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What is a Mutual Fund?

Explains Mutual Fund Concept with People, savings, stocks and bonds

Investors new to the investing arena often wonder what is a mutual fund (MF). In this article, I will explain MFs in some detail.

 

Definition of Mutual Fund

A mutual fund is an investing scheme. Retail investors who do not possess the required knowledge for making direct investments in stocks opt for mutual funds. A large number of retail investors contribute small sums towards the fund. The fund issues mutual fund units to the investors in return. Specialists manage the funds, with an objective of earning returns for the investors in the form of dividends or capital appreciation or both.

 

Types of Mutual Fund

Based on characteristics MFs fall under various categories as follows:

Attribute Type of MFs
Underlying assets Equity or Debt funds
End use of income earned Growth (reinvestment of income) or Regular Income (income is distributed) Fund
Type of Fund Management Actively Managed/ Passive Funds
Liquidity Liquid Funds
Tenure Close Ended (fixed tenure) or Open Ended (indefinite tenure) Funds

 

Equity versus Debt funds

Depending on what type of assets into which the fund money is invested, mutual funds are classified into three types:

  • An Equity fund Invests its 100% money in the equity shares of companies.
  • A debt fund deploys all the money in debt instruments like government bonds, treasury bills, corporate bonds, etc.
  • The Hybrid fund is one which allocates funds partly in shares and partly in debt instruments.

 

Equity, Debt and Hybrid Mutual Funds

 

 

Growth versus Regular Income Funds:

In a growth fund, the incomes earned, for example, dividend received from the underlying assets, are reinvested. Growth funds are usually equity based.

On the contrary, in a regular income fund, the income earned by the fund by way interest, dividend, etc., is distributed to the unitholders.

 

Growth and Regular Income Mutual Fund

 

 

Active vs Passive Funds

Mutual fund managers constantly churn portfolios with an intention to beat the performance of certain benchmarked indices like the S&P 500, S&P BSE Sensex, etc. Such funds actively manage the investments. The companies operating active funds charge a high fund management fee, usually 3 to 4% of the funds managed as a justification for actively managing the funds. However, this high fee is detrimental to the investors.

 

Actively managed versus passive mutual fund

On the other hand, a few funds passively track or reflect a popular index like S&P 500 and BSE Sensex. In this case, the fund manager simply makes a one-time investment and sits quietly. She will make changes to the portfolio only when there is a change in the composition of the index. Since the fund does not actively manage the investments, the management fee is low (usually below 0.50%). Therefore passive funds benefit the investors.

Advocates of active funds say that the high fee is justified as they deliver superior results. However, there is no empirical evidence to prove this claim. Whatever evidence exists suggests that over a very long period both passive and active funds deliver similar results.

 

What are Liquid Funds

Liquid funds suit corporations which often hold huge funds for temporary periods. They would like to invest these funds and earn some returns in this short period of time. Liquid funds offer limited returns and negligible growth (capital appreciation). So we can see that liquid funds do not suit the common investor who has to build wealth.

 

Liquid Mutual Fund is one funds are invested in short-term financial instruments

 

 

Exchange Traded Fund is a Special MF

Exchange traded fund (ETF) is a unique type of a mutual fund. I doubt if I can discuss an ETF side by side a mutual fund. But I also think that if I discuss an MF without touching upon an ETF I will not do justice. So I talk here about ETFs.

 

ETF, a special mutual fund shown as a tag

 

The fund lists its units of an ETF on the stock exchanges. Here ETFs trade shoulder-to-shoulder with stocks. Thus an ETF provides following unique features/ advantages compared to a regular mutual fund:

  1. ETFs offer Convenience: Unlike mutual funds, in the case of ETF no paperwork is involved. You can simply buy and sell them on any online stock trading platform.
  2. ETFs do not require special redemption: If you want to liquidate your investment with a regular mutual fund you have to submit an application to the mutual fund for redemption. It may require that you visit the fund office or their representative will visit you. This usually takes some time. Compare this with ETFs where you simply sell on the online trading platform and receive the proceeds into your account within three working days.
  3. Exchange Traded Funds are passive: ETFs mostly track popular indices like the S&P BSE 500 and S&P BSE Sensex, NIFTY 50, NIFTY 100 and so on. Therefore ETFs are passive. Hence, the fund management fees of an ETF is low.

 

To Conclude

To conclude, a mutual fund is a collective fund. Here a large number of small investors contribute tiny sums of money to the fund house. Experts who know how to invest manage the funds. There are many types of mutual funds based on the type of assets managed, whether income is accumulated or distributed, whether actively or passively managed, and so on.

 

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