A mutual fund is a collection of stocks, bonds, or other securities. When you buy a mutual fund, you own part of the mutual fund.
A mutual fund a type of financial vehicle made up of a pool of money collected from multiple investors to invest in stocks, bonds, money market instruments, and other assets.
The price of each mutual fund share called its NAV or Net Asset Value. It the total value of all securities divided by the number of shares of the mutual fund.
Mutual funds managed by professional investment managers called fund managers. These specialists buy and sell securities on behalf of investors. The performance of the fund depends on the performance of the investment portfolio. For this, fund managers spend a lot of time analyzing the market and choosing the right stocks to buy.
Mutual funds provide small or individual investors with access to a professionally managed portfolio of equities, bonds, and other securities. Therefore, each shareholder participates proportionately in the profit or loss of the fund.
Mutual funds invest in a large number of securities, and performance typically tracked as a change in the fund’s total market cap – derived from the overall performance of the underlying investment.
How Mutual Funds Work
A mutual fund is both an investment and a real company. This dual nature may sound strange, but it is no different from how Apple Inc., part of AAPL. represents.
When an investor buys Apple stock, he is buying partial ownership of the company and its assets. Similarly, a mutual fund investor is buying partial ownership of the mutual fund company and its assets.
The difference is that Apple is in the business of making innovative devices and tablets. Whereas a mutual fund company is in the business of investing.
Mutual funds are essentially a basket of multiple financial instruments that generate returns over a period of time. If an investor invests in a mutual fund scheme, he/she buys units of that scheme based on the Net Asset Value (NAV) of that fund on the day of the transaction.
The fund manager invests the accumulated funds in various financial instruments like equity stocks, debt instruments, derivatives, arbitrage, etc. to generate returns for the portfolio holders. The total capital gains from these allocations are added to the assets under management of the fund, on which the fund’s NAV depends.
Investors can redeem the fund units at their convenience. Units redeemed at the current NAV of the fund. Which may be significantly higher than the NAV at which the units were purchased.
This increase highlights your total return on investment. If the NAV at the time of redemption is not much higher than at the time of investment. It suggested to invest in the fund, and wait for the market sentiment to turn in your favor.
How do Mutual Funds Generate Returns for Investors?
1. Dividend payments
When a fund receives dividends or interest from securities in its portfolio, it distributes a proportionate amount of that income to its investors.
When buying shares in a mutual fund, you can choose to receive your distributions directly, or reinvest them in the fund.
2. Capital gains
Mutual funds invest in securities with high growth potential or in companies available at attractive market valuations.
The NAV of a mutual fund varies after the number of shares held by it. So when there is a net increase in the prices of the stocks held by a mutual fund, the NAV of that mutual fund increases accordingly, giving the benefit of capital appreciation on the units held by its investors. Investors can redeem their mutual fund units at higher NAV and realize capital appreciation.
3. Net asset value
Mutual fund share purchases are final after the close of the market when the total financial value of the underlying assets is assessed.
The price per mutual fund share known as its net asset value or NAV. As the value of the fund increases, so does the purchase price (or NAV per share) in the fund.
It’s the same as when the price of a stock goes up — you don’t get an immediate distribution, but your investment is worth more, and you’ll make money if you decide to sell.
Types of Mutual Fund
Mutual funds are divided into a number of categories, which represent the types of securities they target for their portfolios and the types of returns they generate.
1. Equity Funds
The largest category is that of equity or stock funds. As the name suggests, this type of fund primarily invests in stocks.
There are various subcategories within this group. Some equity funds are named for the size of the companies they invest in: small-, mid- or large-cap.
Others named by their investment approach: aggressive growth, income-oriented, value, and others. Equity funds are also classified based on whether they invest in domestic (U.S.) stocks or in foreign equities.
2. Fixed-Income Funds
Another large group is the fixed income group. Fixed-income mutual funds focus on investments that pay a set rate of return, such as government bonds, corporate bonds, or other debt instruments.
The idea is that the fund portfolio generates interest income, which it passes on to shareholders.
Sometimes referred to as bond funds, these funds often actively managed and seek to buy relatively low-value bonds to sell at a profit.
These mutual funds are likely to deliver higher returns than certificates of deposit and money market investments, but bond funds are not without risk.
Because there are many different types of bonds, bond funds can vary dramatically in where they invest.
3. Index Funds
Another group, which has become extremely popular over the years, goes under the nickname “index funds”.
Their investment strategy is based on the belief that trying to beat the market consistently is too difficult and often costly. Therefore, the index fund manager buys stocks that match a major market index, such as the S&P 500 or the Dow Jones Industrial Average (DJIA).
This strategy requires less research from analysts and advisors, so it costs less to eat the returns before they are passed on to shareholders. These funds are often designed with cost-sensitive investors in mind.
4. Balanced Funds
Balanced funds invest in a hybrid of asset classes, whether stocks, bonds, money market instruments, or alternative investments.
Its purpose is to reduce the exposure to risk across asset classes. Such funds also known as asset allocation funds. These two forms of such funds designed to meet the objectives of investors.
