Mutual Fund

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Mutual Fund Meaning

A mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etc. Professionals handle the investments on behalf of the investors who gain enhanced earnings based on their risk appetite.

The portfolio of securities under the fund can be diversified into many types. For example, there could be a combination of stocks and bonds or only equities/bonds. Securities could also be segmented by industries such as tech or energy.

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Key Takeaways

  • A mutual fund is a diversified investment scheme whereby each investor owns a partial share of the securities bundle in which typically an asset management company (AMC) invests their accumulated funds.
  • It is professionally handled by the fund manager whose job is to ensure optimum returns to the investors as per the fund objectives.
  • In return, investors pay certain charges such as the total expense ratio. Charges could vary as per companies but many involve management and transaction fee.
  • These funds are available under the systematic investment plan (SIP), where investors contribute funds in the scheme through small fixed amounts payable every month. However, an investor can opt for a lumpsum investment too.
  • It is a lucrative opportunity for early investors and middle-and high-income groups as it provides diversification, tax-saving, liquidity, and affordability.

How Does a Mutual Fund Work?

A mutual fund is an investment scheme that holds assets such as stocks/bonds or a combination of two. The portfolio of securities held under the fund comes with a variety to suit the needs of diverse investors. For example, risk-averseRisk-averseThe term "risk-averse" refers to a person's unwillingness to take risks. Investors who prefer a low-return investment with known risks to a higher-return investment with unknown risks, for example, are risk-averse.read more investors can opt for a mutual fund account with fixed-interest bonds as they are safer and pay a regular income. Additionally, those with a medium risk appetite can go for a mixture of equities and bonds. If the stock market crashesStock Market CrashesA stock market crash occurs when stock prices in all sectors begin to fall rapidly. It is often the result of global factors such as war, scam, or the collapse of a certain industry. In such a crash, panic acts as a catalyst.read more, your loss can be somewhat offset with the fixed interests of the bonds.

Moreover, the fund helps with affordability as it pools money from a group of investors. Suppose you want to buy an expensive stock priced at $900 per share. For a retail investorRetail InvestorA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more, that’s expensive. As an alternative, you can invest $900 in a mutual fund that holds this stock along with many other stocks.

As such, these funds allow middle-income retail investors to be a part of a professionally managed and large-scale investment. They own a part of the investment, just like getting a smaller slice of an apple. Investors get units or shares of the fund in the ratio of the investment made by them. For example, if a fund has total assets of $15000, and an individual invests $750, they will acquire 5% of the total fund value. 

Risks and profits are shared amongst investors. Most funds allow the investor to sell off their shares at any point they want, bringing in liquidity. Also, typically, an asset management companyAsset Management CompanyAn Asset Management Company (AMC) refers to a fund house, which pools money from various sources and invests the same in purchasing capital on behalf of their investors.read more (AMC) undertakes investments with the fund manager overlooking the fund management.

What is Mutual Fund? Video Explanation

 

Features

t-rowe-mutual-fund
  1. A typical portfolio holds between 40-100 stocks depending on the manager’s objective. Investments can be diversified by industries, nations, mid-cap, large-cap stock, etc.
  2. Depending on the type of mutual fund, investors could gain dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more, interests, or a combination of both and even capital gains. The income is distributed in the ratio of funds invested by them. The fund manager may decide to reinvest or share the profits out of sales or price appreciation amongst the investors.
  3. The value of each unit of the mutual fund is referred to as net asset value (NAV). NAV = (Market value of all securities in the fund – fund expenses)/ total number of units outstanding in the fund
  4. Suppose a fund has assets worth $70 million and $5 million expenses. The total number of units held by investors is $2 million. Then, the NAV will be $32.5. If an investor has 100 units, with NAV being $32.5, the total investment held by the investor is $3250.
  5. NAVs are updated every day. Investors can compare profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more by comparing NAVs of different months/periods.
  6. An investor should always go through the total expense ratio of a mutual fundExpense Ratio Of A Mutual FundMutual Fund Expense Ratio is the percentage amount charged by the fund manager in exchange of the services provided. The charges include management expense, advisory fees, travel cost, consultancy charges, however, brokerage cost for trading in excluded.read more before investing in it as it reflects its fees. Charges vary with companies, but often, it is a management and transaction fees which is usually between 1-3%. Other charges may include the shareholder fees and early withdrawal penalty if any.
  7. The funds are either actively or passively managed. Actively managed funds take trading decisions actively based on ongoing trends and fluctuations of the market. They have higher fees due to more participation. While passively managed funds hold securities of a benchmark index and follow their movement with no active management.
  8. Many schemes come with tax advantage. Citing the importance of after-tax returns, few products can help investors gaining the tax alpha. For tax alpha, the individual accounts are handled by an investment manager who knows the long and short-term tax implications.

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Types of Mutual Fund

We can classify mutual funds based on structure and asset class.

