A mutual fund is a professionally managed company that collects money from many investors and invests it in securities such as stocks, bonds and short-term debt, equity or bond funds and money market funds.
Mutual funds are a good investment for investors looking to diversify their portfolio. Instead of betting everything on one company or sector, a mutual fund invests in different stocks to try to minimize portfolio risk.
The term is typically used in the US, Canada and India, while similar structures around the world include the SICAV in Europe and the open-ended investment firm in the UK.
What are the limits of index funds?
Index funds suffer from three key disadvantages due to their passive style. They do not offer flexibility to the fund manager in managing negative aspects of the market. If the index tracked by the fund generates negative returns due to unfavorable economic or market conditions, an active fund manager has the option to choose stocks to better manage the downside. But an index fund must follow the benchmark, both during market and downward trailers.
An active fund manager seeks to generate alpha, i.e. a return in excess of the fund’s benchmark. So active funds can generate returns above their benchmark by taking additional risks. But index funds are low-risk products that simply mimic an underlying benchmark. Therefore, an investor seeking a return higher than the benchmark index should avoid an index fund as it generates an average market return.
While index funds
are thought to track an index and provide returns in line with it, in real life most index funds delay their benchmark returns due to tracking errors. An index fund incurs costs each time it has to adjust its portfolio as a result of changes in the composition of its index. The index does not involve such transaction costs when its composition changes. The transaction costs incurred by the index fund reduce its return compared to the benchmark return.