Understanding Mutual Funds

Understanding Mutual Funds
Understanding Mutual Funds

Mutual funds pool money from the investing public and use that money to buy other securities, usually stocks and bonds. The value of the mutual fund company depends on the performance of the securities it decides to buy. So, when you buy a unit or share of a mutual fund, you are buying the performance of its portfolio or, more precisely, a part of the portfolio’s value. 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.

That’s why the price of a mutual fund share is referred to as the net asset value (NAV) per share, sometimes expressed as NAVPS. A fund’s NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Outstanding shares are those held by all shareholders, institutional investors, and company officers or insiders. Mutual fund shares can typically be purchased or redeemed as needed at the fund’s current NAV, which—unlike a stock price—doesn’t fluctuate during market hours, but it is settled at the end of each trading day. Ergo, the price of a mutual fund is also updated when the NAVPS is settled.

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Equity funds

These funds invest in stocks. These funds aim to grow faster than money market or fixed income funds, so there is usually a higher risk that you could lose money. You can choose from different types of equity funds including those that specialize in growth stocks (which don’t usually pay dividends), income funds (which hold stocks that pay large dividends), value stocks, large-cap stocks, mid-cap stocks, small-cap stocks, or combinations of these.

Balanced funds

These funds invest in a mix of equities and fixed-income securities. They try to balance the aim of achieving higher returns against the risk of losing money. Most of these funds follow a formula to split the money among the different types of investments. They tend to have more risk than fixed-income funds, but less risk than pure equity funds. Aggressive funds hold more equities and fewer bonds, while conservative funds hold fewer equities relative to bonds.

Index funds

These funds aim to track the performance of a specific index such as the S&P/TSX Composite Index. The value of the mutual fund will go up or down as the index goes up or down. Index funds typically have lower costs than actively managed mutual funds because the portfolio manager doesn’t have to do as much research or make as many investment decisions.

Risk-Based mutual funda
Very Low-Risk Funds

Liquid funds and ultra-short-term funds (one month to one year) are known for its low risk, and understandably their returns are also low (6% at best). Investors choose this to fulfil their short-term financial goals and to keep their money safe through these funds.

Low-Risk Funds

In the event of rupee depreciation or unexpected national crisis, investors are unsure about investing in riskier funds. In such cases, fund managers recommend putting money in either one or a combination of liquid, ultra short-term or arbitrage funds. Returns could be 6-8%, but the investors are free to switch when valuations become more stable.

Medium-risk Funds

Here, the risk factor is of medium level as the fund manager invests a portion in debt and the rest in equity funds. The NAV is not that volatile, and the average returns could be 9-12%.

Special role of mutual funds

Mutual funds perform different roles for the different constituents that participate in it. Here are some of the important roles played by them.

  • Primary role of the mutual fund is to assist investors in earning an income or building their wealth.
  • Mutual funds are flexible and can structure a scheme for different kinds of investment objectives. It can target needs like wealth creation, regular income, liquidity, tax efficiency, macro defence etc.
  • The money raised from investors helps the markets to get quality inflows, the investors to earn wealth and the market overall benefit by the surge in the equity cult among the investors.
  • Mutual funds also help companies raise funds through debt by investing in their debt instruments. This facilitates capital allocation and ensures that productive projects are able to get funds.
  • Mutual funds are in a better position to keep a check on the operations of the investee company, compared to individual investors due to their networks, size and market intelligence.
  • Mutual funds with their large corpus can play the role of stabilizing the volatility in the markets by bringing in the required stability. This is useful at times when there is panic in the market resulting in bouts of volatility.
  • But the most important role that mutual funds play is to create wealth for the investors and allows them to build a reasonable corpus over a period of time.
Mutual funds are a popular investment option because they offer:
  • Professional management—By pooling money, funds can afford to hire top-notch managers. Some also have large teams of researchers and analysts.
  • Diversification—Many funds own hundreds (or even thousands) of individual securities. Investors can build fully diversified portfolios with just one or two mutual funds.
  • Liquidity—Although you can’t trade them as frequently as stocks, you can usually buy or sell fund shares on any day the market’s open.
  • Affordability—Many funds let you invest with only a few hundred or thousand dollars to start. Mutual fund fees vary, but most are much cheaper than the typical hedge fund, and the cheapest funds cost only pennies for every $100 you invest.
  • Oversight and regulation—Mutual funds must file periodic reports on their investments, report the value of what they own every day, and follow restrictions on what investments they can buy. It would be basically impossible for a mutual fund to pull off a Bernie Madoff–type fraud.

A mutual fund is an investment option that pools the money of many investors to buy stocks, bonds, and other securities. A mutual fund portfolio is professionally managed, comparatively affordable, and is subject to strong oversight and regulation. Most mutual funds invest in stocks, bonds, or a mix of the two.

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