Mutual Funds: Definition, Types, Pros and Cons

What is a Mutual Fund? A mutual fund is a professionally managed investment vehicle that pools money from multiple investors to buy a diversified portfolio of stocks, bonds, or other securities. This pooling of resources allows individual investors to access a diversified and professionally managed portfolio, making it an attractive option for those looking to […]

September 24, 2023
Meta Matt

What is a Mutual Fund?

A mutual fund is a professionally managed investment vehicle that pools money from multiple investors to buy a diversified portfolio of stocks, bonds, or other securities. This pooling of resources allows individual investors to access a diversified and professionally managed portfolio, making it an attractive option for those looking to invest without the burden of managing their investments.

The top-performing mutual funds can change over time and depend on various factors like investment goals, risk tolerance, and market conditions. It's essential for investors to research and consult with financial experts to identify suitable funds. 

Mutual funds are also not risk-free, as they are subject to market fluctuations. The safety of a mutual fund depends on its underlying assets and the fund manager's strategy. Generally, they are considered a relatively safe investment option compared to individual stocks. So, beginners can easily invest in mutual funds.

Also Read: Why Investing Is Important: Don’t Let Your Savings Sit Idle

Mutual funds definition

Key Difference

  • Mutual funds are a collection of various securities that a group of investors buy after pooling their money together.
  • Mutual funds help investors hedge against risk by diversifying their portfolios.
  • Major types of mutual funds include stock funds, bond funds, money market funds, and balanced funds.
  • You can profit from a mutual fund through capital appreciation, dividend income, and capital gains distribution.

Terms that you need to know

Securities: It is a broad term for stocks, bonds, mutual funds, ETFs, or other types of investments that you can buy or sell.

Bonds: Bonds are issued by governments or corporations to raise money. The investor is paid a fixed interest by the bond issuer.

Dividends: These are the regular payments made by a company to its shareholders. A company shares its profits with the shareholders.

Understanding How a Mutual Fund Works

Here's a step-by-step breakdown of how a mutual fund operates:

Investor Contributions: Individual investors buy shares or units of the mutual fund. Each share represents a portion of the fund's holdings. When an investor buys shares, they contribute money to the fund.

Pool of Funds: The money contributed by all investors is pooled together into a single fund. This pool of funds creates a substantial capital base that can be used to invest in a diverse range of assets, such as stocks, bonds, money market instruments, or a combination of these.

Professional Management: A professional fund manager is responsible for making investment decisions on behalf of the mutual fund. The fund manager's goal is to achieve the fund's stated investment objectives, whether it's capital appreciation, income generation, or a specific level of risk.

Diversification: The fund manager diversifies the fund's portfolio by investing in a variety of assets. This diversification helps spread risk across different securities and reduces the impact of poor performance by any single investment.

Portfolio Adjustments: The fund manager continuously monitors the performance of the portfolio. They may buy or sell securities within the fund to align with the fund's objectives or respond to changing market conditions. This active management aims to optimize returns while managing risks.

Reporting and Transparency: Mutual funds provide regular updates to investors, including periodic statements, annual reports, and prospectuses. These documents offer insights into the fund's performance, holdings, fees, and investment strategy.

Regulation: Mutual funds are subject to regulatory oversight to protect investors' interests. The Securities and Exchange Commission (SEC) regulates mutual funds in the United States, and funds must adhere to specific rules and disclosure requirements.

Price of Mutual Funds

A mutual fund's price, referred to as Net Asset Value per share (NAV) is calculated daily. You can measure the NAV of a mutual by dividing the total value of its assets by the number of its shares. Investors can buy or sell shares in the mutual fund at the NAV price. These transactions occur at the end of each trading day, ensuring that all investors receive the same price for their transactions on that day.

Fees and Expenses

Mutual funds charge fees to cover operating costs, including the fund manager's compensation, administrative expenses, and marketing costs. These fees are typically expressed as an annual expense ratio, which is a percentage of the fund's assets. Some funds may also charge sales loads when shares are bought or sold, as well as other fees like redemption fees or account maintenance charges. Also, you can withdraw your investment in a mutual fund at any time.

