Mutual Funds (Part 1) || Investments 101
- finminati
- Sep 13, 2020
- 4 min read
Updated: Jun 12
When thinking about investing, you would have likely stumbled upon the term 'Mutual Funds', and may have wondered what they are? Are they more beneficial than other investment options? If yes, then how can I invest in them and so on. I’ll try to answer all these questions for you and clear away all your doubts. This would be the 1st blog in this this series, where I’ll try to cover everything mutual funds.
In this blog, I will be talking about the following points about Mutual Funds:
WHAT ARE MUTUAL FUNDS?
You probably would have heard the saying “Don’t put all your eggs in one basket”, and that is basically what a Mutual Fund is. A mutual fund (MF) is a financial asset which pools the savings of several small investors and invests it in different financial instruments such as equity (shares) and bonds.
You can think of a Mutual Fund as a company with different assets being the different departments, all contributing to the final overall net profit of the company (here that is the market value of the mutual fund). Hence the value of a mutual fund depends on the performance of its holdings.
Mutual funds are maintained by an Asset Management Company (AMC), which basically consists of professional fund managers who use their expertise to
manage the fund on a day-to-day basis
hand-select the best instruments to invest the pooled money
decide the proportion of amount to be invested in different securities
decide when to buy and sell the securities
This investment is made based on the investment objective of the fund. For example, a Blue-Chip fund would invest in big, well-established and financially sound companies as oppossed to a NIFTY 50 index fund, which would invest the pooled funds in such a way that it replicates the composition of the NIFTY 50 Index.
A mutual fund is a financial asset which pools the savings of several small investors and invests it in different financial instruments such as shares & bonds.
Some key points:
The combined holdings of a mutual fund is known as ‘portfolio’.
The market value of the portfolio is known as the Net Asset Value (NAV).
Price of a unit of mutual fund is called the net asset value per share.
Mutual funds are different from stocks, mutual fund owners do not get voting rights.
Each investor is a part-owner of the mutual fund i.e. they share the profits and losses in the proportion of the invested funds.
Mutual fund investors do not own the holdings - stocks or bonds - that have been purchased by the fund / AMC, they own a part of the portfolio and NOT the actual component assets. It is the AMC that owns the shares, debentures, bonds etc.
FEATURES
Diversification
Professional Management
Affordability
Liquidity
(These features would be explained in detail in the next blog post)
HOW DO MUTUAL FUNDS WORK?
Many small investors invest their savings by investing in a mutual fund.
The mutual fund invests the pooled money into several financial instruments such as shares, bonds, debentures and money market instruments, based on the investment objective of the fund.
Whenever the AMC sells the assets at a higher price, or when the mutual fund receives interest on debentures or dividend from shares, the value of the portfolio increases.
Now, this increase in the value of portfolio translates into returns for the investors, which they can earn by selling off their investment (less the expenses).
HOW DO MUTUAL FUND INVESTORS MAKE MONEY?
Dividend & Interest Payments: A mutual fund may earn dividend from the stocks it has invested in and / or interest from bonds. This amount is either reinvested in the fund (a.k.a. growth or dividend reinvestment) or is paid to the investors (a.k.a. dividend payout).
Capital Gains Distribution: When the fund sell a security it had invested in at an increased price, the fund has a capital gain. Again, this amount may be reinvested into the fund i.e. used for further investment in other securities by the fund, or the capital gains (less capital losses) can be paid to the investors at the year end.
Increased NAV: Increase in the market value of the assets owned by the fund leads to an increase in the value of the fund (NAV). Higher the NAV, higher is the value of your investment.
That's it for this blog! Hope this would have helped you understand the basic concept of mutual funds. In the coming blog, I would further elaborate on the advantages and disadvantages of Mutual Funds. Stay Tuned!
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