deferred accounts such as retirement accounts could be considered. Deferring the realization of capital gains, investing in tax-exempt securities such as certain Federal government bonds, municipal bonds etc are other strategies that can be considered. When comparing two similar investments, decisions should be made on after-tax returns and not pre-tax returns.

6. Work on Asset Allocation
Asset Allocation is the process by which the investor decides how much is to be invested in each asset class. Asset allocation depends heavily on the investor’s objectives, risk profile and individual preferences. Equities and real estate instruments are risky but offer high returns. Most fixed income securities barring junk bonds tend to give low but stable returns. Government bonds yield the least but are the safest securities.

It is wise to diversify across asset classes and across different securities within an asset class. This reduces the volatility of returns to some extent. Also try to choose assets which are not well correlated with each other. For example, Oil and Gold are not well correlated. Therefore, am Oil ETF may make a good addition to a portfolio heavily weighted with a Gold tracking ETF.
It is impractical to expect large returns despite investing in low risk assets. For a rough idea of the kind of returns that can be expected in the long from different asset classes, refer to the following table. Needless to say, these are just rough estimates of long term expected returns.

7. Plan your response to unexpected changes in market conditions
Investment returns can be volatile, especially over the short-medium run. Try to plan your response ahead of time. At what price will you exit your investment position? What time horizon do you have in mind for each investment? How much of a decline in the value of your investment can you bear before you sell? All these are questions that you should ask yourself before making an investment.

Investors who stick to the fundamental rules such as these tend do well in the long run. Remember, investing involves planning and patience.

Summary of an example plan

• Victor Zhukovsky is a 24 year old Computer Engineer residing in Ithaca, USA with an annual income of US$ 75,000. He is enjoys adventure sports and traveling around the world. He seeks long term capital appreciation from his portfolio worth $50,000. His willingness to take on risk is high.

• Victor needs $20,000 in January 2014 to pay for his tuition fees for a graduate program in Business Management that he plans to attend at a state university in USA. He also needs $10,000 to go on a tour of South America in January 2010.

• Victor is taxed at approx 24% by the United and 7.5% by the New York State Government. In order not to exacerbate his tax burden, all debt instruments in his portfolio should be either Federal, State or Municipal debt unless the after tax yield of the alternate debt instrument is greater than the yield of the equivalent tax-free debt instrument.

• His investments should appreciate at a minimum 5-year average rate of 15% p.a. subject to a maximum decline of 20% between any 2 consecutive years and 10% in any given 5-year period.

• Not more than 90% and not less than 50% of the portfolio may be allocated to equities at any given point of time with the sole exception of the times when the Dow Jones Industrial Average falls by more than 20% in the preceding three months.

• Victor is strongly against the use of tobacco and thus, none of his portfolio companies may be directly involved in the production, processing or distribution of tobacco/tobacco products.

What are commodities?
Commodities are goods which have no differentiation between them and which are identical no matter who produces them. For example, 24 carat gold is the same whether it is mined in South Africa, India or China. It is impossible to tell the difference between two barrels of Brent crude. Therefore, at any given point of time, two different barrels of Brent crude should sell at the same price, and so should 2 different bushels of wheat or 2 different ounces of gold.

Commodities could be precious metals such as gold and silver, base metals such as lead, softs such as coffee or energy related such as crude oil etc. Even complex instruments such as options on freight contracts or weather are traded frequently.

How can one trade in commodities?
Commodities are traded on commodity exchanges such as the Chicago Board of Trade (CBOT) or the Singapore Commodity Exchange (SICOM). The bulk of the commodity trading is done through derivatives such as Futures and Options. A  commodity future is a contract that gives the buyer the right and the obligation to buy or sell a certain quantity of that commodity at a particular price after a particular period of time.

A commodity option gives the buyer the right but not the obligation to do the same. These futures and options can in turn, be traded. Traders can also trade in commodities without using futures or options. For example, I could buy 1 ton of cotton at X dollars and sell it a day later for a profit.

