Mutual Fund: Meaning, Types and Associated Benefits and Risks

Mutual fund advertisements draw a rosy picture concerning money growth and then quickly display a disclaimer stating – “Mutual fund investments are subject to market risks, read all scheme related documents carefully”. Isn’t it complicated? When a person is unaware of the basics of mutual funds, such a statement can be intimidating for them. Moreover, the vast number of available mutual fund options can be highly confusing. Though one can always rely on a trusted financial advisor, the importance of making yourself aware cannot be undermined. In this write-up, we are sharing all the important details about Mutual Funds. Keep reading if you want to #RiseMoneyWise!

What is a Mutual Fund?

Mutual Funds are a pool of money collected from many investors and managed by a professional fund manager. This pool of money is collected for investing in shares, bonds, money market instruments, and other financial assets. Fund managers allocate the money collected from investors into different financial assets to produce capital gains for the investors.

Each mutual fund plan has an investment objective that is clearly stated in its prospectus. As small investors invest money for a larger pool, the profits (or losses) of the pool are divided proportionately among the individual investors.

Important Terms Related to Mutual Funds

1. Net Asset Value (NAV) – In the simplest terms, the price of a mutual fund share is called its net asset value (NAV). The NAV, unlike the share price, does not fluctuate during the market hours; the price is settled at the end of each trading day. NAV per unit of a mutual fund represents the market value of one unit of that fund on a given day. This market value is reached after considering total expenses and liabilities plus income accrued divided by the outstanding number of mutual fund units in the scheme.
2. Growth Option – The growth option mutual funds are the funds in which no interim payments are given to investors. All the interest, gain, bonus, and dividend earned on the units are re-invested for further growth of the fund.
3. Dividend Option – The dividend option in mutual funds indicates that dividends earned on the stock holding will be paid out to the mutual fund unit holders in cash. However, investors are also given the option of dividend re-investment.
4. Systematic Investment Plan (SIP) – The SIP is one of the most used terms concerning mutual funds. The term simply means that the investors are at the liberty to pay a certain small amount every month rather than investing a big lump sum amount. Fresh units are bought for investors each month with the amount received as SIP. This purchase is done at the NAV on that particular day.
5. Corpus – The term corpus is often used to describe the size of a mutual fund. It is the total amount of money invested by all the investors. We can understand this as the size of the pool of money collected from individual investors.
6. Load – It is the term used to signify the fee paid by investors at the time of buying or selling a mutual fund. The fee paid at the time of purchase is called entry load and the fee paid at the time of selling the mutual fund units is called exit load.
7. Portfolio – This term is related to individual investors rather than a mutual fund. A portfolio is the total set of investments an individual investor has in her kitty. It includes mutual fund investments and all other investment assets.

Difference between Mutual Fund and Shares Investment

• Holders of Mutual Fund, unlike shares, do not get voting rights. When you hold equity shares of a company, you get voting rights for the same. But, when you buy units of a mutual fund you do not get any voting rights for your holdings.
• Holding a unit of the mutual fund represents an investment in different stocks (as decided by the fund manager) and not just one company. On the other hand, investment in a share of a company represents an investment in that particular company only.
• The price of share/stocks keep fluctuating throughout the market hours. The market value of mutual fund units are determined at the end of the day (after market hours).
• Shares are comparatively more liquid than mutual funds.

Benefits of Investing in Mutual Funds

Mutual funds are seen as a great investment option by many. Some other people are also opposed to the opinion. Mutual funds are definitely subject to market risks (as you already know!). Just like any other investment option mutual funds do have certain pros and cons. Under this sub-heading, we are listing the pros or benefits of investing in Mutual Funds.

• Easy Access for Small Investors – Investors with a small amount of money at their disposal can get access to a professionally managed diversified portfolio. In most cases, small investors do not possess the knowledge of hand-picking stocks on their own. Further, diversification of investment, which is very important for risk management, becomes tough to achieve with little money. Mutual fund solves both the issues in one go.
• Diversification of Portfolio – As stated above, diversification of portfolios is easily achieved through mutual funds. It reduces the risk and increases the advantages for the investors. While diversification can be done by investing strategically in different stocks, mutual funds make it cheaper and faster. Typically mutual funds own hundreds of different stocks; this level of diversification is practically not feasible for individual investors.
• Economies of Scale – The primary goal of any investment is to increase the return on investment as much as possible while simultaneously managing the risk. Mutual funds help achieve this goal with economies of scale. Buying individual shares can eat up a large chunk of returns in the name of the commission, transaction fees, etc. As mutual funds buy a huge number of stocks at a time with the pool of investments from many small investors, the overall cost for individual investors gets reduced significantly.
• Professional Management – Though the market cannot be accurately predicted by any means, we can assume that trained professionals can read market movements much better than a lay person. So, we can safely say that mutual funds have the advantage of being managed by professional fund managers who have more in-depth knowledge and expertise in the financial market.

