Mutual Funds - Guide to Types of Mutual Funds and How They Work (2024)

What Are Mutual Funds?

A mutual fund is a financial instrument that pools assets in the form of money from multiple shareholders and invests in different financial instruments, such as stocks, bonds, and real estate, on behalf of the shareholders.

These investment funds are operated and managed by professional fund managers specializing in portfolio management. These fund managers allocate the client's funds in a way that generates income and maximizes the return for shareholders.

The money invested by the fund managers is based on the investment strategy adopted by the client. Mutual funds can adopt various investment strategies, including aggressive, balanced, growth, and conservative, often in combination.

These funds allow small individual investors to invest in the financial markets without applying technical knowledge, as the clients essentially deposit their money with a fund that a professional fund manager operates.

The shareholders of this fund experience gains or losses based on the proportion of their investment in the fund. The overall performance of a mutual fund is evaluated based on its net asset value (NAV), which represents the fund's per-share market value.

Mutual funds allocate investments across different asset classes based on the adopted investment strategy, leading to varying weightage in the portfolio. However, a mix of asset classes in the portfolio helps the investor reap diversification's benefits.

Vanguard, Fidelity Investments, JP Morgan Chase, and Goldman Sachs are renowned companies known for offering mutual funds whose shares are traded among investors in the market.

Mutual funds differentiate themselves based on various factors, including investment objectives, strategies, historical performance, and returns and costs.

How Are Mutual Funds Priced?

When investing in mutual funds, an individual puts their money into a basket of diverse securities. Unlike individual stocks, mutual fund shares don't come with shareholder voting rights. Instead, they represent investments across various stocks and securities.

The mutual fund's value hinges on how well the securities in its portfolio perform. This means that when you purchase mutual fund shares, you're investing in the overall performance of the fund's holdings.

Mutual fund shares are priced at the Net Asset Value (NAV) per share, a figure determined by dividing the total worth of the securities in the fund by the total number of outstanding shares.

The NAV of a mutual fund fluctuates during market hours based on the values of its underlying securities and is calculated and settled at the end of each trading day after the market closes.

One significant advantage of mutual funds is the diversification they offer. For instance, if an investor only bets on a single company like Tesla, their fortunes are tied solely to its successes or failures.

However, mutual funds typically spread their investments across multiple companies. Therefore, gains in some stocks can offset losses in others, providing a balanced and less risky investment approach.

Types of Mutual Funds

There are several different categories of managed funds being traded on the market. The different types can be explained as follows:

1. Money Market Funds

These funds invest in low-risk, short-term debt instruments like Treasury bills and commercial paper. They are relatively low-risk and offer stable returns.

2. Bond Funds

Bond funds invest in various fixed-income securities, including government, corporate, and municipal bonds. They provide regular interest income and are generally considered safer than stock funds.

3. Stock Funds

Stock funds, also known as equity funds, invest primarily in stocks. There are different types within this category:

• Index Funds: These funds aim to replicate a specific market index (like the S&P 500) and provide exposure to the securities included in that index.
• Sector Funds: Sector funds focus on specific sectors of the economy (e.g., technology, healthcare) and invest in companies within that sector.
• Growth Funds: These funds invest in companies with high growth potential, often reinvesting profits for future expansion.
• Value Funds: Value funds target undervalued stocks, looking for companies with strong fundamentals but lower market prices.
• Income Funds: Income funds invest in dividend-paying stocks, providing a steady income stream for investors.

4. Hybrid or Balanced Funds

These funds invest in a mix of stocks, bonds, and sometimes other assets like real estate. They offer diversification and are suitable for investors seeking a balanced approach between risk and return.

5. Target-Date Funds

Also known as lifecycle funds, these funds automatically adjust their asset allocation based on the investor's target retirement date. They start with a higher allocation to stocks for younger investors and gradually shift to more conservative investments as the investor approaches retirement age.

6. Specialty Funds

These funds focus on specific assets or strategies, such as commodities, real estate, socially responsible investments (SRI), or emerging markets. They cater to investors with specific interests or preferences.

