What are Mutual Funds?
A mutual fund is an investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. Managed by professional portfolio managers, mutual funds provide individual investors access to a broader range of investments than they could achieve on their own.
To explain it better, take an example: Let’s say John is a really successful investor. It seems anything he puts his money in always does well. Seeing John’s success, all his friends are asking John to teach them and give them tips. Now John is tired of answering each and every question again and again. So he decides to start a “mutual fund”. He asks ten of his friends to give him $100 each and he will invest it in them. Now he has $1000 dollars and he invests it in a diversified portfolio of stocks, bonds, and other securities that appear to be profitable. In one year he has grown the money from $1000 to $1100. Now the value of each of the units has grown from $100 to $110. Now if anyone has to buy some units they have to buy from John’s friends. This is mutual funds.
Now the “$100 to $110” is called NAV or Net Asset Value. NAV = (Total Assets – Total Liabilities) / Total Outstanding Shares. So in John’s case, his NAV is ($1100 – $0/10) = $110.
The net average value is used to determine the current market value of an investment fund’s net assets. This may differ from its current share price.
Actively Managed And Passively Managed Funds.
Active management refers to a mutual fund scheme in which the fund manager actively manages the portfolio and continuously monitors it, deciding on which stocks to buy/sell/hold and when, using his/her professional judgment backed by analysis. An active fund manager seeks to outperform the scheme’s benchmark and generate maximum returns.
A passively managed fund, by contrast, simply follows a market index, i.e., the fund manager remains inactive or passive inasmuch as he/she does not use his/her judgement or discretion to decide which stocks to buy/sell/hold, but rather replicates / tracks the scheme’s benchmark index exactly as it does. An Index Fund and all Exchange Traded Funds are examples of Index funds. The goal of a passive fund manager is to simply replicate the scheme’s benchmark index, i.e., generate the same returns as the index, rather than outperform it.
Now what are its advantages and disadvantages?
Advantages of Mutual Funds
- Diversification: Mutual funds invest in a variety of assets, reducing the risk associated with any single investment.
- Professional Management: Experienced portfolio managers make investment decisions, which can benefit investors who lack the time or expertise.
- Accessibility: Mutual funds allow investors to invest in relatively small amounts of money.
- Variety: There are numerous mutual funds available, catering to different investment goals, risk tolerances, and sectors.
Disadvantages of Mutual Funds
- Fees and Expenses: Mutual funds charge management fees and other expenses, which can reduce overall returns.
- Lack of Control: Investors do not have direct control over the individual securities within the fund.
- Performance Variability: Not all mutual funds perform well; some underperform the market or their benchmarks.
- Conflict of interest: The interests of fund managers might not always align with those of the investors. Managers might take on excessive risk to achieve higher returns and bonuses or to attract more investors, sometimes compromising long-term stability.
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