What is a Mutual Fund?
A mutual fund is an investment fund that allows an individual investor to pool his/her money together with other investors. Purchasing the collection of bonds, stocks, or other securities can be difficult for an investor on his/her own. Still, it is easier to do in mutual funds. Professional money managers are in charge of allocating the fund’s assets and producing capital gains for the investors of the funds. The portfolio of a mutual fund is structured and maintained to match the investment objectives from its prospectus.
How does a mutual fund investment work?
A mutual fund is an investment, but it is also a company. So, investing in it means that the investor is purchasing partial ownership of a company and its assets. It is similar to other companies that sell their shares. However, while the companies make their products, a mutual fund company makes investments. You can earn a return of investment from mutual funds in three ways:
- Fixed income can be earned from bond yield and stock dividends held in the fund’s portfolio. The income received by the fund over the year is distributed among fund owners. The option offered to the investors is simple – receive a check or reinvest the profit and get more fund shares.
- If fund holdings increase in price and the fund manager does not sell them, then the shares of the fund rise. Investors can sell mutual fund shares to make a profit in the market.
- When selling securities that increased in price, the fund collects capital gains. These gains are also distributed among the investors by most funds.
How to invest in a mutual fund?
If you invest in a mutual fund for the first time, then these are the steps you need to follow:
- Define an investment goal: First, you need to fix your financial goal, budget, and tenure. By doing this, you can decide how much you can invest and evaluate your risk profile.
- Pick the right type of fund: You can start by reading about various mutual fund types to choose the right category. Typically, a balanced or debt fund is recommended for first-time investors because it provides higher returns with minimal risks.
- Choose one mutual fund after shortlisting: Analyse and compare the mutual fund schemes to select the right one for you. Consider the essential factors like the fund manager’s credentials, portfolio components, expense ratio, and assets under management.
Mutual Fund’s Assets
What is NAV?
NAV stands for Net Asset Value or the per-share market value of a fund. In other words, it is the bid price for investors at which they buy shares from a fund company. It also stands for the redemption value at which the shares are sold to another fund company. You can derive NAV if you divide the total value of all the securities and cash in a fund’s portfolio by the number of outstanding shares. The fund computes the NAV at the end of each trading day according to the closing market prices of the portfolio’s Securities. The calculation Net Asset Value is crucial because we understand the worth of one share of the fund.
What assets can mutual fund hold in the portfolio?
Some of the most common asset classes that mutual fund can hold in the portfolio are:
- Cash: Cash assets include T-Bills, near currency assets viz., liquid short-term government bonds, and money market instruments.
- Bonds: A bond refers to a debt security investment. With it, the issuer of the bond has to repay the borrowed money amount to the investor with defined interest.
- Equity: Stock is also known as a share of a company’s ownership. When an individual owns a share of a corporation, he/she receives a stake in the company, as well as its profits. The individual can increase his/her ownership in the company by purchasing more stocks. While stocks provide an opportunity to earn significant returns, there are also risks of partial or complete loss of the invested amount.
- Gold: Gold or gold instruments remains the most popular among all precious metals as an investment. Not only it is renowned as a hedge against inflation, but its downside risk is also limited.
- Real estate: Investing in real estate has become very popular recently. With the introduction of real estate mutual funds, investors from various sectors can take advantage of the growth of real estate.
Why Invest? Advantages
Mutual funds have been the best choice for investors for decades. The reason behind this is the various advantages offered by it, such as:
- Active professional management: Investors do not need to choose stocks or manage investments themselves. Instead, all are taken care of by a professional investment manager with careful research and skillful trading. While most private money managers deal with high net worth individuals only, mutual funds offer the benefit to small investors with lower minimums.
- Diversification: It is the allocation of investments in different asset classes, not related to each other. Diversification helps a portfolio to reduce risk. At the same time, it enhances the portfolio’s returns. Now, rather than buying individual securities, it is way cheaper and faster to buy a mutual fund.
- Liquidity: Mutual funds allow investors to buy or sell their funds once a day at the fund’s NAV at the close of the market. Invest can also be reinvested automatically from capital gain distributions and dividends. The required minimum initial investment is also less than individual stocks in most cases.
- Easy access: It is easy to buy and sell mutual funds because they are highly liquid. Moreover, mutual funds are the most feasible way for individual investors to participate in certain types of assets, such as foreign equities, exotic commodities, or bonds.
No asset is perfect. Mutual funds also have some drawbacks, along with their advantages. The disadvantages you should know about are:
- High management fees: Mutual funds provide investors with professional management, but the costs can be surprisingly expensive. Despite the fund’s performance, it can charge the asset management fee from the investor’s pocket. Moreover, the overall payout of the fund is also reduced by the fees.
- High tax rate compared to ETFs: When a fund manager sells a security, it triggers a capital-gains tax. The tax rate is higher than the ETF’s. So, if you are concerned about tax, you need to consider investing in mutual funds carefully. You can mitigate the tax rate by holding non-tax sensitive mutual funds and investing in tax-sensitive funds in tax-deferred accounts.
- Fluctuating Returns: Like other investments without guaranteed returns, your mutual fund value depreciating always remains. All mutual funds experience and suffer from price fluctuations.
- Cash drag: Sometimes, the money sits in mutual funds as cash without working, which is not beneficial for the investors. Cash earns no return, which is referred to as cash drag. It happens when funds keep a large portion of their portfolio as cash, to maintain the liquidity and capacity of accommodating withdrawals.
If you are a beginner, then make sure to learn about mutual funds in-depth before you invest. It will help you to take the right actions in difficult situations.