Mutual Funds

A financial instrument that pools assets in the form of money from multiple shareholders and invests in different financial instruments on behalf of the shareholders.

A mutual fund, also known as a managed investment fund, is a financial instrument that pools assets in the form of money from multiple shareholders and invests in different financial instruments, such as stocks, bonds, and real estate, on behalf of the shareholders.

These investment funds are operated and managed by professional fund managers specializing in portfolio management. These fund managers allocate the client's funds in a way that generates income and maximizes the return for shareholders. 

The money invested by the fund managers is based on the investment strategy adopted by the client. Different investment strategies can be aggressive, balanced, growth, and conservative. The objective of a particular fund is stated in its prospectus. 

These funds allow small individual investors to invest in the financial markets without applying technical knowledge, as the clients essentially deposit their money with a fund that a professional fund manager operates. 

The shareholders of this fund experience gains or losses based on the proportion of their investment in the fund. Since these investment funds invest in a variety of securities, the overall performance of the fund is calculated by measuring the difference in market capitalization

Most of these funds invest in a wide variety of securities. Depending upon the investment strategy adopted by the fund, the weightage into different asset classes varies. However, a mix of asset classes in the portfolio helps the investor reap diversification's benefits. 

Vanguard, Fidelity Investments, JP Morgan Chase, and Goldman Sachs are some of the most famous companies whose mutual funds are traded on the market. Most of these funds compete against each other and can be differentiated based on returns and costs. 

Types

There are several different categories of managed funds being traded on the market. The different types can be explained as follows: 

1. Equity Funds: As the name suggests, these funds tend to invest heavily in the equities market. Within this category, there are several sub-categories, which can be explained as follows: 

  • Large Cap Funds – These funds invest money in the stocks of firms of a very large size and high market capitalization. These firms generally have a well-established track record of performance and are least affected by market fluctuations. 
  • Mid-Cap Funds – Mid-cap funds tend to invest money in medium-sized enterprises. Compared to large funds, these firms have lower performance stabilities; thus, they carry relatively higher risk and higher returns. 
  • Small Cap Funds – These funds invest money in small-sized companies. In financial markets, small-sized companies always possess the highest potential to grow or fail, so these funds carry even higher risk and return options. 
  • Multi-Cap Funds – Multi-cap funds aim to allocate proportions of their funds in all kinds of equity assets. 

Apart from selecting firms based on market capitalization, equity funds also invest based on market sectors, such as funds for IT and software firms, FMCG firms, and banking institutions, and based on location, for example, funds for international equity. 

2. Debt Funds: A debt mutual fund is a kind of investment scheme that allocates most of its funds to debt instruments like corporate and government bonds, treasury bills, debentures, and other money market instruments

Since these funds invest most of their funds in fixed-income instruments, they carry very low risk and thus minimal returns for the investor. 

A debt fund manager, in most cases, actively manages the asset portfolio by buying undervalued bonds on the market, intending to sell them at a higher price to earn a profit for the shareholders. 

3. Index Funds: Index funds are those kinds of investment funds that try to replicate the market index's performance, such as the S&P 500 for American markets, SENSEX for the Indian market, and FTSE100 for the British markets. 

Since the main aim is to generate returns similar to that of the market index, index funds adopt a passive investment style, resulting in less research. As a result, fewer expenses are to be borne by the shareholders. 

Types of Investment Strategies 

A managed investment scheme is a very useful financial instrument for individual investors and investors who need to learn more about financial markets. The different types of investing strategies adopted by these investment funds are as follows: 

1. Aggressive and High Growth Strategy – The main objective of adopting a high-growth aggressive strategy is to generate wealth and high returns for the investor in the long term.

Since there is a higher emphasis on wealth creation and returns, most funds (usually at least 65%) are invested in equities. The remaining funds are invested in a mixture of debt instruments and other asset classes like real estate. 

2. Income-Based Strategy – The primary objective of an income-based approach is to generate a steady return for investors who demand frequent payments in the form of dividends or interest payments in the medium to long term.

As a result, a heavy weightage is given to fixed-income instruments like corporate bonds and treasury bills, which results in a low-risk and low-return portfolio. 

Due to the low risk arising from such financial instruments, the investors can guarantee a fixed periodic payment in interest. However, the potential for wealth creation and growth is restricted in such investment funds. 

3. Balanced Investment Plans – These funds follow a balanced outlook and invest in both equities and debt instruments in varied proportions. The main goal of the scheme is to generate steady returns, periodic income, and low risk.

Fund managers, in this case, invest around 60% of their assets in equity, 30% in debt instruments, and 10% in assets like derivatives and real estate. 

Since these investment options cover different classes of assets, the benefit of diversification helps reduce the overall risk. It suits investors who want a stable return rate at a lower risk level. 

4. Liquid Funds – As the name suggests, liquid funds aim to maintain a certain level of liquidity for the shareholders, which can be met easily whenever the need arises, and ensure capital protection and income stability, mostly in the short-run. 

As a result, a majority of the assets of the fund are invested in safe, short-term instruments like T-Bills, certificates of deposits, commercial paper, and other money-market instruments. 

