What is Mutual Fund and How Does It Work?

Individual stocks can be quite volatile and can vary considerably in price, depending on a variety of both internal and external factors for the companies that issued them. Although bonds are not as volatile, their prices can also move up and down, depending on prevailing interest rates and economic expectations.

What if you could create a basket of stocks and/or bonds that would generally rise over the long term, with the losses of some of the securities more than balanced out by the gains of the other securities? Well, you may be able to do just that by investing in mutual funds. In this article, we explore mutual funds and take a look at some basic mutual fund investment strategies.

What is Mutual Fund?

A mutual fund is nothing more than a pool of stocks and/or bonds that a mutual fund manager buys and sells. The mutual fund manager researches the securities and makes all buy and sell decisions. 

When you buy a share of a mutual fund, you buy a proportional stake in the pool’s assets. As such, you have no input or control over the buying and selling decisions that the mutual fund manager makes. 

Mutual funds are collective investment pools that are professionally managed. Many investors contribute to their capital, which can be enormous in some cases. 

Money is invested in a variety of investments and securities, including bonds, stocks, mutual funds, money markets, and commodities like silver and gold. Mutual funds are managed by fund managers.

According to the prospectus of each mutual fund, he is responsible for selling and buying the fund’s holdings. Generally, U.S. regulations require mutual funds registered with the Securities and Exchange Commission to distribute almost all income and net gains made by selling securities to their investors at least once a year.

The majority of mutual funds are furthermore overseen by trustees or boards of directors. Their job is to make certain that the fund is properly managed by its investment adviser for the investors of the fund’s ultimate good.

How Do Mutual Funds Work?

There are really a wide variety of different securities that mutual funds are permitted by the SEC to purchase. This is somewhat limited by the objectives spelled out in the prospectus of the fund, which is comprised of a great amount of useful information on the fund and its goals.

While cash instruments, stocks, and bonds are the more common types of investments that they purchase, mutual funds might also buy exotic types of investments like forwards, swaps, options, and futures. The investment objectives of mutual funds explain clearly the types of investments that the fund will purchase.

As an example, if the fund’s objective stated it was trying to achieve capital appreciation by investing in U.S. company stocks regardless of their market capitalization, then it would be a U.S. company stock fund. Other mutual funds invest in specific sectors or industries.

These include utilities, technology, and financial service funds. These are called sector funds or specialty funds. Also, there are bond funds that invest in different kinds of bonds, such as investment-grade corporate bonds and high-yield junk bonds.

Bonds issued by government agencies, municipalities, and companies can be invested in. They can also be divided up based on whether they purchase long-term or short-term bonds. Funds may also purchase bonds or stocks of domestic companies, foreign companies, or even international companies outside the United States.

Another type of mutual fund is an index fund that attempts to match the performance of a certain market index over time. Index mutual funds are based on indexes such as the S&P 500. A mutual fund with this type of index fund would find derivatives based on the S&P 500 stock index futures in order to match the index’s performance as closely as possible.

The SEC came out with the 40′ Act in order to help investors better understand the type of fund that they are getting into. The rule makes funds actually invest in eighty percent of securities that match up with their name.

So a fund called the New York Tax Free Bond Fund would have to use eighty percent or more of its funds to purchase investments of tax-free bonds that New York State and its various agencies issued.

An investor can earn a return from a mutual fund in three ways:

  • The fund earns income from dividends on stocks and interest on bonds it holds. In general, funds distribute almost all of the income they receive to fund owners each year. Many funds offer investors the option of receiving a check for distributions or reinvesting the earnings.
  • The fund makes a capital gain if it sells securities that have appreciated in value. It usually distributes these gains to investors as well.
  • Fund shares increase in value if fund holdings increase in price but are not sold by the fund manager. After that, you can sell your mutual fund shares in the market for a profit.

Mutual Fund Fees

Mutual fund managers generally charge a yearly fee as compensation for their efforts. Keep an eye on mutual fund sales fees and commissions; they can be a significant drain on your investment returns. Consider some of the ways managers may charge mutual fund fees:

  • Front-end load: The sales fee is paid when shares of the mutual fund are purchased.
  • Back-end load: The sales fee is paid when shares of the mutual fund are sold.
  • Level load: The sales fee is paid once a year, as a fixed percentage of a mutual fund’s average net assets.
  • No load: No sales fee is required when shares of the mutual fund are bought or sold.