How can individual investors trade commodities?
It is not easy for small investors to trade commodities in general. Investors wanting exposure to oil or gold prices can trade Exchange Traded Funds (ETFs) that track the spot price of gold/oil such as the Benchmark Gold ETF (Gold) or the Macro Shares Oil Up ETF (Oil). Investors have to use options or futures traded on exchanges to get exposure to the prices of other commodities.

Many investors who would like large exposures to commodity prices in a passive manner use collateralized futures positions. This involves the purchase of treasury bills or bonds and the simultaneous entering into a futures contract on the buy side. This position can be rolled over indefinitely as long as the collateral is sufficient to maintain the required maintenance margin.

Commodities are not well correlated with equities and could thus provide valuable diversification benefits.

What are options?
An option is a legally binding contract that gives the buyer the right but not the obligation to buy(or sell) a pre-determined asset at a pre-determined price on a pre-determined date. For example, a call option on 1 Google share with strike price of $500 expiring on 22^nd June, 2009 gives the buyer the right to buy 1 Google share at the price of $500 on 22^nd June, 2009.

Terminology

Strike Price: The pre-determined price at which the option buyer can buy (or sell) the underlying asset at the pre-determined date.

Expiry Date: The pre-determined date on or before which the option buyer can buy (or sell) the underlying asset at the strike price.

Exercise: The process by which the option buyer “exercises” his right to buy (or sell) the underlying asset on or before the expiry date, thereby taking delivery of the underlying asset.

American option: The type of option which gives the buyer the right to exercise it anytime on or before the expiry date.

European option: The type of option which gives the buyer the right to exercise it only on the expiry date.

Option premium: The price of the option, i.e. the amount of money that the option buyer has to pay the seller in order to buy the option.

In the money: If the exercise of an option would result in a profit at that particular moment, it is said to be “in the money” at that moment.

Out of the money: If the exercise of an option would not result in a profit at that particular moment, it is said to be “out of the money” at that moment.

Types of Options
There are two main types of options are:

1. Call Options: Call options give the buyer the right but not the obligation to buy the underlying asset at a pre-determined price on a pre-determined date.

1. Put Options: Put options give the buyer the right but not the obligation to sell the underlying asset at a pre-determined price on a pre-determined date.

Modalities
Options give investors leverage as they expose investors to large possible changes in the value of their position with small amounts of initial capital. Leverage serves to multiply gains as well as losses.

For example, in order to gain exposure to the movement in price of 1000 shares of PQR Corp, trading at $10 per share, an investor could spend $10,000 and buy 1000 shares. A 10% increase in the share price of PQR (to $110 per share) would give him a profit of $1000, i.e. 10% of his initial investment. This is the traditional way of investing.

However, if the same investor were to buy an American style call option with strike price $10 and 1 month to expiry, he would only have to pay the option premium which is say, $0.5 per option i.e. a total of $500. The same 10% increase in price of the underlying shares (to $110 per share) would make it attractive for him to exercise his options. He could exercise his options and receive 1000 shares of PQR Corp at $10 per share, paying $10,000. He could then sell these shares in the open market at $110 per share (current market price), thereby making a profit of $1000. This is 200% of his initial investment (of $500).

Fortunately, this is not true for losses. A 10% fall in the price of the underlying shares would ensure that it is unattractive for the option buyer to exercise his option. Why buy 1 share of PQR Corp at $100 when it is available in the open market for $90? The investor would allow his option to expire, worthless. This however, means that he would lose the option premium paid. Thus, the maximum amount that an option buyer can lose is the option premium.

The option seller however, has an unlimited downside. If the option were to be exercised, he would have to deliver the underlying shares at the pre-determined price (call option) even if it means buying shares in the open market and delivering them at a loss. The option seller is rewarded for taking this risk in the form of the option premium.

How are options traded?
Like futures, options too are traded on exchanges. The exchange regulates the trade of options and acts as the counterparty to both the buyers and the sellers. The major difference between futures and options in this regard is that options on the same underlying asset can have different strike prices unlike futures where the price is market determined.

Advantages

1. Options give their buyers leverage. Hence, they gain exposure to large price movements with limited amounts of capital thereby making them excellent tools for speculators.
2. Options are good ways to hedge exposure to the underlying asset price movement.

