Mutual funds – one of the first investment types that comes to our mind. Mutual funds are professionally managed investment fund that pools money from many investors to purchase securities. These investors may be retail or institutional in nature. Mutual funds investments have advantages and disadvantages compared to direct investments in individual securities.
What are mutual funds?
A mutual fund is at its core a managed portfolio of stocks and/or bonds. You can think of a mutual fund as a company that brings together a large group of people and invests their money on their behalf in this portfolio. Each investor owns shares of the mutual fund, which represent a portion of its holdings.
Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give its holders any voting rights. A share of a mutual fund represents investments in many different stocks (or other securities) instead of just one holding.
Investors typically earn a return from a mutual fund in three ways:
- Income is earned from dividends on stocks and interest on bonds held in the fund’s portfolio. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. Funds often give investors a choice either to receive a cheque for distributions or to reinvest the earnings and get more shares.
- If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
- If fund holdings increase in price but are not sold by the fund manager, the fund’s shares increase in price. You can then sell your mutual fund shares for a profit in the market.
How to calculate the Mutual Funds NAV?
Mutual Funds NAV = Total net assets of the fund / the total number of units issued to investors.
When it comes to investing, certain terms have special significance. For mutual fund investors, net asset value (NAV) is one such term. Whenever you attempt to buy or sell mutual fund units, this acronym comes up.
Check out the value of mutual fund in Mutual Fund NAV calculator
Advantages of Mutual Funds
The primary advantage of mutual funds is not having to pick stocks and manage investments. Instead, a professional investment manager takes care of all of this using careful research and skillful trading. Investors purchase funds because they often do not have the time or the expertise to manage their own portfolios, or they don’t have access to the same kind of information that a professional fund has. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments.
By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out across many different holdings. The idea behind diversification is not to put all of your eggs in one basket. Instead, spread investments across a large number of diverse assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can seriously hurt your finances.
Economies of Scale:
Mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions. Moreover, a mutual fund, since it pools money from many small investors can invest in certain assets or take larger positions than a smaller investor could. For example, the fund may have access to IPO placements or certain structured products only available to institutional investors.
Buying a mutual fund is fairly straightforward. Many banks or brokerage firms have their own line of in-house mutual funds, and the minimum investment is often small. Most companies also have automatic purchase plans whereby a small can be invested on a monthly basis. Brokers can also purchase any other listed mutual fund on behalf of clients.
Mutual funds today exist with any number of various asset classes or strategies. This allows investors to gain exposure to not only stocks and bonds but also commodities, foreign assets, and real estate through specialized mutual funds. Some mutual funds are even structured to profit from a falling market (known as bear funds). Mutual funds provide opportunities for foreign and domestic investment that may not otherwise be directly accessible to ordinary investors.
Mutual funds are subject to industry regulation that ensures accountability and fairness to investors.
Disadvantages of Mutual Funds
Management is by no means infallible, and, even if the fund loses money, the manager still gets paid. Actively managed funds incur higher fees, but increasingly passive index funds have gained popularity.
Costs and Fees:
Creating, distributing, and running a mutual fund is an expensive undertaking. Everything from the portfolio manager‘s salary to the investors’ quarterly statements cost money. Those expenses are passed on to the investors. Since fees vary widely from fund to fund, failing to pay attention to the fees can have negative long-term consequences. Actively managed funds incur transaction costs that accumulate over each year.
It’s possible to have poor returns due to too much diversification. Mutual funds can have small holdings in many different companies, high returns from a few investments often don’t make much difference on the overall return. When new money pours into funds that have had strong track records, the manager often has trouble finding suitable investments for all the new capital to be put to good use.
A mutual fund allows you to request that your shares be converted into cash at any time. However, unlike stock that trades throughout the day, many mutual fund redemption take place only at the end of each trading day.
When a fund manager sells a security, a capital-gains tax is triggered. Investors who are concerned about the impact of taxes need to keep those concerns in mind when investing in mutual funds.
Types of Mutual Funds:
A mutual funds types can be any one of the followings:
Money Market Funds:
The money market consists of safe short-term debt instruments, mostly government Treasury bills. You won’t get substantial returns, but you won’t have to worry about losing your principal. A typical return is a little more than the amount you would earn in a regular checking or savings account and a little less than the average certificate of deposit (CD).
Income funds are named for their purpose of providing current income on a steady basis. These funds invest primarily in government and high-quality corporate debt, holding these bonds until maturity in order to provide interest streams. While fund holdings may appreciate in value, the primary objective of these funds is to provide a steady cash flow to investors.
Bond funds invest and actively trade in various types of bonds. These funds are often actively managed and seek to buy relatively undervalued bonds in order to sell them at a profit. These mutual funds are likely to pay higher returns than certificates of deposit and money market investments. Bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities.
The objective of these funds is to provide a balanced mixture of safety, income and capital appreciation. The strategy of balanced funds is to invest in a portfolio of both fixed income and equities. A typical balanced fund will have a weighting of 60% equity and 40% fixed income. The weighting might also be restricted to a specified maximum or minimum for each asset class, so that if stock values increase much more than bonds, the portfolio manager will automatically re-balance the portfolio back to 60/40.
Funds that invest primarily in stocks represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth. There are many different types of equity funds as there are many different types of equities.
An international fund (or foreign fund) invests only in assets located outside your home country. Global funds, meanwhile, can invest anywhere around the world, including within your home country. Although the world’s economies are becoming more interrelated, it is still likely that another economy somewhere is outperforming the economy of your home country.
These funds exactly replicate an index. In this investment model, funds hold stocks in the same proportion as they weigh in the index. This means no risk for fund managers. They track the NIFTY or the SENSEX and hence, always are large cap diversified funds.
Exchange Traded Funds (ETFs):
A twist on the mutual fund is the exchange traded fund, or ETF. These ever more popular investment vehicles pool investments and employ strategies consistent with mutual funds, but they are structured as investment trusts that are traded on stock exchanges, and have the added benefits of the features of stocks. ETFs also typically carry lower fees than the equivalent mutual fund.