Mutual Fund Definition
A mutual fund is a type of investment fund that is professionally managed by investors by pooling in money from multiple investors for the purpose of initiating investment in securities that are individually held to provide an enhanced level of liquidity, greater diversification, lower level of risks, etc.
A mutual fund is a pool of investment managed professionally for the purpose of purchasing various securities and culminating them into a strong portfolio that will offer attractive returns over and above the risk-free returns which are currently being offered by the market. A mutual fund is a financial product that invests in stocks or bonds. Owning a mutual fund is like getting a smaller slice of an apple. Investors get units of the fund in proportion to their investments. Suppose a mutual fund has total assets of $5000 and someone invests $500, he/she will get 10% units of the fund.
Benefits of Mutual Fund
There are various benefits of investing in Mutual Funds such as:
- The higher level of diversification since the basket of a portfolio will be aimed at spreading the investment in order to offer protection against concentration risks
- They provide regular liquidity as shareholders of open-ended funds and unit investment trusts may sell their holdings back to the fund at regular intervals at a price equal to the NAV of the fund’s holdings.
- Managed by professional investors who have rich experience in investment and can understand the nerves of the market.
- Since mutual funds are regulated by a Government body i.e. AMFI in India, it offers protection and comfort to the investors before considering an investment opportunity.
- All the mutual funds are required to report the same level of information to the investors which makes it relatively easier for comparison in case of diversification.
- These funds provide regular reports of their performance and are also easily available on the internet to understand past trends as well as the strategies implemented.
Structures of Mutual Funds
There are 3 primary structures of mutual funds:
#1 – Close-Ended Mutual Funds
These funds issue shares to the general public only once during the IPO (Initial Public Offering). The shares are listed on the stock exchange and shares can be sold only to another investor in the market and not to the fund. The price which investors can garner for their investment may differ from the NAV and could either be at a ‘Premium’ or at a ‘Discount’ of the NAV.
#2 – Open-Ended Mutual Funds
Most of the mutual funds existing belong to this category as they permit investors to trade units at any point of time at the NAV (Net Asset Value). This NAV of the fund is computed basis the price of the securities in the portfolio. Such advantages offer benefits to the investors for the enhancement of returns during bullish markets or relevant liquidation during choppy market conditions.
#3 – Unit Investment Funds
These trusts issue shares only once upon their creation with the overall portfolio also remaining unchanged. They generally have a restricted life span whereby the investors can redeem shares directly from the fund at any point in time or can choose to wait until the termination of the trust. Such funds do not have the services of a professional fund manager.
Why Invest in Mutual Fund?
Individuals, corporations, small businessmen, etc. who want to invest in the stock market but do not have expertise and time to do so can invest through a mutual fund. Some key benefits of investing in an MF
#1 – Professional Management
“Portfolio Manager” invests money on investor’s behalf with the responsibility of growing it and making profits for unitholders. So investors don’t need to be an expert on stock fundamentals or market technicalities. The portfolio manager performs research to unveil new profitable stock ideas. He keeps a tab on economic activities in regions/countries and accordingly decides his investment exposures.
Most of you know Warren Buffet. He is a legendary manager outperforming the market index for many years. He employed valuations and a quality-based approach to investing. We will discuss different investment styles in the below section.
#2 – Diversification
A mutual fund provides diversification by investing in a variety of stocks. Imagine you want to buy a Google stock which will cost you ~$800 for one stock so it is expensive. Now think of investing $800 in an MF, that holds Google stock along with many other stocks. This is a very important advantage in investing through an MF.
A typical portfolio holds between 40-100 stocks depending on the manager’s objective. A manager invests in stocks of various industries or countries to reduce the risk of losing the money. See below T Rowe Price Emerging Market fund example for diversification.
The fund has invested more than 80% of the money in the top 10 countries like China, India, and Brazil, etc. Similarly across different sectors with highest in IT, financials and consumer staples. This provides diversification to investors with less money.
