What Is A Mutual Fund?

A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. And the income / gains generated from this collective investment is distributed proportionately amongst the investors after deducting applicable expenses.

In other words, the money pooled in by a large number of investors is what makes up a Mutual Fund.

Example:

Here’s a simple way to understand the concept of a Mutual Fund Unit.


Let’s say that there is a box of 10 chocolates costing ₹50. Five friends decide to buy the same, but they have only ₹10 each and the shopkeeper only sells by the box. So the friends then decide to pool in ₹10 each and buy the box of 10 chocolates. Now based on their contribution, they each receive 2 chocolates or 2 units, if equated with Mutual Funds.

And how do you calculate the cost of one unit? Simply divide the total amount with the total no. of chocolates:50/10 = 5

So if you were to multiply the number of units (2) with the cost per unit (5), you get the initial investment of ₹10

This results in each friend being a unit holder in the box of chocolates that is collectively owned by all of them, with each person being a part-owner of the box.

Next, let us understand what is NAV or “Net Asset Value”. Just like an equity share has a traded price, a mutual fund unit has Net Asset Value (NAV) per Unit. The NAV is the combined market value of the shares, bonds and securities held by a fund on any particular day (as reduced by permitted expenses and charges). NAV per Unit represents the market value of all the Units in a mutual fund scheme on a given day, net of all expenses and liabilities plus income accrued, divided by the outstanding number of Units in the scheme.

Why do people buy mutual funds?

Mutual funds are a popular choice among investors because they generally offer the following features:

Professional Management: The fund managers do the research for you. They select the securities and monitor the performance.
Diversification: or “Don’t put all your eggs in one basket.” Mutual funds typically invest in a range of companies and industries. This helps to lower your risk if one company fails.
Affordability: Most mutual funds set a relatively less amount for initial investment and subsequent purchases.
Liquidity: Mutual fund investors can easily redeem their shares at any time, for the current net asset value (NAV) plus any redemption fees.

Type Of Mutual Fund Schemes

Mutual Fund schemes could be ‘open ended’ or close-ended’ and actively managed or passively managed.

Open-Ended and Closed-End Funds

An open-end fund is a mutual fund scheme that is available for subscription and redemption on every business day throughout the year, (similar to a savings bank account, wherein one may deposit and withdraw money every day). An open ended scheme is perpetual and does not have any maturity date.

A closed-end fund is open for subscription only during the initial offer period and has a specified tenure and fixed maturity date (similar to a fixed-term deposit). Units of Closed-end funds can be redeemed only on maturity (i.e., pre-mature redemption is not permitted).

Actively and Passively Managed Funds

An actively managed fund is a mutual fund scheme in which the fund manager “actively” manages the portfolio and continuously monitors the fund’s portfolio, deciding on which stocks to buy/sell/hold and when, using his professional judgment, backed by analytical research. In an active fund, the fund manager’s aim is to generate maximum returns and out-perform the scheme’s benchmark.

A passively managed fund, by contrast, simply follows a market index, i.e., in a passive fund, the fund manager remains inactive or passive inasmuch as, she does not use her judgment or discretion to decide as to which stocks to buy/sell/hold, but simply replicates/tracks the scheme’s benchmark index in exactly the same proportion. Examples of Index funds are an Index Fund and all Exchange Traded Funds. In a passive fund, the fund manager’s task is to simply replicate the scheme’s benchmark index i.e., generate the same returns as the index, and not to out-perform the scheme’s benchmark.

Common Categories Of Mutual Funds

  • Equity funds – funds that invest only in stocks and other equity instruments.
  • Debt funds – funds that invest only in fixed income instruments.
  • Money market funds – funds that invest in short-term money market instruments.
  • Hybrid funds – funds that divide investments between equity and debt to create a balance.