What is a Mutual Fund?
A mutual fund is collective investment that pools together the money of a large number of investors to purchase a variety of securities, like stocks or bonds. A mutual fund can also be seen as a collection stocks, bonds, cash and other securities that are managed by a professional.
Generally, people buy mutual fund because they want a simple way to invest in a diversified portfolio with security of knowing that someone will be watching it for them. A mutual fund can be likend to a basket investments.
When you purchase a share in a mutual fund, you are buying one share of this basket and therefore have a stake in one small fraction of all the investments in that fund.
Benefits Of Mutual Funds
Mutual Funds can potentially benefits investors in several ways, example.
(1). They can provide diversification and mostly managed by financial professionals.
They tend to offer investors a wide variety of Investment types. To see these benefits in action, let's take a look at some example of how a mutual fund works.
Supposed there's an investor who want to invest some of there retirement portfolio in the stock market, but they don't have time to analyze the individual stocks and create a diversified stock portfolio. Instead, they decide that they would rather purchase a mutual fund.
This way the investor can purchase a single investment, which will be similar to purchasing an entire portfolio of stocks. But which mutual fund is right for them ? To find the best mutual fund or right one, the investor uses online tools such as mutual fund searches and ratings given by independent third party organization to find the best mutual fund that meets their investing goals.
Once they find a mutual fund that looks like a good fit, they will review the mutual fund's prospectus, which is the official summary and explanation of how the mutual fund operates. The prospectus provides useful information about the mutual fund including the fees and charges, the minimum investment amounts, performance history, risks and many more.
After researching about the mutual fund and it's prospectus, the investor then decides that, this mutual fund looks like a good platform for Investment. Afterwards they buy the minimum required Investment amount and purchase the shares of the mutual fund.
By owning a share, the investor now participate in the gains and losses of all the companies held in the mutual fund. A benefit of this is diversification, which is when an investment or portfolio is spread across several different investments.
Doing this can help lower risk, for instance, if one company that the mutual fund invests in has a rough year, the impact on the mutual funds total assets can be small because, that struggling company is only one fraction of the mutual funds total assets.
(2). Professional Management: Another potential benefit of mutual fund is professional management. Like many other mutual funds, the funds the investors chose is actively managed, meaning that, it is run by a mutual fund manager or managers who buy and sell the mutual fund's assets.
The mutual fund managers aims to provide the biggest returns they can for investors by using financial analysis and professional expertise. While a talented manager could earn good returns for investors fund, there is no guarantee of success. If the manager make a choice or choices that does not pay off, the investors won't earn the returnr there were hoping to earn.
However if the mutual fund doesn't perform well, the manager still collects a fee, which is paid from the mutual fund assets, meaning even on lower returns. Management fees are not the only cost the investor has to pay either, besides the transaction fees, the fund may have a sales load which is a charger to either buy or sell shares.
Some mutual funds also charge an additional load if shares are sold within a specific timeframe.
(3). Variety of investment available: Finally, another benefit of mutual funds is the variety f of investment they make available. The investors chose a mutual fund that invest in stocks.
However, there is a mutual fund for almost every type of investment. Example equity funds buy stocks, fixed income funds buy bond and balanced funds buy both. Mutual fund may invest in a whole index, while others focus on stocks of certain country or market sector.
Certain funds have different objectives as well, some may look for riskier stocks in growing industries while others will invest in more stable companies.
Mutual Funds are basically an indirect way of investing in stock market. But there are different categories of these mutual funds that cater for the needs of various people.
There are basically three (3) types of mutual funds, they are ;
1. Equity Funds
2. Debt Funds
3. Hybrid Funds
Equity Funds
What is Equity Funds?
Equity funds are funds that are invested majorly in equity stocks or shares of companies. These are considered as risky funds but they also have the potential to provide higher returns over a longer period of time.
Debt Funds
What is Debt Funds?
Debt funds are funds that are invested in debt instruments. Examples are companies debentures, government bonds and other fixed income assets.
They are considered relatively safer and stable when compared to equity funds.
Hybrid Funds
What is Hybrid Funds?