1) Based on Structure

2) Based on Asset Type

Mutual Fund Example

fidelity-mutual-fund

There are many mutual fund companies and websites with screeners, advisors and calculators to help investors prepare an ideal portfolio along with their expected returnsExpected ReturnsThe Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results. Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn), where, pi = Probability of each return and ri = Rate of return with probability. read more. BlackRock, Vanguard Group, and Fidelity Investments are some highly reputed mutual fund companies.

Distinct metrics judge the ranking of funds. For instance, Invesco Premium Portfolio is a famous money market fundMoney Market FundA money market fund is a form of short-term debt security or open-ended mutual fund with a shorter maturity, offering good returns at high liquidity and low credit risk. The instruments it invests in include US Treasury bills, bank debt funds, and corporate commercial papers that could be taxable or free from tax.read more. Its minimum investment requirement is $1000, 0.18% expense ratio and a 7-day yield of 0.11%.

Mutual Funds – Advantages and Disadvantages

For years, these funds have helped young individuals, especially those with limited or fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.read more, to make bigger gains due to their affordability and the option of SIPs. Besides, open-ended funds provide greater liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more to the investors while many bring down the tax liability.

Professionals who understand the market’s nerve and hold rich experience can help grow funds exponentially. Additionally, investors hold regulatory assistance as the industry is appropriately regulated. For example, the law requires funds to file shareholder reports regularly with the SEC.

However, there are also certain disadvantages. Investors should invest in a portfolioInvest In A PortfolioPortfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns that are proportional to the investor's risk profile.read more after ensuring it is suited to their risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more and financial goals. A balanced portfolio helps in offsetting losses. Otherwise, it could bring in heavy losses as mutual funds are prone to market fluctuations, lowering average returns of even actively managed funds that customize trading as per trends.

In 2018, even the actively managed funds saw massive losses in the US owing to interest rates hikes and economic slowdown. Sometimes, the fees charged from the investors is relatively high, lowering earnings. Besides, some funds have lock-in periods where early withdrawals result in penalties.

Mutual Fund Vs ETF Vs Index Fund

An exchange-traded fund is a combination of securities which is tradable on a stock exchange. They track an index or commodity, etc. An index fund tracks an underlying benchmark market index value like the S&P 500.

BasisMutual FundExchange-Traded FundIndex Fund
TradingThrough a company or brokerage firm at NAV at a day’s closingIntraday trading on the stock exchange at the current valueBought and sold through a fund manager at the day’s closing
Investment GoalOutperform the marketFulfil long-term objectivesReplicate the index performance
Fund ManagementActively/ Passively managed by professionalsPassivePassive
Expense RatioCosts more under active managementInvolves comparatively low feesInvolves comparatively low fees and even lowest at times
Tax EfficientDepends on the assetsComparatively moreTo some extent
LiquidityComparatively low HighLower than ETFs
ExampleFidelity Government Cash ReservesJPMorgan BetaBuilders US Equity ETFiShares Core FTSE 100 UCITS ETF

FAQs

What is meant by mutual funds?

Mutual funds refer to diversified investment schemes that accumulate sums from various investors to buy a bundle of different assets such as stocks, bonds, money market instruments, gold or other securities.

How to make money in mutual funds?

An investor can earn from mutual funds in the following ways:
• Price rise of securities;
• Dividends and interest on equity and bonds; and
• Appraisal of fund’s share value.

Are mutual funds safe?

These funds are pretty safe and rewarding if you select a suitable product as per your investment objective. Also, many are beneficial if held for the long term. But an investor should only invest in a scheme that aligns with their risk capacity and profit goals.

This has been a guide to Mutual Fund, its definition, investment objective and why people invest in mutual funds. You may also have a look at these articles below for further details –

Reader Interactions

Comments

  1. Bryant peters says

    Thanks for posting such an informative blog. Great work Sir. Are there any kinds of mutual funds on the basis of the maturity period of investments?

    • Dheeraj Vaidya says

      Hey Bryant, There are 3 kinds of mutual funds followed on the period of investments they are as follows
      1. Open Ended- under these scheme units can be bought or sold at any time and maturity date is also not fixed
      2. Close Ended- under this scheme maturity period is stipulated and also the investments can be made by the investors only at the time when they are launched initially.
      3. Interval- This operates as a combination of the schemes that are open as well as closed-ended and investors are allowed to do trading of the units and the intervals that are pre-defined.

  2. Braden Connor says

    Great resource with excellent blogs. Congrats for your great work. Very helpful and informative. do you have any blog where you have explained about hedge funds and mutual funds? I want to know their diffrences and how these both work. Let me know if have any blog related to my subject.

    • Dheeraj Vaidya says

      Thanks Braden! I would like you to refer this link for Hedge funds related answers. This is one of my best work in which I have explained all the differences and the strategies of both. Hope you will like this.