What are mutual funds, and how they make money?

Mutual funds are an investment scheme managed by professionals/Assets Management Company that invests the people’s money in shares of different companies, bonds, and other investment opportunities. The fund manager is expected to strongly understand the stock and related fluctuations of the underlying assets.

The most significant advantage of mutual funds is that even small investors can access the professionally managed pool of the investment by paying a minimal fee.

The investors of the mutual funds buy units in the scheme. The value of the units keeps fluctuating with an increase/decrease in the total worth of the funds, and the value of the individual fund is termed as NAV – Net Asset Value. If the NAV increases, it represents an increase in the worth of the overall investment portfolio and vice versa. It’s important to note that the investors have the option to redeem the units at their desire.

Features of the mutual funds

The mutual funds are different from the ordinary shares of the company and do not bring voting Rights.

The performance of the mutual funds depends on the underlying portfolio of investment. Suppose the underlying portfolio performs well the NAV increases. On the contrary, if the underlying investment performs adverse, the NAV decreases.

An average mutual fund has hundreds of underlying securities, which means it is well diversified.

The mutual fund may be open-end or close end. An open-end fund is when the investor has the discretion to invest/withdraw the money at their discretion. There is no time restriction on the investor to tie the money in the funds. On the other hand, in closed-end funds, there is limited time for investment in the funds. The scheme is announced, and the time is fixed for the subscription of the units. There may be a penalty if the investor withdraws funds earlier than the fixed period. So, there is a need to exercise due care before investing in mutual funds for fixed time.

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The performance of the mutual funds is measured by changes in the size of the fund’s capital. If the size of a fund has increased, there is again which can be allocated to the investors in increased NAV. On the other hand, if the fund’s market capital decreases, the loss is divided into the number of unitholders. Hence, the performance of the funds determines the worth of the NAV.

How do mutual funds earn?

The mutual funds charge the investor the annual maintenance fee for managing the investment on their behalf. Usually, the fee depends on the size of the investment as it might range from 1-3% of the total fund’s size.

Similarly, the fund charges a fee at the time of purchase and redemption of the units. This fee is charged under the heads of the commission expenses and sales charges etc. These charges are termed as ”the load” of the mutual fund. With front end load, the commission expenses and the sales charges are assessed at the time of the unit purchase. On the other hand, in the case of the back-end load, the fee is charged at the time of sale of the units.

However, some of the mutual funds are free from the load and do not charge the investor commission for the purchase and redemption of the units. On the other hand. some of the mutual funds impose a penalty on the investors for early redemption of the units. So, the pricing and earnings of the mutual fund depend on the agreed terms between the investor and the fund.

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Although, the mutual funds have to incur considerable expenses that include cost for the infrastructure, the cost for the regulatory compliance, selling cost, and the cost of transactions etc. These all of the expenses are deducted from the revenue earned by the funds in the form of management fee and commission income.

Advantages of investment in the mutual funds

1- A qualified and professional fund manager manages the funds of the investors.

2- The extent of the diversification can be is expected to be much larger than the investment size of the individual investor.

3- The units of the mutual funds are liquid and can be redeemed daily. It means investment can be made in mutual funds by the investors that want to invest funds even for a short period.

4- Investors with limited funds can avail the opportunity that requires a higher amount of investment. For instance, mutual funds have higher investment capacity and can invest in the foreign market.

5- Government authority regulates the mutual funds. Hence, there is an element of safety for the investors.

6- Consistent reporting mechanism enables the investors to compare the performance of the individual mutual funds.

7- Mutual funds have a variety of offerings. In other words, they can offer different investment plans to match the requirement of the investor.

Disadvantages of investment in the mutual funds

Following are some of the disadvantages of investing in mutual funds.

1- The investor has to pay a fee for the management of the fund. Some of the mutual funds may charge a higher fee from the investors.

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2- The investor does not have the ability to customize the investment plan. They have to decide if they want to purchase the units or no.

3- The investors can not predict the income from mutual funds as they are not expected to have the same level of information as in a self-managed investment portfolio.

4- The investors do not have control over the decision-making process. For instance, the investors do not decide if certain shares should be purchased or no. In other words, the control does not remain in the hands of the investors but the hands of the fund’s manager.

5- If an investor is significant in size, they can diversify the investments themselves. So, there remain no use of mutual funds.

6- There is no FDIC coverage for the mutual funds.

7- There may be a lack of transparency in the holdings.