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Investors have a basic choice: they can invest directly in individual securities, or they can invest indirectly through a financial intermediary. Financial intermediaries gather savings from investors and invest these monies in a portfolio of financial assets.
A mutual fund is a type of financial intermediary that pools the funds of investors who seek the same general investment objective and invests there in a number of different types of financial claims (e.g., equity shares, bonds, money market instruments).
These pooled funds provide thousands of investors with proportional ownership of diversified portfolios managed by professional investment managers. The term ‘mutual’ is used in the sense that all its returns, minus its expenses, are shared by the fund’s unit holders
Mutual funds are only one kind of financial intermediary. Bank is the largest intermediary in the financial system. Thousands of depositors pool their savings in a bank. However, investments in banks entitle the depositors to different financial claims than the one generated by the mutual funds.
In a sense, mutual fund is the purest form of financial intermediary because there is almost perfect pass through of money between unit holders (savers) and the securities in which the fund invests.
Unit holders are indicated a-priori in what type of securities their funds will be invested. Value of the securities held in the fund portfolio is translated on the daily basis directly to the value of the fund units held by the unit holders.
By contrast, a commercial bank is not a pass through type of financial intermediary. Banks collect deposits from depositors (savers). The depositors have no specific knowledge of how their funds will be used.
Bank invests the monies of the depositors in loans & advances which the bank officers feel appropriate at the time. On the deposits collected banks usually give a specified rate of return (interest) that is not linked to the performance of its loans & advances portfolio.
It is important to understand that a mutual fund is as risky as the underlying assets in which it invests. Though regulations ensure disciplined investments and ceilings on expenses that are charged to the unit holders, unit holders assume investment or market risk, including the possible loss of principal, because mutual funds invest in securities whose value may rise and fall.
Unlike bank deposits, mutual funds are not insured under Deposit Insurance and Credit Guarantee Corporation Act, 1961Of course there is also an upside to investment or market risk. Generally speaking, if you aspire for higher returns then you have to take greater risk. One has to evaluate the riskiness of a mutual fund from the assets it invests.
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