These investment options are most suitable for investors who aim to park their excess money in the market for the short term to earn a stable return. 

Advantages

The advantages of investing money in these funds are as follows: 

1. Benefits of Diversification

The main purpose of investing in these funds is that it allows individual investors to access a variety of securities they might not know. 

Since mutual funds are set up as proportions of different assets, mixing assets in the portfolio to reduce the overall portfolio risk is known as diversification. It is one of the most significant advantages of these investments. 

A well-diversified portfolio with a mix of assets from different industries, risk categories, and geographical locations helps the investor to attain maximum return at the lowest possible risk. 

Investors who do not have much technical information about the market can thus use these investment options to avail themselves of the benefits of diversification. This process is also faster and cheaper than buying individual securities. 

2. Access to a wide variety of securities 

These funds are highly liquid assets, which implies that they can easily be bought or sold in the secondary market, i.e., the stock exchange.

Moreover, assets like international equity shares and derivatives cannot be easily accessed by individual investors who do not have much knowledge about the market. 

As a result, mutual funds provide an equal opportunity to all investors and make it easy for them to invest in these securities, which they would not have been able to do individually. 

3. Achieving Economies of Scale 

These funds also help investors reap the benefits of economies of scale. For example, it eliminates several commission fees the investor will be expected to pay if they purchase securities individually.

Moreover, transactions involving the purchase/sale of individual securities bear higher transaction costs. However, the smaller denominations of these mutual funds enable the investor to benefit from the dollar cost averaging.  

Since these funds deal in large volumes of transactions, the per unit cost of the transactions is lower than what an individual would pay if invested separately. 

4. Freedom to choose any fund 

Since hundreds of managed fund investments are being traded on the market, and an even larger number of fund managers, investors have a wide variety of options to choose from. 

Different fund managers use different techniques to generate returns. For instance, one manager might prefer high growth, whereas the other follows a conservative strategy and invests based on industries. 

These options not only familiarize the investors with the concept of stocks and bonds but also enable them to know more about the alternative asset classes. Investors can research and choose whichever fund they think is suitable. 

Disadvantages

The disadvantages of investing through managed fund investments are as follows: 

1. High Costs involved – Since professional fund managers manage these investment options, the overall payout received from the returns generated by securities is offset by the large number of costs involved.

The fee structure varies from fund to fund, and thus the investors need to keep track of the costs involved. Otherwise, this can cause problems in the long term as fees related to the fund keep on accumulating over the years. 

2. No Guaranteed Return – Like all other securities being traded on the market, these funds also do not guarantee a return to the investors. This implies that the fund can always depreciate over time. 

For example, equity funds experience more volatility as stocks are considered one of the most volatile assets that frequently fluctuate according to market forces. 

3. Higher Cash Involvement – According to investment laws, mutual funds are expected to hold a certain portion of their assets in cash to satisfy daily share redemption. 

To facilitate frequent withdrawals and maintain liquidity simultaneously, these funds hold a larger amount of cash than an individual investor might hold in his/her financial portfolio.

Since cash does not generate any return, this phenomenon is known as cash drag

4. Evaluation of Funds – For investors who do not know much about the financial markets, researching and comparing different funds can be a herculean task. 

Unlike stocks and bonds, mutual funds do not provide detailed information about the securities, such as comparable ratios like price-to-earnings ratio, earnings per share, and sales growth. 

These investment options provide the net asset value, which can be used for comparisons but do not take every aspect that might be needed by the investors, considering the diversity of the portfolios. 

Pricing and Returns Generated by Mutual Funds 

The market value of mutual funds solely depends on the performance of the securities held within the fund. Therefore, the price of a mutual fund is known as the net asset value and is often written as NAV

The value of NAV is derived by dividing the total number of assets held within the fund by the total amount of outstanding shares, which are the total number of shares held by institutional investors, corporations, and insiders.

However, ownership in these funds does not give investors voting rights as investing in equity shares does. 

There are three possible ways to earn a return from mutual funds. They are listed as follows: 

1. The first source of income for investors is the dividend received from shares and interest received on bonds. These funds often allow the investors to receive a cheque or reinvest all distribution earnings into the fund. 

2. The second source of income for investors is capital gain, which results from an increase in the underlying price of the security. 

3. An increase in the overall price of the fund can also be a source of income for the investors as those funds can then be sold in the market at a profit. 

Key Takeaways

  • These investment options allow those investors who do not have a lot of technical knowledge regarding the market to invest in different kinds of securities like bonds, real estate, and private equity that they would not have been able to do otherwise. 
  • Secondly, these financial instruments can be tailored per the investors' investment preferences as they are different investment strategies, such as aggressive, high-growth, and balanced, that these funds tend to offer. 
  • Moreover, this fund is an attractive investment opportunity as it allows investors to access a wide variety of securities at costs lower than what the investors would pay if invested individually. 
  • In the past decade, these funds have become a popular investment option. It also encourages the investor to continuously make additions out of savings to the fund as these funds generally tend to provide higher returns to the investor in the long run.
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Researched and authored by Mehul Taparia | LinkedIn

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