Hybrid Funds are funds that are invested in a mixed of asset classes like equity and debt. In some cases, the proportion of the equity is higher than the debt fund while in others, it is other way round, risk and returns are balanced out this way.
Note: Each of these funds has subcategories which you will find out as you read further.
Different Categories of Equity Funds
(1). Large - Cap: In large Cap funds, a large portion of the investment is done in companies with large market capitalization. These companies are strong, reputable and reliable.
(2). Mid - Cap: In mid - Cap funds, a large portion of the instrument is done companies with medium market capitalization. Stocks of mid - cap companies are riskier than large - cap but not as risky investment instruments as small-cap.
(3). Small - Cap: In small - Cap funds, a large portion of the investment is done in companies with small market capitalization. The stocks of small - cap companies are highly risky and volatile investment instruments.
(4). Multi - Cap Equity Funds or diversified equity funds: They invest in stocks of companies across the stock market regardless of size and sector. These funds provides the benefits of diversification by investing in companies spread across sectors and market capitalization.
They are generally meant for investors who seek exposure across the market and do not want to be restricted to any particular sector.
(5). Equity Linked Savings Scheme (ELSS): This is a dedicated mutual fund scheme that allows investors to save tax under section 80c of Income Tax Act, 1961. It has a locked - in period of 3 years and it provides an opportunity for long term capital appreciation.
An ELSS fund invests in diversified portfolio predominantly, consisting of equity and equity related instruments that carry high risk and have the potential to deliver high returns over a long period of time.
(6). Sectoral Funds: The sector funds invest in the stock of companies that operates in a particular industry or sector of the economy, like banking, public sector undertaking, infra, rural etc. These funds are riskier than the well diversified ones and are more volatile due to holdings in one particular sector.
Types Of Debt Funds
Debt funds can be classified into the following types;
(1). Liquid Funds: The liquid funds invest in money market instruments, having a maturity of maximum of 91 days. Liquid funds are a good alternative for short-term investments.
(2). Money Market Funds: They invest in money market instruments with a maximum maturity of one year. These funds are good for investors seeking low risk debt securities for a short-term period.
(3). Dynamic Bond Fund: The dynamic bond funds Invests in debt instruments of varying maturities based on interest rate regime. These funds are good for investors with moderate risk tolerance and an investment horizon of 4 years and above.
(4). Corporate Bond Funds: They invest a minimum of 80% of it's total assets in corporate bonds which have higher ratings. These funds are good for investors with lower risk tolerance and seek to invest in high-quality corporate bonds.
(5). Gift Bond: The gift Bond invests a minimum of 80% of it's investable corpus in government securities across varying maturities. These funds do not carry any credit risk. However, the interest rate risk is high.
(6). Credit Risk Fund: They invests their investable corpus in corporate bonds whose credit rating is below that of higher quality corporate bonds. Therefore, these funds carry an amount of credit risk and can also offer a slightly better returns than the high quality bonds.
(7). Overnight Fund: The overnight funds Invests in debt securities having a maturity of one day. These funds are considered to be the lowest amongst the debt funds in risk table, since both the credit risk and the interest rate are low.
Hybrid Funds
Hybrid funds are those Investment instruments where the asset management company invests the money in both debt and equity. These are pretty diversified, the higher the proportion of Investment into debt, the safer it is.
How does mutual fund investors make money?
a. Through Appreciation: This is when the mutual funds shares goes up in value. Typically,, when the fund assets rises in value, the funds share do the same or follow suit. However, when the mutual funds assets falls in value, the mutual funds shares also do the same, which is a risk of owning a mutual fund.
Unlike a stock, the value of the shares does not change through out the trading day, instead the funds value is calculated and updated when market closes.
b. Through Dividend Payment: This is when a mutual fund pays out a portion of it's earnings to shareholders.
Finally, on this topic about understanding what mutual fund is, how it works, types of mutual funds, how mutual fund investor makes money etc.
In our next topic, we will try to cover most of the frequently asked questions about mutual funds. Like The top mutual funds, best performing mutual funds or top performing mutual funds, best money market mutual funds, Index mutual funds, groww mutual fund, dsp mutual fund etc.
Note: This article does not recommend any particular fund or stock, all of these are just for educational purpose only.
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