What are mutual funds?

A mutual fund is a type of investment vehicle that pools money from many investors and uses that money to buy a diversified portfolio. The portfolio may contain stocks, bonds or other security types. 

Each investor who puts money in the mutual fund owns shares, representing a portion of the fund’s holdings. How do investors earn profit? The value of an individual’s shares increases or decreases based on the performance of the underlying securities. 

Mutual funds are managed by professional fund managers who make decisions about what securities to buy or sell.  Hence it is considered as a simple and easy way for individuals to invest in a diversified portfolio without having to do extensive research and analysis on their own.

How do mutual funds work?

When you invest in a mutual fund, you essentially buy a small chunk of the total fund. Post-buying, a fund manager takes a call about your investment. But to understand things better, let’s get into the manager’s role. 

The mutual fund manager makes decisions about what securities to buy or sell. They also partake in other decisions like determining the appropriate asset allocation and monitoring the performance of the fund’s portfolio.

The manager is also responsible for managing risk. Ultimately, the goal is to generate returns for you and other shareholders of the fund. If you want to estimate mutual fund returns, you can use an online mutual fund calculator.

How to invest in mutual funds? By contacting the fund company directly or through a financial advisor, broker, or online brokerage. The investor can also redeem or sell their shares in the fund at any time, subject to the fund’s policies and procedures.

What are the types of mutual funds?

• Money market funds: These funds invest primarily in short-term debt securities like treasury bills and commercial paper. The goal is to preserve the capital invested while generating a consistent income.

• Bond funds: These funds invest primarily in bonds, a form of debt securities issued by a company or the government. Again, these funds can be divided into subcategories like government, corporate, and high-yield, based on the issuing party, the extent of risk involved, etc. 

• Equity funds: These funds invest primarily in stocks and can be further divided into subcategories like large-cap, mid-cap, and small-cap funds. 
• Balanced funds: These funds invest in a combination of stocks, bonds, and cash. The goal here is to provide the investors with a balance of growth and income. 

• Index funds: These funds are designed to track the performance of a specific index, such as the BSE SENSEX of NIFTY50. 

Mutual fund terms to know

While investing in a mutual fund, you might come across some standard terms. Knowing these terms will help you understand more about the fund. Some common terms include – 

• Net Asset Value (NAV): The value of a mutual fund’s assets, excluding its liabilities and divided by the number of shares outstanding. 

• Expense ratio: All shareholders pay the annual fee to cover the fund’s operating expenses. It is denoted as a percentage of the fund’s total assets and is regularly deducted from its returns. 

• Load: In addition to the expense ratio, investors must pay sales charges while purchasing or redeeming mutual funds.

• Asset allocation: The dividing of an investment portfolio among different asset categories, such as stocks, bonds, and cash.

How to choose the best mutual fund?

Here are some essential factors to consider when choosing the right mutual fund to avoid hasty decisions-

(Instead of pigs, we can add something else. Maybe just the term ‘mutual fund’ on each branch of the tree)

• Investment objective: Assess the mutual fund’s return-generating strategy to ensure it matches your own financial objectives

• Risk and return: Consider the fund’s historical risk and return. This data will help determine whether the risk succumbs to the returns or vice versa. 

• Expense ratio: Look at the fund’s expense ratio and compare it to similar funds. The lower the expense ratio, the more the fund’s returns will be available to the investors. Some standard benchmarks for expense ratios are 0.25% to 1% for index funds and 1.5% to 2% for actively managed funds.

• Liquidity:  Make sure the fund permits simple redemption, either totally or partially, within your desired timeframe. 

How to allocate funds in mutual funds?

Finding the perfect mutual fund allocation varies by individual needs, yet diversification across fund types is a solid strategy to balance risk and potential returns. 

A common strategy is the 60-40 mix of stock (higher risk, higher returns) and bond funds (lower risk, lower returns), adjustable based on one’s risk tolerance. 

However, no strategy guarantees success. As the saying goes, mutual funds investment are subject to market risk. Their values can quickly fluctuate according to the underlying market and economic conditions. 

Key takeaways

What is a mutual fund? A mutual fund pools investors’ money to buy diverse portfolios, targeting goals like income or growth. Depending on investing objectives and risk tolerance, diversification among a number of mutual funds can help distribute risk and possibly increase returns over time.

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