What Is a Mutual Fund?

Assume there is a box of 12 chocolates worth $40, and four friends want to buy the same, but they only have $10 each. On top of this shortage, the shopkeeper only sells the chocolates by the box.

So, to solve this problem, the friends decide to pool each of their $10 and buy a box of 12 chocolates. When they get the box of chocolates, based on their equal contributions, they will get three chocolates each, if equated with mutual funds.

The cost per unit is calculated by dividing the total amount by the total number of chocolates: 40/12 = 3.33. Similarly, when you multiply 3 (the number of units) by 3.33 (the cost per unit), you will get an initial investment of $10.

This purchase results in each friend being a unit holder for the box of chocolates that is collectively owned by all of them. The concept of mutual fund investment follows this simple collective trade and gains.

In addition to this, just like how an equity shared has a trade price, every mutual fund unit has something called the “Net Asset Value Per Unit” (NAVPU). This NAV (Net Asset Value) is the combined market value of the shares, securities, and bonds held by a fund on a given day (after reducing permitted expenses and charges).

Simply put, NAVPU represents the market value of all the units in a mutual fund trust during a particular day after deducting expenses and liabilities plus income accrued, divided by the outstanding number of Units in the scheme.

Many emerging investors consider mutual funds to be a reliable investment path for the following reasons:

Professional Management

As fund managers do the research for you in terms of selecting securities and monitoring performance, you have more assurance and credibility about the choices made.

Diversification

Mutual funds perfectly work with the basic investment concept: “Don’t put all your eggs in one basket”. Mutual funds typically focus on investing in a range of companies and industries. This reduces the risk and impact of losses even if one company/fund unit fails.

Affordability

Most mutual funds set a relatively low amount for the initial investment and then the subsequent purchases.

Liquidity

Investors can easily redeem their shares whenever they need at the current net asset value (NAV) plus any redemption fees.

Generally, mutual funds fall into one of four main categories: (1) Money market funds, (2) Bond funds, (3) Stock funds and (4) Target date funds. Each type of mutual fund investment has different features, risks, and rewards.

Money Market Funds

Money market funds are known for their low-risk benefit. They focus on short-term low securities such as treasury bills, certificates of deposit, commercial paper, and other highly liquid instruments. This type of mutual trust fund is regulated by the Securities and Commodities Authority (SCA) to ensure investor protection and compliance with relevant statutory regulations.

Bond Funds

Bond funds provide higher returns than money market funds because they typically carry a higher risk profile. As bonds are of different types, the risk-to-return ratio of bonds can vary dramatically with mutual fund investments.

Stock Funds

Stock funds invest in corporate stocks. However, not all stock funds are the same. Some examples are:

  • Growth funds focus on stocks that have varying dividends but have the potential to earn above-average returns.
  • Income funds invest in stocks that assure regular dividends.
  • Index funds track and monitor a particular market index, like the “Standard & Poor’s 500 Index”.
  • Sector funds specialise in a specific industry segment only.
Target Date Funds

Target date funds focus on a mix of stocks, bonds, and other investments. With time, this mix shifts depending on the fund’s strategy in place. Target date funds, also referred to as lifecycle funds, are exclusively designed for investors with particular retirement dates or plans in mind.

Benefits & Potential Risks of Mutual Fund Investments

Apart from the instrumental benefit of professional investment management and portfolio diversification, mutual fund investments allow you to earn money in three ways:

1. Dividend Payments

A mutual fund earns income from dividends on stock or interest on bonds. The fund then pays the shareholders almost all of the income after reducing the expenses incurred.

2. Capital Gains Distributions

The price of securities in a mutual fund investment has the probability of increasing. So when a fund sells a security that has increased in price, the fund benefits from a capital gain. The fund then distributes these capital gains to investors at the end of the year after reducing any capital losses.

3. Increased NAV

When the market value of a mutual fund's portfolio increases after reducing the expenses, then the value of the fund and its subsequent shares increases. Generally, a higher NAV reflects the higher value of your investment.

As with any investment option, risks are inevitable in mutual funds as well. You can lose some or all of the money you invest, and the securities held by a fund can go down in value. Similarly, dividends or interest payments may also change as market conditions change.

On the other hand, while a fund’s past performance is not detrimental when predicting future returns, it can tell you a lot about how volatile or stable a fund has been over the years. The more volatile a fund is, the higher the risk of investment.

Studying, researching, and analysing these market conditions, alongside making smart choices, comes with experience. This is where the help and guidance of a reliable financial advisory firm can be beneficial when you decide how to invest in mutual funds. They can aid you in making the right decisions with strategies personalised to your financial goals.

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  • An Example of a Mutual Fund Investment
  • Why Do People Buy Mutual Funds?
  • Types Of Mutual Funds
  • Benefits & Potential Risks of Mutual Fund Investments
  • What’s Next?
  • Learn more

  • An Example of a Mutual Fund Investment
  • Why Do People Buy Mutual Funds?
  • Types Of Mutual Funds
  • Benefits & Potential Risks of Mutual Fund Investments
  • What’s Next?