A mutual fund is an investment vehicle that allows a group of investors to pool their money together and invest in a portfolio of financial instruments. Mutual funds are operated and managed by a professional fund manager who is responsible for investing the pooled money into specific securities (equities, bonds, money market instruments and/or other assets) to meet the predefined investment objective. When investors subscribe into a mutual fund, they are buying units of the mutual fund and thus become a unit holder of the fund.
How Does a Mutual Fund Work?
Mutual funds give investors the right to earn a portion of the returns that are generated by the fund’s portfolio. The portfolio can hold a variety of assets such as bonds, equities, and other financial assets.
The investments that are held in the portfolio of a mutual fund generate dividends and interest. The earned returns are either reinvested or distributed by the fund manager to the investors. If the fund manager earns any returns by selling the assets, then the returns are passed on to the investors as well. Similarly, if the fund manager incurs a loss, the same is passed on to the investors.
There are primarily two ways through which money is generated from investments in a mutual fund:
- Distributions: If the fund’s portfolio strategy seeks to provide income and invests in income yielding assets, then the fund manager may distribute the dividends and the interest to the investors. Investors can opt to receive the cash dividend distributions that can be remitted to their accounts or reinvest them and get more mutual funds units.
- Capital Gains: If there is an increase in the price of the invested securities, there can be an increase in the Net Asset Value (NAV) of the units of the mutual fund. When this happens, investors can opt to sell their units in the mutual fund to get capital gains.
Types of Mutual Funds
There are several types of mutual funds that you can invest in as per your financial goals, objectives and risk appetite. They can also be classified according to the structure as well as the asset classes. To know more about different types of mutual funds, check the explanations below:
By Structure
Open-ended Funds
A mutual fund that has an open-ended fund structure can be defined as one that is open for subscription throughout the year. It also does not come with a fixed maturity date. As a result, the units can be bought and sold by investors on a day-to-day basis at the fund’s net asset value (NAV).
Close-ended Funds
A mutual fund that has a close-ended fund structure is one that comes with a specific maturity period and it can be subscribed to only during the specified period. Investors can invest in a close-ended fund only when the fund is offered during the specified time. They have to hold the investment till it matures.
By Asset Classes
Equity Funds
Equity funds generally invest in equities, either across geographic regions or across sectors. One of the main objectives of equity funds is to offer capital appreciation across medium to long-term investments. These investments can be ideal for investors who have high-risk portfolios and are looking for long-term growth returns.
Bond Funds
Bond funds aim to offer regular and steady income to investors and hence they are invested on assets that pay a fixed rate of return. Some of the examples of bond funds are corporate bonds, government bonds, etc. Bond funds may not offer excessive capital appreciation but are usually considered low-risk investments when compared to equity funds. When interest income is generated from the fund portfolio, it gets passed on to the mutual fund investors. These funds can be explored by investors who want capital stability and a regular income.
Index Funds
Index funds aim to correspond to the performance of a major market index such as Dow Jones or S&P 500. These funds are designed for investors who are cost-sensitive. When fund managers invest in index funds, the aim is to not beat or exceed the underlying index but rather match the performance.
Balanced Funds
Balanced funds are funds that are invested across asset classes such as equities and bonds. One of the main objectives of balanced mutual funds is to provide long-term growth of both principal and income. These funds can be ideal for investors who are looking for capital stability and long-term growth returns.
Money Market Funds
Money market funds are funds that are invested in short-term debt instruments (for example, treasury bills, certificates of deposit, commercial paper, etc.) issued by corporations or the government. The objective of money market funds is generally to offer high liquidity at potentially lower risk. They are also ideal for investors who want to put aside their surplus funds for a short duration. However, these investments may not necessarily offer substantial returns.
Benefits of Investing in a Mutual Fund
Apart from letting you earn potential returns, mutual funds also offer other benefits. Some of them are mentioned below
Diversification
It is an investment strategy wherein investors can spread their investments across different sectors and companies. Diversification of an investment portfolio can help reduce risk. So, if one sector underperforms, the investor will still have other investments to rely on. Mutual funds can help investors diversify their investment portfolios as the pooled funds may be invested in several financial securities. They can also be explored by investors who are not keen on the ownership of individual equities or bonds.