Investment Strategies for Mutual Funds

A managed investment scheme is a very useful financial instrument for individual investors and investors who need to learn more about financial markets.

The different types of investing strategies adopted by these investment funds are explained below:

Aggressive and High Growth Strategy

The main objective of adopting a high-growth aggressive strategy is to generate wealth and high returns for the investor in the long term.

Since there is a higher emphasis on wealth creation and returns, most funds (usually at least 65%) are invested in equities.

The remaining funds are invested in a mixture of debt instruments and other asset classes, which can include securities related to real estate investment trusts (REITs) but not direct real estate properties.

Income-Based Strategy

The primary objective of an income-based approach is to generate a steady return for investors who demand frequent payments in the form of dividends or interest payments in the medium to long term.

As a result, a heavy weightage is given to fixed-income instruments like corporate bonds and treasury bills, which results in a low-risk and low-return portfolio.

Due to the low risk arising from such financial instruments, the investors can guarantee a fixed periodic payment in interest. However, the potential for wealth creation and growth is restricted in such investment funds.

Balanced Investment Plans

These funds follow a balanced outlook and invest in both equities and debt instruments in varied proportions. The main goal of the scheme is to generate steady returns, periodic income, and low risk.

Fund managers, in this case, invest around 60% of their assets in equity, 30% in debt instruments, and 10% in other financial instruments within the allowable regulatory framework.

Since these investment options cover different classes of assets, the benefit of diversification helps reduce the overall risk. It suits investors who want a stable return rate at a lower risk level.

Liquid Funds

As the name suggests, liquid funds aim to maintain a certain level of liquidity for the shareholders, which can be met easily whenever the need arises, and ensure capital protection and income stability, mostly in the short-run.

Liquid funds primarily invest in highly liquid and safe short-term instruments, such as Treasury Bills, certificates of deposit, and commercial paper, to maintain liquidity for shareholders while ensuring capital protection and income stability in the short run.

These investment options are most suitable for investors who aim to park their excess money in the market for the short term to earn a stable return.

Pros of Mutual Fund Investing

The advantages of investing money in these funds are explained below.

Benefits of Diversification

The main purpose of investing in these funds is that it allows individual investors to access a variety of securities they might not know.

Diversification involves spreading investments across different sectors, industries, and geographic locations to reduce overall portfolio risk. Mutual funds achieve diversification by investing in a variety of securities within the fund.

A well-diversified portfolio with a mix of assets from different industries, risk categories, and geographical locations helps the investor attain maximum return at the lowest possible risk.

Investors who do not have much technical information about the market can thus use these investment options to avail themselves of the benefits of diversification. This process is also faster and cheaper than buying individual securities.

Access to a wide variety of securities

These funds are highly liquid assets, which implies that they can easily be bought or sold in the secondary market, i.e., the stock exchange.

While accessible, international equity shares and derivatives may require a deeper understanding of the market and involve higher risk, making them less straightforward for some individual investors.

As a result, mutual funds provide an equal opportunity to all investors and make it easy for them to invest in these securities, which they would not have been able to do individually.

Achieving Economies of Scale

These funds also help investors reap the benefits of economies of scale. For example, it eliminates several commission fees the investor will be expected to pay if they purchase securities individually.

Moreover, transactions involving the purchase/sale of individual securities bear higher transaction costs. However, the smaller denominations of these mutual funds enable the investor to benefit from the dollar cost averaging.

Since these funds deal in large volumes of transactions, the per unit cost of the transactions is lower than what an individual would pay if invested separately.

Freedom to choose any fund

Since hundreds of managed fund investments are being traded on the market, and an even larger number of fund managers, investors have a wide variety of options to choose from.

Fund managers employ diverse strategies aligned with the fund's objectives, including high growth or conservative approaches based on the fund's investment mandate, not personal preferences.

These options not only familiarize the investors with the concept of stocks and bonds but also enable them to know more about the alternative asset classes. Investors can research and choose whichever fund they think is suitable.