Disadvantages

1. Options expire on the expiry date. Hence is possible for option buyers to lose their entire investment if their options expire out of the money.
2. Option sellers have an unlimited downside and can lose more money than the premium they receive.

Exotic Options
We have only examined basic options in this article. Complex and exotic options such as Barrier options, Digital options, Bermudan style options, James Bond style options exist and are popular with institutional investors. These shall be examined in another article.

What are futures?
Futures are legally binding contracts that give the buyer the right and the obligation to buy a pre-determined asset at a pre-determined price at a pre-determined time. Conversely, the seller has the right and the obligation to deliver that pre-determined asset at that pre-determined price at that pre-determined time.The underlying assets can be stocks, bonds, baskets of stocks, commodities etc.

How are futures traded?
Like stocks, futures are traded on exchanges. The exchange regulates the details of the futures contracts and their trade. The exchange also acts as the counterparty in the case of the buyer as well as the seller of the futures contract, i.e. buyers buy futures contracts from the exchange and sellers sell these contracts to the exchange.This virtually eliminates the risk of default as far as the buyers and sellers are concerned.

Modalities
Futures prices are market determined and there is usually no fee needed to take a position (unlike options). Futures positions can be closed by either delivering the underlying asset using something called the delivery option or by paying (or receiving) the loss (or gain) on the contract in a process called cash settlement. Futures can also be rolled over to a later date as long as all margin requirements are met.
Futures give investors leverage as they expose investors to large possible changes in the value of their position with small amounts of initial capital. Leverage serves to multiply gains as well as losses.

For example, in order to gain exposure to the movement in price of 1000 shares of PQR Corp, trading at $10 per share, an investor could spend $10,000 and buy 1000 shares. A 5% increase in the share price of PQR would give him a profit of $500, i.e. 5% of his initial investment. This is the traditional way of investing.However, if the same investor were to enter into a futures contract, he would only have to put up the initial margin which is say, 10% of the value of the contract, i.e. $1000. The same 5% increase in price of the underlying shares would give him the same profit, i.e. $500. However, this is 50% of his initial investment. Unfortunately, this is true even for losses. A 5% fall in the price of the underlying shares would also cause a loss of 5% to the stock investor by a loss of 50% to the futures investor.

Terminology

Long Position: When an investor enters into a contract to buy a certain asset at a certain market determined price, he is said to take the long position in that contract.

Short Position: When an investor enters into a contract to sell a certain asset at a certain price, he is said to take the short position in that contract.

Marking to Market (MTM): The process by which the value of holding a given futures contract at that particular moment of time is determined. This value of a contract is the money that were to be gained or lost if the contract were to be settled at that moment. This is usually done on a daily basis by the exchange. The gains or losses from marking to market are immediately credited (or deducted) from the investors’ accounts.
For example, if an investor were holding a long position a futures contract on ABC Stock at $ 714 and the market price of ABC stock were $720, she would gain $6 in the process of marking to market. This amount would immediately be credit to his/her account.

Initial Margin: This is the amount of money that investors have to deposit as a performance guarantee in order to open a futures position. This amount is determined by the exchange and is typically about 10-15% of the value of the futures contract.

Maintenance Margin: This is the minimum amount of money, as a percentage of the contract’s value, which investors have to put up in their account as a performance guarantee. If investors lose money during the process of marking to market and their account margin falls below the maintenance margin, a margin call is triggered and they will have to deposit more money.

Expiration: The day the contract expires and the asset has the delivered is called the expiration date of that contract.

How individual investors can invest in futures
Investors can open futures positions through a broker. The broker would then give access to futures traded on an exchange.

Advantages

1. Futures give investors leverage and can thus be used to achieve large gains with small amount of capital.
2. The exchange is the counterparty to all futures transactions and thus, there is virtually no credit risk involved.
3. Futures can be used for speculation as well as hedging.

Disadvantages

1. The leverage that futures contracts give investors in also their biggest disadvantage. Investors can potentially lose more money than they had initially invested.
2. The mark to market feature of futures can potentially impose severe cash-flow pressure on investors.

