What Is a Mutual Fund?

A mutual fund is a pool of money professionally managed by a fund manager. It is a trust that gathers money from investors who share a common investment objective and invest in the same equities, bonds, money market instruments and/or other securities.

In simple terms, mutual funds allow you to pool your money alongside other investors to “mutually” buy stocks, bonds, and other investments. By investing in a mutual fund, you buy a share of the fund itself and its assets, such as stocks, bonds, or even a combination of both.

Over time, mutual funds may distribute dividends (income earned from the fund’s investments) and capital gains (profits from the sale of securities within the fund). These distributions can be taken in cash or reinvested to purchase more shares of the fund.

Mutual fund investments are usually run by professional money managers who decide which securities to buy and when to sell them.

This pooled structure allows individual investors to gain access to a diversified collection of investments, which might be difficult to achieve on their own due to cost and expertise constraints.

Each unit or share of the Fund is priced every day based on the daily market value of its underlying investments. NAVPU (net asset value per unit) represents the per-share value of the fund’s assets minus its expenses and liabilities divided by the total number of units of participation.

Operating a mutual fund involves costs such as shareholder transaction costs, investment advisory fees, and marketing and distribution expenses. Mutual funds pass along these costs to investors by imposing charges that include operating expenses, purchase fees, redemption fees, etc.

Initial Investment: Suppose you invested $1,000 in a mutual fund with a NAV of $100 per share, so you purchased 10 shares.

  • Dividends and Capital Gains Distributions: Over the holding period, you received $600 in dividends, which were reinvested to purchase additional shares at various NAVs. Assume these reinvestments bought you 6 more shares.
  • Final Value: After some time, the NAV increases to $120 per share. You now own 16 shares.
  • Capital Gain or Loss: The final value of your holdings is 16 shares * $120 = $1,920. The initial investment was $1,000.
  • Capital Gain: $1,920 (final value) - $1,000 (initial investment) = $920.
  • Total Return: If you took the $600 dividends in cash, your total return would be $920 (capital gain) + $600 (dividends) = $1520. If reinvested, the dividends are included in the final value calculation.

Profits from mutual fund investments are subject to capital gains tax. Dividends may also be taxable depending on their nature (qualified vs non-qualified dividends).

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

Professional Management

Mutual funds are managed by professional portfolio managers who use their expertise to select securities and manage the fund’s portfolio according to its stated investment objective.

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 on any business day at the fund’s net asset value (NAV) minus any redemption fees.

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

Money Market Funds

Money market funds can fulfil a number of roles within a client’s portfolio, including:

  • Short-term home for cash balances
  • As an alternative to bonds and equities in a multi-asset class portfolio to lower the overall volatility of the portfolio
  • As part of the asset allocation strategy, to get higher returns than they would receive on cash.

Money market funds also offer a potentially safe haven in times of market falls.

Bond Funds

Bond funds provide higher returns than money market funds because they typically carry a higher risk profile. Most bond funds pay regular distributions, which can be half-yearly, quarterly, or monthly, and, therefore, they can provide an investor with a regular income.

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 are a type of mutual fund designed to provide a convenient investment option for individuals saving for a specific future date, such as retirement. They simplify long-term investing by automatically adjusting the asset allocation as the target date approaches.

Potential Risks of Mutual Fund Investments

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 to take a new step in your financial journey. They can aid you in making the right decisions with strategies personalised to your financial goals.

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  • Mutual Funds
  • Example
  • Why Mutual Funds
  • Types of Mutual Funds
  • Potential Risks
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  • An Example of a Mutual Fund Investment
  • Why Do People Buy Mutual Funds?
  • Types of Mutual Funds
  • Potential Risks