MUTUAL FUND
Introduction to Mutual Fund
A mutual fund is a type of financial vehicle made up of a pool of money collected from many
investors to invest in securities such as stocks, bonds, money market instruments, and other assets.
Mutual funds are operated by professional money managers, who allocate the fund's assets and
attempt to produce capital gains or income for the fund's investors. A mutual fund's portfolio is
structured and maintained to match the investment objectives stated in its prospectus.
Mutual funds give small or individual investors access to professionally managed portfolios of
equities, bonds and other securities. Each shareholder, therefore, participates proportionally in the
gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is
usually tracked as the change in the total market cap of the fund—derived by the aggregating
performance of the underlying investments.
Basics of Mutual Funds
Mutual funds pool money from the investing public and use that money to buy other securities,
usually stocks and bonds. The value of the mutual fund company depends on the performance of the
securities it decides to buy. So, when you buy a unit or share of a mutual fund, you are buying the
performance of its portfolio or more precisely, a part of the portfolio's value. Investing in a share of a
mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not
give its holders any voting rights. A share of a mutual fund represents investments in many different
stocks (or other securities) instead of just one holding.
That's why the price of a mutual fund share is referred to as the net asset value (NAV) per share,
sometimes expressed as NAVPS. A fund's NAV is derived by dividing the total value of the
securities in the portfolio by the total amount of shares outstanding. Outstanding shares are those
held by all shareholders, institutional investors, and company officers or insiders. Mutual fund shares
can typically be purchased or redeemed as needed at the fund's current NAV, which—unlike a stock
price—doesn't fluctuate during market hours, but is settled at the end of each trading day.
The average mutual fund holds hundreds of different securities, which means mutual fund
shareholders gain important diversification at a low price. Consider an investor who buys only
Google stock before the company has a bad quarter. He stands to lose a great deal of value because
all of his dollars are tied to one company. On the other hand, a different investor may buy shares of a
mutual fund that happens to own some Google stock. When Google has a bad quarter, she only loses
a fraction as much because Google is just a small part of the fund's portfolio.
Types of Mutual Fund
Equity Fund
Fixed Income Fund
Index Fund
Balanced Fund
Money Market Fund
Income Fund
International Fund
Speciality Fund
Exchange Traded Fund
Equity Fund
The largest category is that of equity or stock funds. As the name implies, this sort of fund
invests principally in stocks. Within this group is various sub-categories. Some equity funds are
named for the size of the companies they invest in small-, mid- or large-cap. Others are named by
their investment approach: aggressive growth, income-oriented, value, and others. Equity funds
are also categorized by whether they invest in domestic (U.S.) stocks or foreign equities. There
are so many different types of equity funds because there are many different types of equities.
The idea here is to classify funds based on both the size of the companies invested in (their
market caps) and the growth prospects of the invested stocks. The term value fund refers to a
style of investing that looks for high quality, low growth companies that are out of favor with the
market. These companies are characterized by low price-to-earnings (P/E), low price-to-book
(P/B) ratios, and high dividend yields. On the other side of the style, spectrum are growth funds,
which look to companies that have had (and are expected to have) strong growth in earnings,
sales, and cash flows. These companies typically have high P/E ratios and do not pay dividends.
A compromise between strict value and growth investment is a “blend,” which simply refers to
companies that are neither value nor growth stocks and are classified as being somewhere in the
middle.
Fixed Income Funds
Another big group is the fixed income category. A fixed income mutual fund focuses on
investments that pay a set rate of return, such as government bonds, corporate bonds, or other
debt instruments. The idea is that the fund portfolio generates interest income, which then passes
on to shareholders.Sometimes referred to as bond funds, these funds are often actively managed
and seek to buy relatively undervalued bonds in order to sell them at a profit. These mutual funds
are likely to pay higher returns than certificates of deposit and money market investments, but
bond funds aren't without risk. Because there are many different types of bonds, bond funds can
vary dramatically depending on where they invest. For example, a fund specializing in high-yield
junk bonds is much riskier than a fund that invests in government securities. Furthermore, nearly
all bond funds are subject to interest rate risk, which means that if rates go up the value of the
fund goes down.
Index Funds
Another group, which has become extremely popular in the last few years, falls under the
moniker "index funds." Their investment strategy is based on the belief that it is very hard, and
often expensive, to try to beat the market consistently. So, the index fund manager buys stocks
that correspond with a major market index such as the S&P 500 or the Dow Jones Industrial
Average (DJIA). This strategy requires less research from analysts and advisors, so there are
fewer expenses to eat up returns before they are passed on to shareholders. These funds are often
designed with cost-sensitive investors in mind.
Balanced Funds
Balanced funds invest in both stocks and bonds to reduce the risk of exposure to one asset class
or another. Another name for this type of mutual fund is "asset allocation fund." An investor may
expect to find the allocation of these funds among asset classes relatively unchanging, though it
will differ among funds. This fund's goal is asset appreciation with lower risk. However, these
funds carry the same risk and can be as subject to fluctuation as other classifications of funds. A
similar type of fund is known as an asset allocation fund. Objectives are similar to those of a
balanced fund, but these kinds of funds typically do not have to hold a specified percentage of
any asset class. The portfolio manager is therefore given freedom to switch the ratio of asset
classes as the economy moves through the business cycle.
Money Market Fund
The money market consists of safe (risk-free) short-term debt instruments, mostly government
Treasury bills. This is a safe place to park your money. You won't get substantial returns, but you
won't have to worry about losing your principal. A typical return is a little more than the amount
you would earn in a regular checking or savings account and a little less than the average
certificate of deposit (CD). While money market funds invest in ultra-safe assets, during the 2008
financial crisis, some money market funds did experience losses after the share price of these
funds, typically pegged at $1, fell below that level and broke the buck.
Exchange Traded Funds
A twist on the mutual fund is the exchange traded fund (ETF). These ever more popular
investment vehicles pool investments and employ strategies consistent with mutual funds, but
they are structured as investment trusts that are traded on stock exchanges and have the added
benefits of the features of stocks. For example, ETFs can be bought and sold at any point
throughout the trading day. ETFs can also be sold short or purchased on margin. ETFs also
typically carry lower fees than the equivalent mutual fund. Many ETFs also benefit from active
options markets where investors can hedge or leverage their positions.
Advantages of Mutual Fund
Diversification
Easy Access
Economies of Scale
Professional Management
Variety and freedom of choice
Transparency
Disadvantages of Mutual Fund
High fees, commissions, other expenses
Large cash presence in portfolios
No FDIC coverage
Difficulty in comparing funds
Lack of transparency in holdings