Risks

1. This biggest risk of entering futures contracts is the risk arising from large amounts of leverage. Small fluctuations in the price of the underlying assets could result in large losses.
2. If investors are not able to meet margin calls, their position is liquidated. One way to minimize this risk is to over-collateralize the futures position.

What are debt instruments?
Debt instruments such as bonds, bills and commercial paper are loans that governments or corporations take from investors. The difference between ordinary loans and most debt instruments is that these instruments can be traded on the secondary market, i.e. between any two entities without the explicit consent of the issuer (entity that has taken the loan).

Corporations and governments often need capital in order to meet their expenditure, plan new projects or meet obligations. One way they raise capital is to issue bonds

Terminology
Face Value or par value: The notional value of the bond/instrument. This is the amount that will be paid to the instrument holder upon maturity.Coupon payments are also calculated based on this amount as the principal.

Coupon: Periodic interest payments paid to bondholders. Most coupon payments are semi-annual i.e. twice a year.

Yield: Yield can be thought of as the compound interest rate that is received from the investment, which takes into account, the coupon payments and discount/premium from the par value.(Technically speaking, yield is the discount rate that makes the present value of future cash flows received from the investment, equal to the current price of the instrument)

Maturity: The time period after which the face value of the bond is returned to the bondholder and by which time all coupon payments are paid.

Issuer: The corporation or government that takes the loan from the investor.

Discounted Instruments: Instruments that are issued at prices below their par value.

Credit Ratings: Ratings that are given to debt instruments by specialized rating agencies that indicate the probability of default and the likelihood of recovery of the amount due to the bondholder in case of default by the issuer.

Major types of Debt Instruments

Bonds
Bonds are debt instruments with moderate-long maturities issued by governments and corporations. Bonds pay face value at maturity along with periodic interest payments known as coupon payments.

Debentures/ Notes
Debentures are unsecured promissory notes with long maturities usually issued by corporations. Debentures are considered more risky than secured forms of lending and thus tend to pay higher interest than collateralized loans.

Bills
Bills are short term loans usually issued by governments. These are generally discounted securities.

Commercial Paper
Commercial papers are unsecured short term securities (maturities below 9 months) issued by banks and corporations with very high credit ratings to meet short term obligations such as debt and payrolls. Most commercial paper is sold at a discount to par value.

How individual investors can invest in debt instruments
Individual investors can invest in debt instruments either through the issuer directly or through a broker on the secondary market. Investors can also invest in mutual funds that invest in debt securities.

Advantages

1. Debt instruments are generally safer than stocks. Instruments issued by entities with good credit ratings are usually very safe.
2. Most debt instruments such as bonds are fairly liquid and can be traded on the secondary market.
3. Bonds and debentures pay higher interest than cash equivalents.

Disadvantages

1. Debt instruments, carry credit risk i.e. risk of default.
2. Junk bonds (Credit rating lower than BBB) are very risky and have often been defaulted upon.
3. Some debt instruments are illiquid, especially those with low credit ratings.
4. Debt instruments carry interest rate risk i.e. the risk that the interest rates required by the market rise, thereby reducing the value of existing investments.

Risks

1. Credit Risk: Credit Risk is the risk of the issuer defaulting on the principal repayment or the coupon payment.
2. Interest Rate Risk: Interest rate risk is the risk of the market interest rates rising, thereby reducing the market price of existing interest bearing investments.
3. Liquidity Risk: Liquidity risk is the risk that the debt instrument cannot be traded quickly in the market due lack of sufficient interest from potential buyers.

What are cash equivalents?
Cash equivalents are highly liquid securities that mature typically within three months. Cash equivalents include money market securities, short term Treasury bills, short term Government bonds etc. Money in savings accounts and checking accounts too would be considered equivalent to cash as long as the funds can readily be accessed. In most countries, a government linked body guarantees checking and saving deposits in banks up to a certain limit; e.g. FDIC(USA), MAS(Singapore), RBI(India).

