Lesson 4 of 6
Mutual funds are a type of pooled investments that require a small investment for participation as opposed to hedge funds which can require a minimum of US$1 million, sometimes more. The kinds of products that are available in a financial supermarket vary therefore on the proposed investment. Certain mutual funds require investments as small as $50, while others are available in the range of US $1,000,000 and more.
Mutual funds can be defined as a co-mingled investment pool in which investors in the fund each have a pro-rata (in proportion to) claim on the income and the value of the fund.
The value of a mutual fund is called the net asset value or NAV. It is calculated on a daily basis, on the closing value of the securities in its portfolio. Given below is a snapshot of the global mutual fund market between 2005 and 2011. (Source: Fact sheet 2012 of the Investment Company Institute)
If we were to look at 2011 percentage figures for these continents it would look like this:
Mutual funds are favored by investors and institutions alike. To understand how a mutual fund works let us look at an example. An investment firm that wants to start a fund has decided to do so with a target of US$10million. It aims to do this with five individuals and two institutions.
The net asset value of the fund is US$10 million. This is divided into 100,000 shares with each share having an initial value of $100. This fund is given to a portfolio manager to manage. The net asset value will change depending on the value of the assets in the portfolio. The fund is christened FastGrowth100.
The FastGrowth100 mutual fund is an open-ended fund. This fund will accept fresh investment money and issue additional shares at a value equal to the net asset value of the fund at the time of investment. An open ended fund will allow for removal of funds at the NAV at that point of time. If the fund value increases to US$15 million, the new value per share would be $150. If an investor wants to put in US$0.96 million, it would create 6400 new shares. Post investment the Net Asset Value of the fund would be 15.96 million, with a total of 106400 shares.
Let’s say investor C wants to withdraw her shares from the fund totally. Now the fund will need to liquidate $0.75 million in assets to retire 5000 shares at a NAV of US$150. There is a net inflow US$210,000 and 1400 new shares would be created.
Close ended funds are also available; here no new investments are accepted. New investors will have to buy shares from existing investors and those wishing to liquidate their shares will do so by selling their shares to new investors. The number of shares in an open-ended fund stay the same. The sale of shares will happen at premium or discounted prices to NAV depending on the demand for those shares.
The portfolio manager of an open ended fund needs to manage the inflows and outflows. Liquidations would mean redemptions, which the manager has to account for. Likewise new inflow of investments would require of the portfolio manager to seek new investments. These issues are not present in a close ended fund, but then the scope for growth is also limited.
Mutual funds can be classified based on how the funds management is compensated. When no fee is levied for investing or redemption in the fund it is called a no load fund. When funds levy a percentage fee in addition to an annual fee to invest in or redeem shares it is called a load fund.
Mutual funds are also classified based on the assets they invest in. Mutual funds can be stock funds; taxable/non-taxable bond funds; balanced funds that invest in stocks and bonds; and money market funds. We will look a little more into these funds in our next article on the types of mutual funds.