Article Number 1 in the Mutual fund series (For the next article click here)
I am going to post a series of articles on mutual funds of which this would be the first. We will be going through the basics of what mutual funds are in this article and subsequently move on to their benefits & disadvantages, types, performance, expenses among other things in the later articles.
Prerequisite – It would be beneficial in our quest to understand mutual funds by first understanding about the concept of NAV which I have described here.
So lets begin,
What is a mutual fund?
SEC provides a very simple and jargon free definition for a mutual fund. It says that “A mutual fund is a type of investment company that pools money from many investors and invests the money in stocks, bonds, money-market instruments, other securities, or even cash.”
Lets understand what mutual funds are with the help of the following analogy.
Imagine you are good at investing money. A few of your close friends give you some of their money which you pool together and decide to invest in stocks, bonds, money market instruments etc. Lets imagine 9 of your friends contribute $10,000 each and you add your own $10,000 to it. Lets call this the “friends fund” which is now worth $100,000.
In the most basic conceptual form, this is analogous to a mutual fund.
1) Here, you are analogous to the fund manager (who in this case is managing the “friends fund”).
2) 9 of your friends (along with you) who contributed their money placing their faith in you are similar to the investors who invest in mutual funds.
3) You, the fund manager, at your discretion, invested the money by buying some shares, some bonds and kept the rest in cash. Any profits is shared among your friends (investors) proportionate to their initial investment which in this case is equal. Similarly even losses are bore equally.
4) You may be charging a small fee for managing the fund such as 1% of the total fund value per annum. This is what is called the management fee.
5) You promise your friends to follow some rules while investing such as,
1) I will not use the money from the friends fund to buy complex and risky derivatives such as futures & options.
2) I will not trade on margin.
3) I will allot a certain proportion (Say, no less than 25%) of the fund to less riskier assets like bonds/money market instruments/cash.
4) I will follow strict money management rules.
These rules form the guidelines for your friends (investors) which the fund defines beforehand (some guidelines are also laid down by the SEC).
The financial performance of the friends fund can be measured in many ways. One of the popular ways is by using the NAV. To understand the concept of NAV read the previous article here.
Imagine one of your friend who invested in the fund needs his money back, what would happen then? Depending on how much proportion of the fund you have in cash, you may have to liquidate some of your positions in order to return the money. He would get a tenth of the fund value depending on the NAV at the end of that day.
In other words, lets imagine you started this fund on January 1st when the NAV was at $10. If the initial NAV was $10, then the initial number of shares in the friends fund would be $100,000/10 = 10,000 and each friend owned 1000 shares of the fund.
On April 16th one of your friend wants his share of the money back, and at the EOD (end of that day) as the NAV stood at $11.24, he would be eligible to get $11.24 * 1000 = $11,240. Now the number of shares in the fund would decrease to 9000 (from the previous 10,000). Note that the NAV doesnt change. The number of shares constituting the fund decreases from 10,000 to 9000 and the fund value decreases from $112,400 to $101,160 and hence NAV remains unchanged at $101,160/9000 = 11.24
On June 2nd, some other friend might be interested in investing in your fund when the NAV is at $12.16. Then he would be required to purchase shares in the multiples of 12.16, he could purchase 100 shares worth $1216 (12.16*100). The total number of shares in the fund would now increase to 9000 + 100 = 9100 shares from the previous 9000 shares and the total value of the fund would be 12.16*9100 = $110,656. Notice that the NAV remains unchanged at $12.16 even though money was added to the fund.
This continues as long as there are investors interested in investing in your friends fund and as long as you are interested in managing the fund. Once you are no longer interested you can either appoint another manager or liquidate all the positions and return the money back to your friends.
Imagine the next year on September 1st (NAV at $13.08) due to some reason you decide no longer to manage the fund. You search for another manager who is willing to run the fund but find none. You decide to liquidate the entire fund and return the money back to the investors. Everyone agrees and you sell all the 9100 shares and get $119,028 (for simplicity sake I am not taking into consideration brokerage, commissions, etc). You give the initial 8 investors $13,080 each and the last investor (who invested 100 shares on 2nd June of the previous year) $1308. You keep the remaining $13,080 left with yourself.
This is briefly how a mutual fund works, in the following articles lets see the benefits & disadvantages, types, performance, expenses you might incur when investing in mutual funds.
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