Money Market Instruments
Money market instruments are highly liquid, short term securities issued by governments and corporations. These include:

1. Commercial Paper: Commercial papers are unsecured short term securities (maturities below 9 months) issued by banks and corporations with very high credit ratings to meet short term obligations such as debt and payrolls. Most commercial paper is sold at a discount to par value.
2. Repurchase Agreements: Repurchase agreements are a form of collateralized borrowing and are used very often in the inter-bank market.
3. Certificates of Deposit: Certificates of Deposit(CDs) are bank deposits which can usually be sold before maturity in the secondary market.
4. Bankers Acceptances: Bankers Acceptances (BAs) are short term instruments that are often used during international trade. They are generally very safe instruments when issued by large banks. These instruments can be traded in the secondary market as discount instruments. However, the face value of such instruments is usually in excess of US$ 100,000.

How do individual investors invested in Money Market Instruments?
Most money market instruments have very high face values and are probably not of much interest to the individual investor. However, small investors can invest in money market funds which invest in these instruments. This is a good option as long as such funds don’t charge heavy entry/exit loads and administrative fees.

Investors can invest in Certificates of Deposits and Time Deposits through any commercial bank.

Advantages

1. Cash equivalents are highly liquid and hence can be used in case of emergencies.
2. Since most cash equivalents tend to be of very high credit quality, they are generally very safe.

Disadvantages

1. The returns from cash equivalents tend to be very low, usually less than 2% p.a. in most developed economies.
2. Though most money market instruments are of very high credit quality, they are not 100% risk free.
3. Investors, especially those who invest in discount securities face interest rate risk.

What are Exchange Traded Funds?

Exchange traded funds (ETFs) are mutual funds whose shares trade on stock exchanges just likes any other stock. Investors can buy shares of ETFs just as they buy shares of any other company, through stock brokers.

Unique features
ETFs tend to trade at prices very close to their Net Asset Values (NAVs). This is facilitated by a unique mechanism involving arbitrage. Certain large players and institutional investors are designated as “Authorized participants” and are allowed to create and redeem shares of these ETFs by exchanging shares of the ETF with a basket of the shares that the ETF tracks.

For example, if ABC ETF tracks the Dow Jones Industrial Average and has an NAV of $9.31 but trades on the NYSE at $9.41, an authorized participant XYZ Investments Corp would simply buy the equivalent number of shares of the components of the Dow Jones Industrial Average and give this basket to the mutual fund that manages ABC ETF, which would then issue shares of ABC ETF to XYZ Corp. XYZ would immediately sell these ETF shares in the open market for $9.41 and make a profit of $0.1 per share. If XYZ sells 1 million shares, it would earn $100,000. This would bring down the price of ABC ETF in the open market.

The inverse transaction would occur if the ETF were to trade below its NAV.
Thus, arbitrage ensures that ETFs trade at prices that are very close to their NAVs.

Advantages
1) ETFs do not involve entry or exit load. Thus, they are efficient means of getting exposure to the underlying basket of securities.
2) Most ETFs track a given index. Thus, they provide good diversification benefits.
3) Since they usually trade at prices very close to their NAVs, ETFs are cost-efficient. Investors however, have to pay brokerage charges to buy/sell shares of ETFs.
Though it is possible that illiquid ETFs may trade at discounts/premiums to their NAV, it is very rare because of the above mentioned mechanism.

What is a mutual fund?
Simply put, a mutual fund is a basket of assets, typically stocks. An entity, usually a corporation, comes up with a plan to invest in certain assets, typically stocks and raises capital through the issue of shares to investors in a process called a New Fund Offer (NFO). This corporation is called the Mutual Fund. The fund is managed by an individual called the Fund Manager.

The fund then invests this capital in shares/bonds as per the objective of the fund as outlined in the prospectus issued to investors. The mutual fund investors therefore, indirectly own the assets that the mutual fund owns by owning pieces of the mutual fund.

Type of assets owned by the fund
Most mutual funds are equity funds, i.e. they invest in stocks. However, several mutual funds invest in corporate bonds, commodities or a combination of all of these. For example, the Fidelity Equity-Income fund aims to invest 80% of its portfolio in shares of large-cap American companies while the SBI Magnum Midcap fund aims to invest predominantly in a well diversified basket of shares of Midcap companies in India.

Investors will know beforehand, which asset classes the fund invests in as the target asset allocation and the type of investments considered will be outlined in the prospectus.