#3 – Liquidity
Investing in a mutual fund can be considered as closer to holding cash as investors can sell the units anytime and receive cash. The portfolio manager always keeps cash handy for redemption requirements. So if you place a sell order today, you will get cash in the next one or two days. The fund documents generally mention the settlement period e.g. T+2 means 2 days from a trading day (T). A portfolio manager also invests a portion of money in stocks which he can easily sell to meet redemption requests.
#4 – Ease of Investing & Affordability
Investing in an MF has become less painful over the years with the help of technology. Anyone can buy a fund by simply visiting the fund or broker website. One can buy and sell an MF and perform tasks like generating a statement, making incremental investments at a click of a button.
Investing in a mutual fund is not very expensive. To open an account minimum amount could be $1000 or less. For incremental purchases, the minimum amount is $100. Also, investors have a choice of investing in a fund through options like systematic investment or withdrawal which could be used for regular saving or to meet expenses.
Investment Objectives of the Mutual Fund
Kid’s college education or marriage, retirement planning or medical expenses are some of the things many of us are planning through our working lives. I would like to list a few investment objectives of Mutual funds below that may help readers in making an investment decision.
#1 – Goal-Based Investing
This is the top investment objective of Mutual funds. As mentioned above, one can plan future expenses and invest accordingly. Many fund complexes offer “Target Date Funds” or customized “Fund of Fund” which basically allocates the assets to equity and bond MF’s. The difference between two is target-date funds are non-discretionary i.e. investor can only invest in one of the available plans and can’t choose the exposure according to his/her needs. Fund of Funds could be dynamic and invests according to target asset mix suitable for investors after looking at his/her risk profile and liabilities etc.
However, the mix will be rebalanced as the holder is approaching the target date. The basic rule is to invest more money in equities and as a holder grows old; allocate more money to debt mutual fund e.g. at 30 years old investor should invest a 30% in debt and 70% in equities (this is a thumb rule).
Many mutual funds investment objectives include the Investment Growth model. Investors who are retirement ready and looking for aggressive returns can do so by taking some extra risk. Mutual Fund sufficing this objective invests money in fast-growing companies like small caps or companies with positive trends in stock price (price momentum) etc.
Tax Savings is also one of the popular investment objectives of Mutual fund. Mostly wealthy clients, Institutional investors, and corporates have an objective to minimize the tax outlays. Taxes can eat into returns making it negative or trivial. Citing the importance of after-tax returns, few products can help investors gaining the ‘tax alpha’. These products are built by combinations of MFs, Index funds or ETF’s and stocks or bonds. Typically individual account is handled by an investment manager who knows the long and short-term tax implications. Buying and selling are driven by tax alpha gains.
Suppose you are holding fund A and Fund B then
- If you have capital gains in both A&B, you will be taxed for both at applicable income tax.
- If you have a capital gain in A and loss in B, then you can set off the losses against the gains of A and thus reduce the tax liability.
Thus by taking appropriate exposures, tax outgo can be optimized to produce overall gains in An account.
Investing in a mutual fund is a science and I tried addressing some of the jargon and techniques in the above sections. Going by the flow, investors could follow some basic investing rules like
- Age of investing decides allocation in equity, debt or alternative funds. Younger you are more you can invest inequities.
- Liabilities assessment and future expenses
- Risk tolerance- e.g. high risk-taking ability then invest in aggressive growth or deep value or alternative funds
- Choose an MF that suits your needs
- Build a diversified portfolio- allocate money to each class of funds
- Keep an eye on the performance etc.
This has been a guide to what is Mutual Fund, definition, why invest in mutual funds and investment objectives of Mutual funds. You may also have a look at these articles below for further details –
- Incremental IRR in Excel – Examples
- Index Funds vs Mutual Funds – Key Differences
- Capital Gains vs Dividends – Find the Best One!
- Open-Ended vs Close Ended Mutual Funds | Top 14 Differences!
- Top 10 Best Mutual Fund Books
- Mutual Fund Analyst | Complete Beginner’s Guide
- ETF vs Index Funds | Top 8 Differences You Must Know!