What is a Mutual Fund and How Does it Work? (Complete Guide)

“Mutual funds sahi hai” or “Mutual funds sheri aanu.” Most of us might have come across this advertisement, especially on television. But what is this mutual fund? How does it work? Is there any risk to it? This blog will be your ultimate guide to mastering mutual fund investment.

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What is a mutual fund?

Imagine there is a big pot, and a bunch of people come together to pool their money into the pot. This money is taken by a professional manager who invests it in things like stocks, bonds, or other assets. In this way, with everyone’s money being in the picture, the risk would be spread out when compared to a person investing on his own. When the investments do well, everyone gets a piece of the profit based on how much money they had put in.

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This is what makes up the core idea of a mutual fund. Of course, this is the simplified version and contains the soul of the whole process. Mutual funds can be a bit complex as they are completely subjected to market risks as well. An understanding of the ins and outs of the phenomenon is crucial before investing.

Key takeaways:

• A mutual fund is a pool of money from many investors that is managed by a professional fund manager. The money is invested in a variety of stocks, bonds, or other securities, allowing investors to diversify their investments without having to buy each individual asset themselves. When you invest in a mutual fund, you own a small share of all the assets in the fund.
• Types include equity, bond, target-date, ETFs, international, MMFs, hybrid, FoFs, and capital protection funds.
• Benefits consist of diversification, involvement of professional managers, liquidity, affordability, and automatic reinvestment.
• When it comes to risks and considerations there are market risks, presence of management fees, lack of authority, overdiversification, and performance risk.

How does a mutual fund work?

As stated above, a bunch of people come together to pool in some money, which is then managed by a professional manager. When a person buys shares from this fund, they gain a small part of the fund. The value of your share goes up or down based on the performance of the investments. Additionally, you would have to pay a small fee to the manager, and you can earn money through dividends or when the fund sells investments for profit.

While a mutual fund manager decides on how to divide the money across sectors, industries, companies, etc., many funds are known as index or passive funds. This is solely based on the funds’ strategy taken up by the manager. Fortunately, these portfolios or strategies do not need a lot of research, as they simply mirror indexes like the S&P 500.

Some of the top mutual fund managers are BlackRock, Vanguard, and Fidelity.

The number of American households invested in mutual funds has increased exponentially since the time it was introduced. From 11.9% of households in 1984 to 44.7% in 2004 and about 56% in 2024. Additionally, 35% of Gen Z households invest in mutual funds. [1]

The major driving factor would be how the risk is reduced by investing in various entities rather than in one.

What are the types of mutual funds?

There are thousands of mutual funds established on a global scale, each with different investment goals and strategies. Here are the main types:

• Equity Funds

These are mutual funds with a primary investment in stocks, along with a goal of achieving long-term capital growth. They come in various types—growth, value, blend, and sector-specific funds—with varying strategies. Growth funds focus on companies that are expected to grow at an above-average rate, while value funds are for the undervalued stocks (the irony, right?!). Blend funds combines both, while sector-specific focuses on various sectors, like technology or healthcare.

Although they offer high growth, equity funds bring risk and volatility as they are subjected to market fluctuations. Managers can manage them actively, by outperforming the market, or passively, by tracking a specific index like the S&P 500. They are better for investors with higher risk tolerance and a long-term investment horizon, as short-term volatility can affect their performance.

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• Bond funds

These funds invest in bonds, which are loans made to companies or governments. They leverage interest payments and are less risky than stocks. However, there’s a catch (you would have guessed it by now!). Bond funds can lose value if the interest rates increase or if the bonds don’t perform well. They are suitable for people who prefer safer, more stable investments.

There are different types of bond funds as well:

• • Government bond funds invest in safe bonds from the government.
  • Corporate bond funds invest in bonds from companies, which offer higher returns but are riskier.
  • Municipal bond funds invest in state or local government bonds, often offering tax benefits.
  • High-yield bond funds invest in riskier bonds but aim to give higher returns.

• Target-date funds

Target-date funds are those types of funds that help investors save for a specific goal, like retirement. When you invest in such mutual funds, you get to decide on a fund that aligns with the year you plan to retire. You then sit back and relax as the manager does the heavy lifting for you. In the earlier years of the plan, the funds are invested in more stocks for growth; meanwhile, the latter years (near to your retirement) are meant for investing in safer investments to protect the money from market swings. Pretty cool, right!

This is one of the best options for those who don’t have the time and expertise to manage these funds. However, it is important to remember that these funds do not guarantee success and may fail, especially in the short term.

Also read: Performance Evaluation of Mutual Funds

• Exchange-traded funds (ETFs)

These funds are similar to mutual funds, as they pool money from a group of investors and then invest it in various commodities. The difference is that, while mutual funds are bought and sold at the end of the trading day, ETFs are traded throughout the day. This gives investors more flexibility to buy or sell whenever they want within the market hours.

ETFs are favourites as they have smaller fees when compared to mutual funds. They offer diversification and hold a wide variety of them, instead of buying many individual stocks or bonds. Great for people who want to invest in broad market indices or specific sectors without picking individual investments. However, beware, just like any investment, ETFs also have risks, especially if the market moves against you.

• International/Global Funds

International funds are a type of mutual fund that invests in companies outside of your country. Talk about upping your game! Your funds are invested in profitable companies worldwide and thus help you diversify your portfolio and reduce risks by putting it all in one country. The biggest flex is that you get a chance to benefit from this opportunity if the country’s economy is faring comparatively.