Professional Management
As each mutual fund is managed by a fund manager, the investor can skip keeping track of the investments or actively trading them. The fund manager will do the job by researching and analyzing current and potential holdings of the mutual fund.
Transparency
Mutual funds follow a transparent process wherein the prices of open-ended mutual funds are typically published daily. The portfolio holdings are also disclosed and are available with the fund factsheets, so investors can stay aware of where their invested funds are utilized.
Liquidity (For open-ended funds)
As most open-ended mutual funds are priced regularly, investors have the liberty to sell their holdings in the mutual fund investments any time. They can sell it at a price that is linked to the net asset value of the fund. This also removes the hassle of finding a buyer who wants to purchase their units at a reasonable price.
Affordability
Investors do not require a large amount to invest in mutual funds. They can start investing with as little as US$1,000 for most funds.
Access to International Markets
Investors can invest and thereby get exposure to international and sometimes to restricted markets via mutual funds.
Challenges of Investing in a Mutual Fund
While mutual funds may offer investors a wide range of advantages, there may also be some challenges. Some of these are explained below:
No Guarantee
There is no guarantee that investors will earn profitable returns. However, they will still have to incur costs such as management fees and performance fees, even if the funds do not perform well.
Lack of Control
When you invest in a mutual fund, you basically give away your control over the assets that are put into the fund. In a mutual fund, the fund manager invests on financial securities on the investors’ behalf. The fund manager also makes the investment decisions and not the investors.
Impact of Fees on Returns
Mutual funds may require one to pay operational fees such as sales fee, management fee, etc. The cost of such charges and expenses can overtake the amount that one may have to pay for investing in individual securities. Investors should also stay cautious about investing in mutual funds that charge high fees as they can reduce potential investment returns.
Risk
Every form of investment is typically accompanied by risks. As a result, investors should be prepared to face the effects of market price fluctuations. There are different types of risks associated with mutual funds and some of them are:
- Market Risk: Market risk is one of the major risks that comes with mutual funds. The risk and volatility arise from the underlying assets that are held by the fund.
- Liquidity Risk: Mutual funds offer liquidity. They allow investors to access funds but within a short time frame. However, if the market dips low or there are economic downturns, the liquidity can be reduced. The redemptions can also be frozen for a period of time, as by doing so the holdings of the funds can be protected.
- Manager’s Risk: How the fund performs will also depend on the skill or reputation of the fund’s manager. If a fund’s manager leaves the company, it can bring forth “key person risks” challenges.
- Interest Rate Risk: Mutual funds that invest in debt-securities such as bonds, debentures, etc., are susceptible to interest rate movements, as debt security prices typically move in an opposite direction to interest rates.
- Foreign Currency Risk: Mutual funds can be exposed to foreign currency risks because if the funds are invested in assets that are denominated in foreign currency, they can be impacted by fluctuating currency price movements.
Frequently Asked Questions
How do you earn money from a mutual fund?
Investors can earn money from a mutual fund through income earned from dividends (for dividend paying funds) and through capital gains.
How are mutual funds priced?
Mutual funds are priced as per the Net Asset Value (NAV). NAV, which represents the market value of the fund per unit, is used by investors while purchasing and selling units from as well as to a Mutual Fund Company. NAV can be calculated by using the formula mentioned below:
NAV = Total value of all cash and securities in a Mutual Fund’s portfolio (less any liabilities) ÷ Total number of units in the Mutual Fund.
Is it good to invest in mutual funds?
You can consider investing in mutual funds if you wish to diversify your investment portfolio and invest passively. There are also other benefits of investing in mutual funds. Some of these benefits are given below:
- Professional Management of investments in the fund's holding
- Helps in the diversification of investment portfolio
- Minimizes transaction costs
- Liberty to sell holdings in open-ended mutual funds at any time
- Access to international markets
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