Limitations of Mutual Funds

As discussed earlier, mutual funds do have certain limitations too. We have already discussed the advantages of mutual funds. Following are some of the drawbacks of mutual funds:

• Subject to Market Risk – Every advertisement related to mutual fund investment explicitly declares that mutual funds are subject to market risks. While mutual funds are managed by professionals, they are not free from the risks attached to anything and everything related to the market. You can track the past performance of a mutual fund scheme or the performance of the portfolio manager, but you can never be certain about its future.
• Fluctuating Returns – As mutual funds are tied to the financial and money markets, the returns keep fluctuating with the market. You can plan some events in advance when your money is tied with something that generates a fixed return e.g. fixed deposits. But, you cannot do the same with mutual funds. You can never predict an exact increase or decrease in your investment in mutual funds.
• High Cost – While mutual funds give the benefit of economies of scale, they also put certain other financial burdens over investors. As you already know that mutual funds are managed by professional fund managers. The service of these professionals is not free of cost. The professionals charge their fee in addition to other additional costs for managing the pool of funds. All these expenses are taken from the invested funds of the investors. So, if a mutual fund is generating profit, these high maintenance cost decreases the profit. Worse, when a mutual fund is running in loss, these costs increase the loss for investors.
• Incompatibility – As an individual investor one can compare the market performance of individual stocks using varieties of indicators. But, the same is not possible in mutual funds. There are numerous companies offering varieties of mutual fund schemes and there is no certain indicator that can be used to compare them. Mutual funds are so varied in nature that it is practically not possible to compare one to the other.

Types of Mutual Funds

Mutual funds are divided into several categories based on their target financial instrument and the type of return they seek. Fund managers create these varieties of funds suiting the needs of different kinds of investors. We are listing below some of the common types of mutual funds:

1. Equity or Stock Funds

This is the largest category of mutual funds. This is the fund that invests primarily in stocks of different companies. As there are numerous varieties of equities and also investors have varying approaches to investment, there are many sub-categories of equity or stock funds.
Based on the size of the market capitalization of selected equities –

• Small-Cap – Equity funds where the fund is invested in shares with small market capitalization. These are volatile and riskier stocks. And, they are seen as a good option for generating high returns in a relatively smaller time frame.
• Mid Cap – These are equity funds that invest in mid-cap stocks in the market. These funds are lesser volatile and risky as compared to small-cap funds. And, they provide greater growth potential as compared to large-cap funds.
• Large Cap – These are equity funds that invest in stocks of blue chip companies with large market capitalization. They are seen as funds with lesser risk and lesser growth potential.
• Multi-Cap – This category of an equity fund is a hybrid fund that invests in small, mid as well as large-cap stocks in a fixed proportion. Fund managers of multi-cap equity funds try to balance the proportion of risk and growth through investment in all three categories.

Similarly, there are different categories of equity funds depending on the investment approach of investors – Aggressive growth, Income oriented, Value equity funds, etc. Equity funds are also categorized as domestic and foreign-based on whether the pool of money is invested in domestic shares or foreign market shares.

An equity mutual fund may be formed by mixing different kinds of funds based on market capitalization and investment approach as well as domestic or foreign market share.

2. Fixed-Income Funds

This is the category of mutual funds that generate a fixed return for the investors. Fund managers of fixed income funds invest the pool of money collected from investors into financial assets like government bonds, corporate bonds, and debt instruments like debenture. Thus, the portfolio generates interest income for the holders of fixed-income mutual funds.

As bonds form a major portion of these funds, they are also termed bond funds. Though the return on bond funds is interest-based, they are not entirely risk-free. Portfolio managers of bond funds seek to buy undervalued bonds so that they can be sold at higher profits. So, they may invest in high-yield junk bonds that are much riskier than government bonds.

3. Index Funds

Another popular category of mutual funds is an index fund. This is the fund where portfolio managers invest in popular indexes like S&P 500 (for the U.S. market) or Nifty 50 (for the Indian market) rather than hand-picking stocks themselves. These funds are based on the notion that it is not possible to beat the market consistently. Hence it is better to invest in the indexes consisting of top-performing stocks in the market. This requires very less calculations and analysis on the part of analysts and fund managers. It is considered the best mutual fund investment from the viewpoint of cost-sensitive investors. In 1976, Jack Bogle created the First Index Investment Trust as the first index mutual fund available to the general public.

4. Asset Allocation Funds

This is the category of mutual funds where the fund managers allocate funds into a mix or hybrid of asset classes. This hybrid of asset classes may include stocks, bonds, money market instruments, and/or other alternative investment tools. The allocation of funds in this category is done in two broad ways – specific allocation and dynamic allocation. Whether the allocation is done specifically i.e. in a pre-defined way or dynamically i.e. changing as per the market condition the end goal remains the same – earn returns for the investors as stated in the prospectus.

5. Money Market Funds

This is the category of mutual funds where the fund is allocated into short-term money market instruments like government treasury bills. This is one of the safest modes of investment in mutual funds as the money market instruments are risk-free (A global financial crisis like the crisis of 2008 should be considered an exceptional situation). These funds generate comparatively lesser returns but the principal amount is almost always safe.