Mutual fund is a company that pools money from a number of investors and invests that money into securities. These securities can be Stocks, Bonds or Short Term money market loans.

There can be a number of mutual funds managed by a financial company. Such an asset management company that manages a number of mutual funds is known as a fund family. Each mutual fund may have its own investment theme such as one which invests only in the Blue Chip Companies, one may have the theme of investing only in the Oil Producing and Marketing companies, one fund may be replicating the benchmark index and so on.

Since a mutual fund pools money from many investors, the coffer becomes quite large and they can diversify easily. The fund has to clearly set out goals and investment principles before collecting money from the investors.

The first mutual fund was started in 1774 by Dutch merchant Adriaan Van Ketwich who started the first mutual fund in the World. Van Ketwich called his fund as Eendragt Maakt Magt which means 'unity creates strength'. This managed to spread out the risk of losses and similarly the gains would be distributed among the investors in the proportion of their investment.

Van Ketwich's fund was a closed-end fund which remained open until all the 2000 shares were sold out among the public. After all the shares were sold out in the initial offer, the fund was closed for general public and they could acquire or accumulate it only from an existing shareholder in the open market.

The first modern-day mutual fund, Massachusetts Investors Trust, was started in 1924. The mutual fund attracted investors from the beginning and eventually went public in 1928.

A mutual fund has many underlying components, none of these components can be removed or replaced.

An open ended mutual fund can allocate any number of shares to its shareholders. A shareholder can acquire shares of mutual fund only from the fund. A fund manager constantly looks at new opportunities to enhance the portfolio.

Shares of an open-ended fund can be bought any time in its lifetime after it is opened to the public. A few open-ended funds may close itself for the new investors or additional interments once it becomes too large to manage new investments. Sometimes when the market is at its peak and the fund manager cannot find anything attractive in the market to add to their portfolio.

A shareholder can only sell his/her share back to the mutual fund. An open-ended mutual fund has to always maintain a comfortable level of liquidity to pay the shareholders in case they redeem their shares. The fund manager has to be always aware of the market conditions otherwise in case of heavy selling the fund may not have enough liquidity to pay its investors. Once shares are redeemd they cease to exist.

Number of outstanding shares keeps changing with the number of shares redeemed and the number of new shares issued.

A closed-end fund is a mutual fund that is traded as stocks in all major stock exchange. Shares of a closed-end fund are sold to the shareholders through initial public offering (IPO). Once the offering period is closed the shares can be bought from another shareholder in a stock exchange.

The main difference between an open-ended fund and a closed-end fund is that a closed-end fund is static. Number of shares of a closed-end fund remains unchanged. Closed-end funds are of various types: municipal bond funds, closed-end bond funds, general equity fund, growth fund, value fund, balanced fund etc.

Unlike an open-ended fund, a closed-end fund cannot shrink in terms of number of shares. The value of a closed-end fund can change. The assets of a closed-end fund and an open-ended fund are managed in the same way. A closed-end fund either sells at either a premium or a discount to the net asset value (NAV) of its portfolio.

I have never seen a definitive study of whether closed-end funds, as a group, do better or worse than open-ended funds. On casual inspection, neither kind has any particular advantage.

-- Peter Lynch (Beating the Street)

There are mainly two kinds of loads that a fund may charge:

  • Entry Load
  • Exit Load

Entry Load is charged when an investor purchases shares of a Mutual Fund. These charges are paid out to the distributors and reps, who have sold the mutual fund to the investor, to compensate for the expenses that they have made.

An investor is investing INR 10,000 in a fund where the entry load is 2% and NAV is INR 10. 2% will be deducted from the gross investment amount upfront. The net investment amount will be INR 10,000 Minus 2% of INR 10,000 = INR 9,800. So, 980 shares will be allocated to the shareholder.

If an investor wants to remain invested for a long time period, then 2% entry load should not bother much. Some mutual funds have a predefined breakpoint level which means that as the investment grows and the total account holding increases the entry load also decreases.

A mutual fund may have the following table to define the entry load on investment
Total Investment Entry Load Remark
0 to 50,000 2% Entry load of 2% is charged till the total holdings is below 50,000
50,001 to 1,00,000 1% An entry load of 1% is charged if the total holding is between INR 50,001 and INR 1,00,000
Greater than 1,00,000 0% No entry load if the total holdings is greater than INR 1,00,000

Exit Load may be charged by a mutual fund if the investor is redeeming (selling) shares. These are usually charged if the investor is redeeming his/her shares before a certain period. Some funds may charge an exit load of a certain percentage points to compensate for the losses that the fund has made by compensating for the distribution expenses.

A mutual fund may have paid out to the broker/dealer for bringing in the investor to the fund. The mutual fund did not charge an entry load and the investor was allocated shares worth the full investment amount. If the investor does not remain invested beyond a certain period (for example: 12 months), then the mutual fund deducts an amount at a certain percentage from the investor's holdings to compensate the amount it had paid out to the broker/dealer as advance commission.

Mutual funds may not charge any exit load if the investor does not redeem his/her shares for a certain period.

A mutual fund may use a table similar to the one below to charge exit load

Time Period Exit Load Comment
Less than 12 months 2% If the investor redeems the shares within 12 months of investment, then 2% is charged
Between 12 and 24 months 1% If the investor redeems the shares after 12 months but before 24 months from the investment date, then 1% is charged
More than 24 months 0% No exit load is charged if the investor does not redeem for 24 months from the date of investment

A mutual fund charges an amount for the services it provides to the shareholders. The only aim of a mutual fund is to earn the best possible return for the shareholders year after year. A team of analysts work under the fund manager to constantly look for new opportunities. A mutual fund also has to hire a team to do the necessary paperwork and to prepare reports for the sponsors, trustees, custodians , regulators and the shareholders.

Most of the mutual fund companies outsource the transfer agency related work. A few mutual fund companies maintain in-house transfer agency division. Be it maintaining a in-house division or outsourcing of the transfer agency work, a fund requires the spend a certain amount each year.

All these expenses are collectively known as operating expenses. A good mutual fund always strives towards reducing the operating expenses. A fund makes up for these expenses by charging fees from the shareholders. The NAV is calculated after deducting the fees from the asset under management.

Types of Fees charged by a mutual fund

  • Management Fees
  • Redemption Fees
  • Distribution and Service Fees
  • Annual Maintenance Charges

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