Some funds defined with a specific allocation strategy that fixed, so the investor can have predictable exposure to different asset classes.
Other funds follow a strategy of dynamic allocation percentages to meet different investor objectives. This may include responding to market conditions, changes in the business cycle, or changing phases of the investor’s own life.
While the objectives are similar to that of a balanced fund, a dynamic allocation fund does not have a specified percentage of any asset class.
The portfolio manager gave the freedom to change the ratio of asset classes as needed to maintain the integrity of the fund’s stated strategy.
5. Money Market Funds
The money market consists of secured (risk-free), short-term debt instruments, mostly government Treasury bills.
It is a safe place to park your money. You won’t get substantial returns, but you won’t have to worry about losing your principal.
A typical return is slightly higher than the amount you would earn in a regular checking or savings account and slightly less than the average certificate of deposit (CD).
While money market funds invest in ultra-safe assets, during the 2008 financial crisis, some money market funds experienced losses after the share price of these funds typically pegged at $1, fell below that level. Gone and plucked the deer.
6. Income Funds
Income funds named for their purpose: to provide current income on a steady basis.
These funds primarily invest in government and high-quality corporate debt, holding these bonds till maturity to provide interest streams. While the value of fund holdings can increase, the primary purpose of these funds is to provide steady cash flow to investors.
As such, the audience for these funds consists of conservative investors and retirees. Because they produce regular income, tax-conscious investors may want to avoid these funds.
7. International/Global Funds
An international fund (or foreign fund) only invests in assets located outside your home country.
Meanwhile, global funds can invest anywhere around the world, including your country. These funds are harder to classify as riskier or safer than domestic investments, but they tend to be more volatile and have unique country and political risks.
On the other hand, they can reduce risk by actually increasing diversification, as part of a balanced portfolio, as returns abroad may be uncorrelated with returns at home.
Although the economies of the world are becoming more interconnected. It is likely that some other economy is somewhere outperforming the economy of your home country.
8. Specialty Funds
This classification of mutual funds is more than a broad category that includes funds that have proven popular but do not necessarily belong to the more stringent categories described so far.
These types of mutual funds abandon broad diversification to focus on a certain segment of the economy or a targeted strategy.
Sector funds strategy funds targeted at specific sectors of the economy, such as financial, technology, health, etc. Therefore, sector funds can extremely volatile because the stocks in a given sector are highly correlated with each other.
9. Exchange Traded Funds (ETFs)
A twist on mutual funds Exchange Traded Funds (ETFs). These ever more popular investment vehicles pool investments and employ strategies analogous to mutual funds. But they structured as investment trusts that are traded on stock exchanges and have the added benefits of stocks.
Benefits of Investing in Mutual Fund
Diversification
In mutual funds, money invested in several securities. For example, any typical equity fund holds stocks of around 35-60 companies. Investing in these companies individually would require a large investment amount, whereas in mutual funds you can invest in each of them with an investment amount of at least Rs. 500.
This is the major advantage of investing in mutual funds as it helps in reducing the risk when the market goes down. Not every type of asset moves together. Some go up and some fall. By investing in mutual funds, any losses from one type of asset can potentially be balanced out by gains from others.
Power of Compounding
Mutual funds come with the power of compounding which refers to the interest that an investor earns on the interest earned on the principal. In this way, the value of the investment keeps on increasing. In addition, the value of investments also increases over time as companies grow (in the case of equity funds) or asset prices rise (gold, etc.).
Capital Gain Distributions
The profit generated by selling the securities at a higher price called a capital gain, which is distributed among the investors. This additional income through capital gains distribution can be used to buy more units of the portfolio or can be easily redeemed.
Automatic Reinvestment
Mutual funds generate returns in two different ways – dividends and an increase in the value of the units held. An increase in value can only use when you sell units.
On the other hand, dividends available as soon as they are declared or distributed. These can be used to buy more mutual fund units through automatic reinvestment. For investors, mutual fund dividends are tax-free in the hands of investors. However, dividend distribution tax paid by the mutual fund house itself before distributing the dividend.
Fund Exchange or Exchange Privilege
Exchange privilege a facility offered by mutual funds through which an investor can switch from one scheme to another within the fund family without any additional charges. So, if your mutual fund scheme is not performing well, you can switch to another scheme of the same fund house without any charges under the fund exchange facility.
Variety
Mutual funds offer a variety of options for investing. Depending on the risk appetite, return expectations and timing of the investment, an investor can choose from different asset classes. Mutual fund schemes can focus on technology stocks (sectoral funds), blue-chip stocks (large cap funds) or even a mix of bonds and stocks (hybrid funds). It minimizes the market risk associated with mutual fund investments.
Transparency
The mutual fund industry regulated by the Securities and Exchange Board of India (SEBI) and very transparent in its investment decisions and holdings. This helps investors keep track of their mutual fund investments. Asset Management Companies (AMCs) required to provide regular updates about the performance of the fund to the investors.
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