You may have heard the financial term “mutual fund” before. What is a mutual fund, and how does it work?
Table of Contents
- What is a Mutual Fund?
- What is Net Asset Value?
- The Different Types of Mutual Funds
- Fixed Income or Bonds
- Equity or Stocks
- Money Market Mutual Funds or Short-Term Debt
- Hybrid Mutual Funds
- The Benefits of Investing in a Mutual Fund
- Risks Associated with Mutual Fund Investments
- Buying and Selling Mutual Funds
- Fees Associated with Mutual Funds
- In Conclusion
What is a Mutual Fund?
A mutual fund is formed when an investment manager collects money from several investors to create a pool fund. The pooled fund is invested in bonds, stocks, or other assets as the investment manager, who oversees the mutual fund, sees fit.
A mutual fund is one of the most accessible investment options for the average person since it allows them to invest in a diverse, group of securities that is managed professionally at a reasonable cost.
The profits earned on the mutual fund are distributed equally among investors. That is, after deducting relevant fees and expenses to determine the net asset value or NAV of the fund.
What is Net Asset Value?
The net asset value denotes the success or performance of a mutual fund. On any given day, you can calculate the net asset value per unit by dividing the market value of a scheme’s securities by the total number of units in the scheme.
Simply put, it is the market value calculated per share.
The Different Types of Mutual Funds
There are four main kinds of mutual funds. They are:
- Fixed income or bonds
- Equity or stocks
- Hybrid funds, which are a mixture of stocks and bonds.
- Money market mutual funds or short-term debt
Fixed Income or Bonds
The most prevalent form of a fixed-income mutual fund is a bond fund, which pays its investors a fixed return on their original investment. Bond funds invest in corporate and government debt as opposed to stocks.
While it may be seen as a safer investment than stocks, bond funds offer less growth potential than stock funds.
Equity or Stocks
Mutual funds that invest in equities of publicly traded corporations are known as equity mutual funds. According to the Investment Company Institute, more than 50 percent of mutual funds on the market are equities funds. Equity funds have high growth potential, but they also have a greater risk of value volatility.
Additionally, equity funds may vary based on company size, industry or sector, global markets, or growth and value.
Money Market Mutual Funds or Short-Term Debt
Fixed-income mutual funds that invest in high-quality, short-term debt issued by governments, banks, and companies are known as money market funds. US Treasury bills, certificates of deposit, and commercial paper are some of the assets held by these funds. They are one of the safest investments, accounting for 15 percent of the mutual fund market.
Hybrid Mutual Funds
These investments, commonly known as asset allocation funds, are a combination of equities and fixed-income funds with a predetermined investment ratio, such as 60 percent stocks and 40 percent bonds. Target-date funds are the most well-known of these funds, as they automatically reassign your investments from equities to bonds as you grow closer to retirement.
The Benefits of Investing in a Mutual Fund
Mutual funds can be beneficial for investors. Here is a list of advantages associated with mutual funds.
- You can have a diverse retirement portfolio, as your money is invested in a range of industries.
- These funds are tax-efficient.
- With mutual funds, you have the peace of mind that your investment is managed by a professional.
- There is high liquidity. Unless you choose a closed-end fund, you can exit with ease.
- The cost is lower for bulk transactions.
- With a mutual fund, you can choose to automate your payments.
- There is a high level of safety and stability when you invest in this type of fund, as they are observed strictly under government authority.
- Investments may be systematic or once-off, so you can plan your investment to suit your personal needs.
- Because mutual funds are group investments, you can invest low amounts as opposed to other forms of investments.
Risks Associated with Mutual Fund Investments
As with most things in life, mutual investments do carry some risks.
- Management fees are charged for mutual funds, as a professional oversees the fund. Other operational fees must be paid to manage the fund.
- Exiting the fund does incur costs. This was put in place to discourage investors from exiting the fund before its proper maturation, to ensure that investors get the best return on their investment.
- While having a diverse range of investments may be beneficial, it can also dampen profits.
Buying and Selling Mutual Funds
Rather than buying from other investors, investors purchase mutual fund shares directly from the fund, or through a fund broker. The fund’s per-share net asset value plus any fees payable at the time of purchase, such as sales loads, is the price that investors pay for the mutual fund.
Shares in mutual funds may be redeemed. What this means is that investors can sell them back to the fund at any time. In most cases, the fund is required to provide you the payment within seven days.
Fees Associated with Mutual Funds
Fees and expenses are payable by investors. These differ from one fund to the next, so be sure to get enough information about the fee structure from your investment manager. To achieve the same returns for you, a high-cost fund must outperform a low-cost fund.
Small fees can make a dent in your returns over the years. As an investor, you are entitled by law to a prospectus that details the terms of your mutual fund, and you must be provided regular shareholder reports, so you may be fully aware of where your investment stands.
Mutual funds are investments made by groups of investors. These funds are managed by professional investment managers. This money is invested in a range of assets, such as bonds and stocks. This is done at the investment manager’s discretion.
The progress of a mutual fund may be determined by calculating the net asset value. This is done by dividing the market value of the fund’s securities by the total number of units in the scheme.
While mutual funds are beneficial for investors, be sure to take note of the fees and expenses associated with them.
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