How do mutual funds work?
Most of us have a large chunk of our savings as deposits in a bank. Besides bank savings accounts, we usually invest in jewelry and real estate (home), the latter being the biggest investment that one makes during his/her lifetime. Most people do not get involved in other kinds of investments as they do not have knowledge about it or they do not have the time to choose the right kind of investments.
This is where mutual funds come in as one of the best and really popular options of investment for all.
What are Mutual Funds?
Mutual funds can be defined as money pooled in by many investors who want to save or make profit off their savings. It is a lot simpler to invest in mutual funds than engaging in the purchase or sale of bonds or stocks. Also, mutual fund investors have the freedom to sell off their mutual fund shares as and when they want.
The varied investments of every mutual fund are carefully picked and monitored by a team of qualified financial professionals. They use the pool of money gathered for a mutual fund and make a portfolio; such a portfolio can consist of bonds, stocks, money market instruments or a mix of all or some of such securities.
People who invest in a mutual fund are owners of the shares of that specific fund and not of the different securities that make the fund’s portfolio. People can invest as much money as they want in a mutual fund; it can even be small amounts of savings. The benefit is that you are able to invest in securities (via mutual funds consisting of large sums of money invested by numerous other individuals) that are not within your reach as a small time investor. The losses and gains of a mutual fund are shared equally by all the shareholders in proportion to the total money they invested in the fund.
It may also be noted that investment in mutual funds comes with the advantage of diversification of portfolio across many different kinds of securities, thereby lowering the risks. A mutual fund spreads its money across several securities; this minimizes the risk of fluctuation of prices of individual securities that make up the portfolio of a mutual fund.
Types of mutual funds, based on objectives
There are different kinds of mutual funds and each has its own set of objectives or goals. This goal or target is defined by the fund manager and accordingly the bonds and stocks that make up the portfolio of the mutual fund will be decided. For example, if the goal of a mutual fund is to provide capital appreciation in the long term, then it will mainly invest in equity markets. An investor who wants long-term financial gains and savings for activities like education of child or retirement can go for such mutual funds.
Mutual funds can be categorized into 3 main types as per the objectives of fund investment. They are:
- Equity mutual fund: This type of mutual fund buys into stocks which have potential to grow rapidly and quickly gain value. It however comes with high risk element as stocks that gain value rapidly may also quickly crash and lose value during economical downturns. Investors who wish to invest for long term and will not need the money over the next 5 or more years can opt for Equity Mutual Fund. It is not a good option for those who want to preserve capital, but a good one for those who are ok with the risk of losing the investment value in the short-term period. On a long-term basis, however, these funds give superior returns.
- Debt mutual fund: The goal of this fund is capital preservation and hence ideal for cautious investors. This fund does not generate significant gains but may offer interest rates that are higher than bank deposit rates. Debt mutual funds are low risk but the initial buying power of the investment can be adversely affected by inflation. Investors can however easily change their investment plan during inflationary periods as this fund is highly liquid.
- Hybrid mutual funds: Made of a mix of Debt and Equity funds, this fund has a combination of desired objectives. Investors who want current income as well as some chance of growth can go for this fund. Bonds and stocks that make the portfolio will provide income while remaining unaffected by inflation. Hybrid mutual funds come with moderate growth potential and low to moderate level of stability. Investors need to be comfortable with some risk when going for growth and income mutual funds.
Open-end and Closed-end mutual funds
- Subscription for open end funds is available all year round. It is not list and most mutual funds are this type of fund. Investors can sell or buy any portion of investment whenever they want and at a price related to the Net Asset Value of the fund.
- Closed-end funds consist of a number of outstanding units and operate for a set period of time (from 3 months to 5 years). Its subscription is open for a specific duration. These funds are listed and can be traded like stocks. Redemption of closed-end funds are known, i.e., they end on determined dates during which time the units can be redeemed by investors.