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.
- 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-averse 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., 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., 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 Companyset Management Company is a company that takes the financial assets of a person, company or another asset management company (generally this will be high net worth individuals) and use the assets to invest in companies that use those as a operational investment, financial investment or any other investment in order to grow the investment. (AMC) undertakes investments with the fund manager overlooking the fund management.
- 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.
- Depending on the type of mutual fund, investors could gain dividendsDividendsDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company., 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.
- 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
- 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.
- 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. by comparing NAVs of different months/periods.
- 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. 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.
- 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.
- 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.
Types of Mutual Fund
We can classify mutual funds based on structure and asset class.
1) Based on Structure
- Open-ended funds – They are very common and allow investors to trade units at any point of time at the NAV.
- Close-ended funds – Involves issuing shares to the general public only once during the IPO. Once listed on the exchange, they can be sold only to another investor and not to the fund. Shares are traded at a premium or discount of the NAV.
- Unit Investment Funds – where trusts issue shares only once upon their creation with the overall portfolio also remaining unchanged. They don’t come with the services of a professional fund manager and have a restricted life span although investors can sell anytime.
2) Based on Asset Type
- Money Market Funds: They pool money towards short-term low risk assets such as certificates of depositsCertificates Of DepositsCertificate of deposit (CD) is a money market instrument issued by a bank to raise funds from the secondary money market. It is issued for a specific period for a fixed amount of money with a fixed rate of interest. It is an arrangement between the depositor of money and the bank. and treasury billsTreasury BillsTreasury Bills or a T-Bill controls temporary liquidity fluctuations. The Central Bank is responsible for issuing the same on behalf of the government. It is given at its redemption price and a discounted rate and is repaid when it reaches maturity..
- Equity Funds: They could contain value stocksValue StocksValue Stock is one that has the potential of selling at a higher price but due to the company’s adverse condition in the market, the stock is trading at a lower price than its actual worth based on its earnings, dividend, or sales., growth equity, small-cap stocks, mid-cap stocksMid-cap StocksMid-Cap stocks are the stocks of the companies having medium market capitalization. Their capital lies between that of large and small cap companies and valuation of the entire share holdings of these companies range between $2 billion to $8 billion., large-cap stocks, or a combination of all.
- Bonds Funds: These products are made of bonds giving interests as an income. Fixed interest bonds are low risk, giving stable earnings. Those with floating interests allow higher chances of profits but through greater risks.
- Balanced Funds: They are a combination of equities and bonds, usually in the 2:3 proportion, to balance the risk and return profile of the product.
- Index Funds: Such a fund traces the change in the value of its underlying market index like S&P 500.
- Speciality Funds: Here, the securities belong to a specific segment like healthcare, automobile, technology, energy, industrial or telecommunication.
Mutual Fund Example
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. . 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 fund. 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., to make bigger gains due to their affordability and the option of SIPs. Besides, open-ended funds provide greater liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. 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. 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. 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.
|Basis||Mutual Fund||Exchange-Traded Fund||Index Fund|
|Trading||Through a company or brokerage firm at NAV at a day’s closing||Intraday trading on the stock exchange at the current value||Bought and sold through a fund manager at the day’s closing|
|Investment Goal||Outperform the market||Fulfil long-term objectives||Replicate the index performance|
|Fund Management||Actively/ Passively managed by professionals||Passive||Passive|
|Expense Ratio||Costs more under active management||Involves comparatively low fees||Involves comparatively low fees and even lowest at times|
|Tax Efficient||Depends on the assets||Comparatively more||To some extent|
|Liquidity||Comparatively low||High||Lower than ETFs|
|Example||Fidelity Government Cash Reserves||JPMorgan BetaBuilders US Equity ETF||iShares Core FTSE 100 UCITS ETF|
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.
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.
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 –