Cons of Mutual Fund Investing

The disadvantages of investing through managed fund investments are explained below:

High Costs involved

Since professional fund managers manage these investment options, the overall payout received from the returns generated by securities is offset by the large number of costs involved.

The fee structure varies from fund to fund, and investors should be aware of the costs associated with the fund they invest in. This can cause problems in the long term as fees related to the fund keep on accumulating over the years.

No Guaranteed Return

Like all other securities being traded on the market, these funds also do not guarantee a return to the investors. This implies that the fund can always depreciate over time.

For example, stocks, being inherently volatile assets, can lead to fluctuations in the value of equity funds. The volatility is primarily due to the nature of stocks.

Higher Cash Involvement

According to investment laws, mutual funds are expected to hold a certain portion of their assets in cash to satisfy daily share redemption.

Mutual funds maintain a portion of their assets in cash to facilitate frequent withdrawals and meet regulatory requirements, which may differ from the cash holdings of individual investors.

Since cash does not generate any return, this phenomenon is known ascash drag.

Evaluation of Funds

For investors who do not know much about the financial markets, researching and comparing different funds can be an arduous task.

While mutual funds do provide information about their holdings, including the list of securities, the level of detail might not be as extensive as individual stocks. Investors can usually find information about the sectors and top holdings of the mutual fund.

These investment options provide the net asset value, which can be used for comparisons but do not take every aspect that might be needed by the investors, considering the diversity of the portfolios.

Exchange Traded Funds (ETFs) Vs Mutual Funds

Exchange Traded Funds (ETFs) and Mutual Funds are both popular investment options, each with its unique features and advantages. ETFs are investment funds that are traded on stock exchanges, much like individual stocks.

They offer investors the flexibility of trading throughout the day at market prices, allowing for real-time buying and selling. ETFs often track specific indexes, sectors, commodities, or assets, providing a way for investors to gain exposure to a diversified portfolio.

To understand the difference between the two, let's look at the table below:

Example of a Mutual Fund

One of the most renowned mutual funds is the American Funds Growth Fund of America (AGTHX). Established in 1973, this fund is managed by Capital Group, one of the oldest and largest investment management organizations.

Over the years, the Growth Fund of America has gained a reputation for its consistent performance and long-term growth strategy.

Under the management of investment stalwart Stephen Bepler in the 1980s and 1990s, the fund experienced significant growth. Its assets under management (AUM) soared, and it became one of the largest and most successful mutual funds in the United States.

Bepler's expertise and the fund's diversified approach contributed to its stellar performance, making it a preferred choice for many investors.

Despite market challenges, the Growth Fund of America maintained its strong position and demonstrated resilience during economic downturns.

As of the latest available data, the fund boasts an impressive AUM of over $180 billion, making it one of the world's largest actively managed equity funds.

Managed by a team of experienced portfolio managers, the Growth Fund of America continues to be a favorite among investors seeking growth opportunities in the equity market.

Its performance has consistently outpaced or closely mirrored major market indices, cementing its status as a notable player in the mutual fund industry.

Pricing and Returns Generated by Mutual Funds

The market value of mutual funds solely depends on the performance of the securities held within the fund. Therefore, the price of a mutual fund is known as the net asset value and is often written as NAV.

The value of NAV is derived by dividing the total number of assets held within the fund by the total amount of outstanding shares, which are the total number of shares held by institutional investors, corporations, and insiders.

However, ownership in these funds does not give investors voting rights as investing in equity shares does.

There are three possible ways to earn a return from mutual funds. They are listed as follows:

1. The first source of income for investors is the dividend received from shares and interest received on bonds. These funds often allow the investors to receive a cheque or reinvest all distribution earnings into the fund.
2. The second source of income for investors is capital gain, which results from an increase in the underlying price of the security.
3. An increase in the overall price of the fund can also be a source of income for the investors as those funds can then be sold in the market at a profit.

Researched and authored by Mehul Taparia | LinkedIn

Free Resources

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• Asset Management Company (AMC)
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• Open-end Mutual Funds