Open ended and Closed ended mutual funds
Open ended funds are mutual funds that do no limit the number of shares issued by them. In other words, shares of the open ended mutual funds can be issued and redeemed by the fund. The investors of open ended funds transact directly with the fund. New investors who would like to invest in the fund are issued new shares by the fund. Investors who want to disinvest from the fund receive cash from the fund after redemption of their shares.

Closed ended funds are mutual funds who limit the number of shares issued by them. After the NFO, investors who want to invest in closed ended funds have to buy shares of the fund from existing investors of the fund.  The fund does not normally issue new shares after the NFO.

Net Asset Value(NAV)
Net Asset Value of a mutual fund is the total market value of all the assets owned by the fund minus the total market value of all the liabilities of the fund divided by the total number of shares issued by the fund. In other words, it is the per-share value of the fund. For example, if ABC mutual fund owns shares of several companies totalling 5 million US$ and owes its employees, salaries totalling $500,000 and has issued 1 million shares since its inception, its net asset value is $4.5 per share or simply $4.5 .

What is the risk-return profile of mutual funds?
The risk-return profile of a mutual fund depends heavily on the fund’s objective, the asset classes it invests and the type of securities it invests in. The bottom line is that a mutual fund has the same risk profile as the securities that it invests in. Equity mutual funds carry the risk profile of equity securities while bond funds carry the risks of bonds and so on. Midcap funds are generally more risky than large cap funds while money market funds are usually the safest. Since most mutual funds invest in a well diversified basket of securities, the risk carried by such funds is much lower than the risk from investing in a single security.

Types of mutual funds
Equity funds invest in equity securities i.e. shares. They may also invest in stock options, futures etc. Equity funds may focus on investment style such as Value, Growth funds, Index or on specific sectors such as Infrastructure, Automobiles, Telecom etc. Mid-cap funds invest in mid-market capitalization companies while small cap funds invest in companies with small market capitalization. Similarly, Emerging market funds invest in companies from emerging markets such as India, Russia, Brazil etc.

Bond funds invest in a basket of corporate bonds. Bond funds provide diversification benefits and reduce the total credit risk borne by the investor.

Balanced funds invest in a combination of equity and debt instruments i.e. shares and bonds.

Advantages
Investing in mutual funds is a relatively cheap way of diversifying. Depending on the fund objective and structure, it could also provide economies of scale. For example, if person wanting to invest $100 in telecom companies in USA, it would be far easier and cheaper to buy 10 shares of XYZ Telecom mutual fund than buy 1 share of AT&T, 1 share of Verizon and so on. Mutual funds also, in a sense, force some amount of diversification and thus reduce the overall risk borne by the investor.

Disadvantages
Mutual funds often charge entry and exit loads i.e. one time fees to issuance and redeem of shares. This money goes to the fund and is often used for marketing and sales activities. These loads typically amount to about 1-3% of the investment. Thus, investors who invest $100 in mutual funds typically only end up getting shares worth $97. Funds also charge Management fees and/or Other fees which typically amounts to 1-1.5% p.a. This cost too is borne by the investor.

The emergence of No-Load mutual funds is a big step in towards eliminating such unnecessary expense for the investors. Several funds, especially Exchange Traded Funds (ETFs) now have low expense ratios, typically less than 1% p.a.  Investors can consider investing in such funds.

Risks
The main risk that investors in mutual funds face is market risk, i.e. the risk that the prices of the assets that the mutual fund invests in, fall due to changes in market conditions thereby reducing the Net Asset Value of the fund. Note that unsystematic risk (The risk that fluctuations in the prices of individual stocks/bonds due to company specific reasons will effect the NAV), is virtually nil. This is due to diversification benefits.

Investors also bear the risk that the fund manager will deviate from the fund’s stated objective thereby distorting returns. This risk is called manager risk. Investors in funds that invest outside their home country also bear currency risk(The risk that changes in exchange rates distort returns).

How can one invest in mutual funds?
Investors can approach the fund directly or use the services of a broker(e.g. Charles Schwab or E-Trade) in order to buy shares of mutual funds. Most brokers charge a brokerage fee for enabling you to buy no load funds or exchange traded funds.