Also Read: Guide to ETFs and Investing in Them

Types of Mutual Funds

There are four types of Mutual Funds in which you can invest:

Equity/Stock Funds

As the name suggests these funds primarily invest in stocks of companies listed on the stock market. They are further divided based on the companies they invest in. They can be divided into large-cap, medium-cap, and small-cap equity funds. But the important thing to remember is that the major portion of these funds is invested in the stocks.

Bond Funds

These mutual funds primarily invest in government or corporate bonds. Bonds provide a fixed return to the investors in the form of interest payments. These funds are less risky and are also called fixed-income funds.

Money Market Funds

These funds invest in low-risk, short-term debt securities mostly treasury bills. Investors can make money by selling the bill after it has matured or by selling it to other investors in secondary markets.

Balanced Funds

A balanced fund invests in a diverse group of securities from stocks and bonds to other mutual funds. The purpose of these funds is to diversify their portfolio and reduce the risk exposure of their investors. These are also called hybrid or asset allocation funds.

Target Date Funds

These are a sub-type of asset allocation funds. The investment shifts between securities as the target date for withdrawing funds approaches.

Index Funds

Index funds invest in companies that a broad market index such as the S&P 500 or DJIA is tracking. These funds require less research as they just invest in companies already being tracked by the index. These funds also cost less to the investor as there is no deep analysis required by managers of the fund.

Commodity Funds

These funds invest in companies that deal with commodities such as energy, food, or mining companies. They are a good investment option to counter inflation.

Specialty Funds

These funds focus on companies in a specific industry. The managers can choose companies in any industry such as the financial, technology, or food industries.

ESG Funds

Environmental, social, and governance funds are a sub-type of specialty funds. They invest in companies based on how responsibly they follow environmental, social, and governance guidelines. They can also avoid companies in the defense, alcoholic beverage, or gambling industries.

Income Funds

The primary objective of these funds is to provide steady income to its investors, so these funds invest in bonds or high dividend yield stocks.

Global Funds

These mutual funds invest in international markets. These funds require extensive research as socio-political changes in foreign countries can highly affect the investments.

Profiting from Mutual Funds

Capital Appreciation

Investors can profit from mutual funds through capital appreciation. As the fund's underlying assets increase in value, the NAV of the fund rises, and investors' shares become more valuable.

Dividend Income

Many mutual funds pay out dividends to their investors from the income generated by the underlying assets, such as dividend-paying stocks or interest-bearing bonds. Investors can choose to receive these dividends or reinvest them.

Capital Gains Distributions

When a mutual fund sells assets within its portfolio for a profit, it may distribute these capital gains to investors. This can add to an investor's return.

Pros and Cons of Mutual Funds

Pros

  • Diversification: Provides access to a diversified portfolio of assets.
  • Professional Management: Expert fund managers make investment decisions.
  • Liquidity: Shares can be bought or sold daily at NAV prices.
  • Accessibility: Suitable for investors with varying risk profiles and investment goals.
  • Dividend Income: Offers regular income through dividends and capital gains distributions.

Cons

  • Fees: Charges like expense ratios and sales loads can erode returns.
  • Limited Control: Investors have no direct control over individual securities.
  • Tax Implications: Capital gains distributions can have tax consequences.
  • Market Risk: Mutual funds are subject to market fluctuations.

Example of a Mutual Fund

Some of the popular mutual funds are:

  • Vanguard Total Stock Market Index Fund; Institutional Plus
  • Fidelity 500 Index Fund
  • Goldman Sachs FS Government Fund; Institutional
  • Schwab Value Advantage Money Fund; Investor
  • BlackRock Exchange BlackRock

Conclusion

Mutual funds provide a valuable tool for investors seeking diversification and professional management. While they have their advantages, such as access to expert management and a diversified portfolio, it's crucial to be aware of associated fees and potential tax implications.

Comparing mutual funds to ETFs, investors can choose the option that aligns with their investment objectives and preferences.



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