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A mutual fund is a form of collective investment that pools money from many investors and invests their money in stocks, bonds, short-term money market instruments, and/or other securities.[1] In a mutual fund, the fund manager trades the fund's underlying securities, realizing capital gains or losses, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. The value of a share of the mutual fund, known as the net asset value per share (NAV), is calculated daily based on the total value of the fund divided by the number of shares currently issued and outstanding.

Legally known as an "open-end company", a mutual fund is one of three basic types of investment companies available in the India, mutual fund is a generic term for various types of collective investment vehicle.

Mutual funds can invest in many different kinds of securities. The most common are cash, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can invest primarily in the shares of a particular industry, such as technology or utilities. These are known as sector funds. Bond funds can vary according to risk (e.g., high-yield or junk bonds, investment-grade corporate bonds), type of issuers (e.g., government agencies, corporations, or municipalities), or maturity of the bonds (short- or long-term). Both stock and bond funds can invest in primarily Government securities (domestic funds).

Most mutual funds' investment portfolios are continually adjusted under the supervision of a professional manager what we call is Fund Managers, who forecasts the future performance of investments appropriate for the fund and chooses those which he or she believes will most closely match the fund's stated investment objective. A mutual fund is administered through a parent management company, which may hire or fire fund managers.

Mutual funds are subject to a special set of regulatory, accounting, and tax rules. Unlike most other types of business entities, they are not taxed on their income as long as they distribute substantially all of it to their shareholders. Also, the type of income they earn is often unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free bond income are also tax-free to the shareholder. Taxable distributions can be either ordinary income or capital gains, depending on how the fund earned those distributions.

The net asset value, or NAV, is the current market value of a fund's holdings, usually expressed as a per-share amount. For most funds, the NAV is determined daily, after the close of trading on exchange, but some funds update their NAV multiple times during the trading day. Open-end funds sell and redeem their shares at the NAV, and so process orders only after the NAV is determined. Closed-end funds (the shares of which are traded by investors) may trade at a higher or lower price than their NAV; this is known as a premium or discount, respectively. If a fund is divided into multiple classes of shares, each class will typically have its own NAV, reflecting differences in fees and expenses paid by the different classes.

Some mutual funds own securities which are not regularly traded on any formal exchange. These may be shares in very small or bankrupt companies; they may be derivatives; or they may be private investments in unregistered financial instruments (such as stock in a non-public company). In the absence of a public market for these securities, it is the responsibility of the fund manager to form an estimate of their value when computing the NAV. How much of a fund's assets may be invested in such securities is stated in the fund's prospectus..

Picking a mutual fund from among the thousands offered is not easy. Following are some guidelines:

  • Prior to investing in a tax-exempt or tax-managed fund, it is best to determine if the tax savings will offset the possibly lower returns.
  • Investors should match the term of the investment to the time period they expect to keep the investment. Money that may be needed in the short term (for example, for car repairs) should generally be in a less volatile fund, such as a money market fund. Money not needed until a retirement date decades into the future (or for a newborn's college education) can reasonably be invested in longer-term, higher-risk investments, such as stock or bond funds. Investing short-term money in volatile investments puts the investor at risk of having to sell when the market is low, thereby incurring a loss. Investing over the long term in very stable investments, on the other hand, significantly reduces potential returns.
  • Fund expenses degrade investment performance, especially over the long term. Accordingly, all other things being equal, the lower the expenses, the better. A mutual fund's expense ratio is required to be disclosed in the prospectus. Expense ratios are critical in index funds, which seek to match the performance of bond or stock index. Actively managed funds must pay the manager for the active management of the portfolio, so they usually have a higher expense ratio than (passively managed) index funds.
  • Several sector funds often make the "best fund" lists each year. However, the "best" sector varies from year to year. Most sectors are vulnerable to industry-wide events that can have a significant negative effect on performance. It is generally best to avoid making these a large part of one's portfolio.
  • Closed-end funds often sell at a discount to the value of their holdings. An investor can sometimes obtain extra return by buying such funds, but only if they are willing to hold the fund until the discount rebounds. Some hedge fund managers use this gambit. However, this also implies that buying at the original issue may be a bad idea, since the price often drops immediately because of liquidity concerns.
  • Mutual funds often make taxable distributions near the end of the year (semi-annual and quarterly distributions are also fairly common). If an investor plans to invest in a taxable fund, he or she should check the fund company's website to see when the fund plans to distribute dividends and capital gains. Investing just prior to the distribution results in part of one's investment being returned as taxable income without increasing the value of the account.
  • Prospective investors in mutual funds should read the prospectus. The prospectus is required by law to disclose the risks will be taken with investors' money, among other vital topics. Potential investors should also compare the return and risk profile of a fund against its peers with similar investment objectives and against the index most closely associated with it, paying particular attention to performance over both the long term and the short term. A fund that gained 50% over a 1-year period (an impressive result) but only 10% over a 5-year period should create some suspicion, as that would imply that the returns in four out of those five years were actually very low (possibly even negative (i.e., losses)), as 10% compounded over 5 years is only 61%.
  • Diversification can reduce risk. Depending on an investor's risk tolerance and his or her investment horizon, it may be advisable to hold some stocks, some bonds, and some cash. For longer-term investments, it is advisable to invest in some foreign stocks. If all of an investor's mutual funds belong to the same family of funds, the investor's total portfolio might not be as diversified as it might seem. This is so because funds within the same family may share research and recommendations. The same is true for investors who own multiple funds with the same profile or investment strategy; their returns will likely be similar. Holding too large a number of funds, on the other hand, will tend to produce the same effect as holding an index fund, but with higher expenses. Buying individual stocks exposes investors to company-specific and industry-specific risks, and if investors buy a large number of stocks, the commissions may cost more than a fund would.

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