A mutual fund is a type of investment vehicle that pools money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other securities. The fund is managed by a professional fund manager or a team of managers who make investment decisions on behalf of the investors.
When you put your money into a mutual fund, you are basically buying a piece of it, and the value of your piece goes up or down based on how well the investments in the fund are doing.
A cool thing about mutual funds is that they don’t put all their eggs in one basket. Instead of investing in just one type of thing like stocks or bonds, they spread their money across many different things. By doing this, they lower the risk that comes with investing in just one thing. So, if one investment doesn’t do well, it doesn’t hurt the whole fund.
Understanding of Mutual Fund
We can categorized mutual fund in two categories: Open-End mutual fund and Closed-End mutual fund.
Open-End Mutual Fund:
This is simply called mutual fund, it is most common pooled investment vehicle. Open-ended funds continuously issue and redeem shares based on investor demand. Investors can buy or sell shares directly from the fund at the current NAV per share, which is calculated at the end of each trading day. The price of each share is called the Net Asset Value (NAV), which is calculated by dividing the total value of all the assets subtracting any liabilities in the fund by the number of shares outstanding.
Unlike closed-ended funds, which have a fixed number of shares outstanding, open-ended funds can issue an unlimited number of shares. At a high level, open-end mutual fund are broken down into four main categories: money market fund, equity fund, bond fund, hybrid fund.
Types of open-ended mutual funds:
1. Money Market Funds: These funds invest in short-term, low-risk securities like Treasury bills and commercial paper. They are considered low-risk, low-return investments.
2. Equity Funds: These funds invest primarily in stocks. They can focus on specific industries, regions, or market capitalizations (like large-cap, mid-cap, or small-cap stocks).
3. Bond Funds: These funds invest in bonds issued by governments or corporations. They can vary in terms of the types of bonds they invest in, such as government bonds, corporate bonds, or high-yield bonds.
4. Hybrid/Balanced Funds: These funds invest in a mix of stocks and bonds to provide a balance between growth and income.
Closed- End Mutual Fund:
A closed-ended mutual fund is a type of investment fund with a fixed number of shares issued through an initial public offering (IPO). These funds are traded on stock exchanges, and their prices are determined by supply and demand in the market, similar to stocks.
How does it work?
When a closed-ended mutual fund is launched, a fixed number of shares are issued to investors through an IPO. After the IPO, the fund’s shares are traded on stock exchanges like regular stocks. Unlike open-ended mutual funds, closed-ended funds do not issue new shares or redeem existing shares based on investor demand.
Major difference between closed-end fund and open-end fund is that closed-end fund shares can be bought or sold at any time and both long and short position can be taken; open-end funds shares only long position can be taken.
How returns are calculated for mutual fund
Returns for mutual funds are typically calculated in two ways: through price appreciation (capital gains) and income distributions (dividends or interest). The total return of a mutual fund is the sum of these two components.
1. Price Appreciation (Capital Gains):
- The primary source of capital gains for a mutual fund comes from the increase in the market value of its underlying securities (stocks, bonds, etc.). When the prices of these securities rise, the value of the mutual fund’s portfolio increases. The capital gains are realized when the fund sells these securities at a profit.
- The capital gains per share are then calculated by dividing the total capital gains by the number of shares outstanding. This per-share capital gain is added to the fund’s Net Asset Value (NAV). Investors benefit from price appreciation when they sell their mutual fund shares at a higher NAV than their purchase price.
2. Income Distributions:
- Mutual funds often invest in income-generating securities, such as dividend-paying stocks or interest-bearing bonds. The income generated from these investments is distributed to investors in the form of dividends or interest payments.
- The income distributions are calculated on a per-share basis and are typically paid out to investors periodically, such as monthly, quarterly, or annually. Investors can choose to receive these distributions in cash or reinvest them in additional fund shares.
Pros and cons of mutual fund
| Pros | Cons |
| Diversification | Fees and Expenses |
| Professional Management | Lack of Control |
| Liquidity | Tax Implications |
| Transparency | Market Risk |
| Economies of Scale | Performance Variability |
How to calculate Net Asset Value (NAV) in mutual fund
Net Asset Value (NAV) of a mutual fund represents the per-unit market value of all the securities held in the fund’s portfolio, minus any liabilities, divided by the total number of units outstanding.
First, sum up the market value of all securities and cash held in the mutual fund portfolio. This includes stocks, bonds, cash equivalents, and any other assets held by the fund. Deduct any liabilities, such as expenses, fees, and other payables owed by the mutual fund. Subtract the total liabilities from the total assets to determine the net assets of the mutual fund. Determine the total number of units or shares of the mutual fund that have been issued and are held by investors. Divide the net assets by the total number of units outstanding to get the NAV per unit.
NAV= (Total assets – Liabilities) / Number of outstanding units
For example:
let’s say a mutual fund has the following details:
- Total value of assets: $1,000,000
- Liabilities: $50,000
- Number of outstanding units: 50,000
Calculate the NAV:
- NAV = ($1,000,000 – $50,000) / 50,000
- NAV = $950,000 / 50,000
- NAV = $19 per unit
So, in this example, the NAV of the mutual fund is $19 per unit. This means that each unit of the mutual fund is worth $19 based on the current value of its assets.