Different Types of Mutual Funds

Mutual funds come in many different kinds. These funds are some of the most common:

  • Stock funds: Consist of company-issued common stock.
  • Bond funds: Consist of bonds.
  • Balanced funds: Hold both stocks and bonds, in an attempt to balance the long-term fixed-income aspect of bonds with the potential for price appreciation that stocks offer.
  • Sector funds: Pool securities in specific industries, such as technology, financial, or energy.
  • International/global funds: Invest in companies outside the United States.
  • Index funds: Duplicate the mix of stocks in specific stock indexes, such as the Standard & Poor’s 500 or the Dow Jones Industrial Average. As these indexes increase or decrease in value, so do these mutual funds.

Learn more about different types of mutual funds.

Advantages of Mutual Funds

Liquidity

The process of buying and exiting a mutual fund scheme is relatively easy unless you choose closed-ended funds. When the stock market is high, you can sell your open-ended equity mutual fund units to make a profit. Watch out for the mutual fund’s exit load and expense ratio.

Diversification

There are risks associated with equity mutual funds since their performance is based on market movements. Hence, the fund manager spreads your investment across companies from different industries and sectors, a process known as diversification. When one asset class does not perform well, the other sectors can compensate in order to prevent investors from losing money.

Expert Management

Mutual funds are good for investors who lack the time or skills to do the necessary research and asset allocation. Investing is taken care of by a fund manager who makes investment decisions for you.

Depending on the fund’s investment objectives, the fund manager and the team of researchers will select appropriate securities, such as equity or debt. Furthermore, the fund manager determines how long to hold the securities.

To select a mutual fund, you should consider the reputation and track record of your fund manager. As per SEBI regulations, the expense ratio (which cannot exceed 2.25% annualized of the daily net assets) includes the fund manager’s fee.

Disadvantages of Mutual Funds

Costs of managing the mutual fund

Fund managers and market analysts are paid by investors, along with operational costs. When choosing a mutual fund, you should consider the total management charges. Higher management fees do not necessarily result in better fund performance.

Exit Load

AMCs charge exit loads as fees when you exit mutual funds. This discourages investors from redeeming their investments. Moreover, it aids the fund manager in acquiring the required funds for purchasing the appropriate securities at the right time and at the right price.

Dilution

Diversification can reduce risks of loss, but it can also dilute profits. You should not invest in many mutual funds at once. However, if you make informed choices, you can certainly outweigh the disadvantages of mutual funds.

Examples of Mutual Funds

Personal finance expert Eric Tyson has done extensive research on mutual funds to determine which ones are worth your while and which ones you should avoid like the plague. In his book Investing For Dummies, 4th Edition, (Wiley) Tyson names the following mutual funds as the best ones for your investment dollar.

U.S. stock funds

  • American Century Income & Growth
  • Dodge & Cox Stock
  • Fidelity Disciplined Equity, Equity-Income, and Fidelity Low Priced Stock
  • Masters’ Select Equity, Smaller Companies, and Value
  • Neuberger & Berman Focus
  • T. Rowe Price Spectrum Growth
  • Vanguard Total Stock Market Index, Primecap, Tax-Managed Capital Appreciation, and Tax-Managed Small Capitalization

International stock funds

  • Artisan International
  • Fidelity Diversified International
  • Harbor International
  • Masters’ Select International Equity
  • Oakmark International and Global
  • TIAA-CREF International Equity
  • Tweedy Browne Global Value
  • Vanguard International Growth, Tax-Managed International, and Total International Stock Index