As you guessed by now, there are increased risks in this one. Currency fluctuations may affect what you gain or lose along with any kind of political unrest and the economic instability that rises with it. Despite these risks, these funds help you to diversify your portfolio and increase your profit margins internationally.

• Money Market Funds (MMFs)

These types of mutual funds invest in very safe, short-term debt like government bonds or certificates of deposit. They are crafted to protect your fund and offer a small return, which is higher than a regular savings account but lower than stocks or bonds. This is ideal for people who want less risk but want to put their money in something that accumulates a little interest.

Since they provide less risk and less profit, they are best suited for conservative investors or anyone who needs to keep their money for a short period. If you’re looking for higher profits, this is not the one for you, clearly.

• Hybrid Funds

Hybrid funds are a type of mutual fund that combine both stocks and bonds, thus creating a combination of growth and safety. Stocks help in accumulating higher returns, while bonds are safer and offer steady income. You get the best of both worlds in hybrid funds.

There are different types of hybrid funds as well, some of which are aggressive—with a large portion of the money in stocks—or conservative—with a focus more on bonds. Hybrid funds are suited for people who want to spread their risk and ensure a minimum profit throughout their venture.

Also read: Mutual Funds vs Fixed Deposit

• Fund of Funds (FoF)

These funds take use of other funds. This “dog-eat-dog” situation actually invests in other mutual funds rather than individual stocks or bonds. This lets you buy a collection of different funds, thus diversifying your portfolio and reducing the risk. Essentially, you get multiple funds without selecting an individual one by yourself.

FoFs charge a high amount when compared to other types. This is due to the cost of managing the primary funds invested by you and the underlying funds that will be involved while investing. Good for people who want to invest in a wide variety of assets. However, it is necessary to consider the extra costs inherent within this type.

• Capital Protection Funds

Capital Protection Funds aim to protect the investors money by investing heavily in bonds and a small amount in stocks to generate a small revenue. This provides a peace of mind, especially for conservative investors. Ideal for investors who do not want to lose their amount at the same time and can gain some modest returns. You have to keep in mind the returns are comparatively lower than aggressive investments like stocks.

What are the benefits of mutual funds?

Mutual funds contain many benefits, and most of these benefits depend on the type of mutual funds as well. Here are some of the common and well-known benefits:

• Diversification

Mutual funds help you to spread your money across a variety of assets like stocks, bonds, or other securities. This method reduces risk drastically, as you don’t have to depend on just one investment.

• Professional Managers

One major benefit is the professional and experienced fund managers who will be managing your funds, researching as to which assets should be traded. This is really helpful for people who do not have the time and expertise to invest.

• Liquidity

Your mutual fund shares can be bought and sold easily, making them a liquid investment. You can access your money whenever you need it, typically at the end of the trading day.

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• Affordability

Mutual funds allow you to enter the market with a small amount. This helps individuals to get exposed to the harvests of the market without any large amounts of money.

• Automatic Reinvestment

Many types of mutual funds have an inherent feature wherein dividends or interests are reinvested automatically, thus making sure that the maximum profit is attained.

These benefits make mutual funds easy, economical, and accessible, thus making them compatible for freshers and those who want a hands-off approach.

What about risks and considerations?

Now let’s discuss the ‘dark side’ of mutual funds. With benefits, there are risks associated with mutual funds, and it is always best to consider the following before investing.

• Market Risks

Nail this down in your head. The value of your fund can go up and down based on market conditions. If the overall market or specific indices perform poorly, the value of your investment goes down as well. The possibility increases if the fund holds a lot of stocks or high-risk assets.

• Management fees

The management fees for managing your funds can result in reducing your returns over time. Fees include various divisions like expense ratios, sales charges, and other costs that may not be clear upfront.

• You are not the boss.

Once you have invested, you do not have a say on what happens to your fund. The fund manager takes decisions on your behalf and decides where to invest. Even if you do not agree with the fund manager on a particular investment, your voice or opposition doesn’t hold any value.

• Overdiversification

While diversification is smiled upon, it’s not the same case for over-diversification. When your funds hold too many investments, your money is also spread too thinly, preventing you from benefitting fully from strong-performing assets.

• Performance Risk

Past performance may not always be an indicator of guaranteed success. Mutual funds that have performed well in the past may underperform in the future, leading to a loss of money.

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Is Mutual Funds the Right Choice for You?

All investments related to banking and finance need to be approached with the most keen eyes. Only after understanding the ins and outs of mutual funds should one venture into the path. This exhaustive list contains all that you need to get started in your investment for the future, and we suggest that you only advance after careful analysis and weighing of the benefits and risks.

If you feel like you to want to learn more about mutual funds, check out our mutual funds course to learn with industry experts and top-notch quality materials. Mutual funds may not be everyone’s cup of tea, and you might prefer trading on your own. In that case, you should check out our stock market course or forex trading course. Enrol now and secure your future with Entri. Happy trading!

References

• The New Face of Fund Ownership: A Bigger and More Diverse Marketplace – https://www.ici.org/viewpoints/24-view-mfowners
• Frequently asked questions about Mutual Fund Directors – https://www.idc.org/idc/faqs/mutual-fund-directors#II.%20Duties%20and%20Responsibilities