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.
Table of contents
- 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. 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 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. (AMC) undertakes investments with the fund manager overlooking the fund management.
What is Mutual Fund? Video Explanation
- 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 dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity., 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 IPOIPOAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.. 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 DepositsA certificate of deposit (CD) is an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn high returns. CDs essentially require investors to set aside their savings and leave them untouched for a fixed period. and treasury billsTreasury BillsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government..
- 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 stocksSmall-cap StocksSmall cap stocks are offered by relatively small companies that are publicly listed. A small cap company has a low market capitalization ranging between $300 million to $2 billion. Small cap investors have a high-risk, high-reward approach., 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 stocksLarge-cap StocksLarge-cap stocks refer to stocks of large companies with value, also known as the market capitalization of 10 billion dollars or more, and these stocks are less risky than others and are stable. They also pay a good dividend and return, and it is the safest option to invest., 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 indexMarket IndexA market index tracks the performance of a diverse selection of securities that make up a significant part of the financial market. It serves as an indicator of the overall financial market condition by listing the historical and real-time trends in different market segments. 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 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.. 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 is the ease of converting assets or securities into cash. 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.
|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
|Outperform the market
|Fulfil long-term objectives
|Replicate the index performance
|Actively/ Passively managed by professionals
|Costs more under active management
|Involves comparatively low fees
|Involves comparatively low fees and even lowest at times
|Depends on the assets
|To some extent
|Lower than ETFs
|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 –