Bond funds

  • Vanguard Short-Term Tax-Exempt
  • Vanguard Limited-Term Tax-Exempt
  • Dodge & Cox Income
  • Harbor Bond
  • USAA GNMA
  • Vanguard GNMA, High Yield Corporate, and Total Bond Market Index 􏰃 Fidelity Spartan Intermediate Term Municipal Income
  • USAA Tax-Exempt Intermediate Term
  • Vanguard Intermediate-Term Tax-Exempt
  • Fidelity Spartan CA Muni Income
  • Vanguard CA Long-Term Tax-Exempt
  • Fidelity Spartan CT Muni Income

Balanced funds

  • Dodge & Cox Balanced
  • Fidelity Asset Manager, Freedom Funds, and Fidelity Puritan
  • TIAA-CREF Managed Allocation
  • T. Rowe Price Balanced
  • Vanguard LifeStrategy Funds, Wellesley Income, and Wellington

How to invest in mutual funds

We’ve put together a step-by-step guide on how to invest in mutual funds if you’re ready.

When investing in a mutual fund, you should keep the following points in mind. In this way, you can choose the right type of funds to invest in, and accumulate wealth over time.

1. Determine why you want to invest

Investing in a mutual fund begins here. A goal for your investment can be to buy a house, pay for your child’s education, plan your wedding, retire, etc. It is important to know how much wealth you hope to accumulate and in how long if you do not have a specific goal. When an investor identifies their investment objective, they can narrow down their options based on risk level, payment method, lock-in period, etc.

2. Meet the requirements for Know Your Customer (KYC)

Investors who want to invest in mutual funds must comply with KYC guidelines. For this, the investor will need to submit copies of Permanent Account Number (PAN) cards, proofs of residence and age, etc. as specified by the fund house.

3. Learn about the available schemes

Markets for mutual funds are flooded with choices. There are funds for almost any need. If you wish to invest, make sure you have done your homework by researching different types of schemes on the market. After you’ve done that, align it with your investment objective, your risk appetite, and your affordability and decide what works for you. If you aren’t sure about which investment scheme to choose, get the advice of a financial advisor. This is your money after all. Make sure you are using it wisely.

4. Consider the risk factors 

Investing in mutual funds is not without its risks. Investment schemes that promise high returns often come with high risks. Equity schemes are a good option if you want high returns and have a high appetite for risk. If, on the other hand, you are willing to accept moderate returns and do not wish to risk your investment, then debt schemes are the way to go.

You can start investing in mutual funds once you’ve outlined your investment objectives, met the KYC requirements and explored the various schemes. Investing in mutual funds requires a bank account as well. A canceled check leaf containing the IFSC (Indian Financial System Code) and MICR (Magnetic Ink Character Recognition) of the bank is most often requested by mutual fund houses.

Ways to Invest in Mutual Funds

You can invest in mutual funds in different ways. These include:

1. Investing directly with the fund house offline

Visit the nearest branch of the fund house to invest in mutual fund schemes. Make sure to bring the documents below with you.

  • Proof of Address
  • Proof of Identity
  • Cancelled Cheque Leaf
  • Passport Size photograph

In order to apply, you must complete an application form and submit it with the necessary documents.

2. Investing through a broker offline

Mutual fund brokers and distributors will walk you through the entire process of investing. You will be provided with all the information you require in order to make your investment, including details about various schemes, documents required, etc. He can also provide guidance regarding which schemes to consider. A fee will be charged for this, which will be deducted from your total investment.

3. Online at the official website

These days, most fund houses let you invest in mutual funds online. Taking advantage of the fund house’s official website requires nothing more than following the instructions, filling out the necessary information, and submitting it. You can also complete the KYC process online (e-KYC) by providing your Aadhar number and PAN. You will be able to start investing once the information has been verified. Most investors prefer investing in mutual funds online since it is easy, convenient, and hassle-free.

4. Via an app

Investors can make investments through a mobile app that can be downloaded from a fund house. Investors can use the app to invest in mutual fund schemes, buy and sell units, access account statements, and check other account details. ICICI Prudential Mutual Fund, Aditya Birla SunLife Mutual Funds, Axis Mutual Fund, and HDFC Mutual Funds are some of the fund houses that allow investments via their mobile apps. Investors can access the details of their investments from multiple fund houses with some apps, like myCAMS and Karvy.

Learn more about the investment strategies for managing a portfolio of mutual funds.

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