Mutual funds: Meaning, how it works, types and more

Investments drive the general economy of a nation and further aids business growth in the long and short run. Large-scale investments have recently become the attraction of most entrepreneurs, as they offer stronger prospects that make the business scalable.

Nonetheless, some low-income earners or investors who are simply weary of investing large sums often demand the option to grow their income while also engaging in investments that scale businesses. For this style of investment, where investors with little resources can make impactful investments in the market, to thrive, the mutual fund investment scheme must come into place.

This post takes a look at mutual funds and all there is to know about the concept.

What is a mutual fund?

Mutual funds are investment arrangements where multiple investors pool their small resources into a single scheme held by a fund manager, who subsequently invests the pool of gathered funds in a profit-yielding investment on a large scale.

Mutual funds are also known as Unit Trust Schemes, or simply the scheme, and are a type of Collective Investment Scheme. Mutual funds are regulated in Nigeria by Sections 152 to 196 of the Investment and Securities Act 2007. The scheme is held by a Trustee in trust for the investors, who are referred to as unitholders.

How mutual funds work

The Mutual Fund Scheme begins with the creation of the fund by the Fund Manager. The Manager sets up all there is to know about the scheme in a fund portfolio. The fund portfolio acts similarly to the constitution of the fund, creating and setting the major terms that guide the parties in the fund.

The Fund Manager must be a person or corporation registered by the Securities and Exchange Commission (SEC) to carry on the activities of the mutual fund scheme. The fund manager appoints the Trustee (also registered by the SEC to carry on business as a Trustee) on behalf of the Unitholders.

The Unitholders own a share or unit in the Mutual Fund and eventually get a part of the profit of the fund from their holdings. The fund manager can invest the pooled funds in a variety of assets or a single asset. Where the investment made by the fund manager succeeds, the fund profits, and where it fails, the fund draws a loss.

The fund manager controls the necessary investments to be made with the portfolio, subject to informing the Trustees. The fund is usually placed into varying industries, companies, businesses, industries, and other areas.

Before the scheme is put in place, the SEC must authorize it. The mutual fund manager initiates the SEC’s authorization process by filing all necessary documents, including the fund portfolio and the Trust deed, for scrutiny.

Parties to a mutual fund

There are generally six parties to a mutual fund: the fund manager, the Trustee, the Custodian, the Unitholders, the Registrar, and the SEC.

1. Fund manager

The fund manager is significant to the mutual fund’s commencement and progress. The trick is that the more experienced the fund manager is in the concept of mutual funds, the greater the likelihood of the fund being successful.

The fund manager strategizes the areas in which the fund would be invested and controls the progress of the fund scheme. The fund manager also appoints the trustee and custodian.

2. Trustee

The trustee is a company in the business of offering trust services to a group. For example, FBN Trustees, ARM Trustees, etc. The trustee acts on behalf of the Unitholders and works to protect their group interests.

Because there may be over 100 Unitholders all pooling their little funds into the scheme, the Trustee acts as a single entity, interfacing with the fund manager on the Unitholders’ behalf.

3. Custodian

As the name implies, the custodian is a company tasked with the responsibility of keeping the funds. The custodian (usually a bank) holds the funds until they become a single pool to be handed to the fund manager.

4. Unitholders

These are the investors who place their small resources to fund the scheme. They are a direct beneficiary of the scheme if it is profitable.

5. Registrar

The register maintains a list of all Unitholders, inclusive of the units held by each under the fund.

6. SEC

The SEC plays a regulatory role for mutual funds. It regulates the activities of all the parties to ensure the investments of the Unitholders are further protected.

Types of mutual funds

There are two types of Mutual funds: open-ended and closed-ended mutual funds. The fund portfolio usually states what kind of mutual fund is intended.

A. Open-ended mutual fund

The open-ended fund is a kind of fund that continually issues and redeems units to Unitholders. This fund is designed to be repetitive and active all the time through the issuance of units.

B. Close-ended mutual fund

The close-ended fund is the direct opposite of the open-ended fund. It acts as a one-off fund issued to the Unitholders, with no continuous issuance in the future. The close-ended fund is usually traded on the floor of the Nigerian Exchange. 

Pros and cons of investing in mutual funds

Below are the benefits and downsides of investing in mutual funds.

Pros

Prose of mutual fund investment include:

1. Investment diversity

Investing in mutual funds offers investors a chance to diversify their investments, thereby reducing risks. Instead of investing in one sector, fund managers usually spread the investment across a variety of sectors.

2. Low risk

Since investors only put in a few funds that are spread across several investors, the chances of the investment failing become slim.

3. Professional management

Fund managers, Trustees, and the SEC are usually seasoned professionals who look through the management process of mutual funds. Moreso, the fund managers are accredited professionals by the SEC to ensure minimal losses in the fund.

Cons

There are still some disadvantages of investing in mutual funds, such as:

1. High professional costs

Before unitholders receive profits from the scheme, all professionals working on the scheme must be paid their fees in full. These include the fund manager, the Trustee, the Registrar, and the Custodian. These professional fees can significantly reduce the amount earned by the Unitholders.

2. Flood Gate of funds

Perhaps one of the most significant challenges is the possibility of an overinvestment in the fund with no known area for the fund manager to invest the excess sum.

Conclusion

The world of business has grown incredibly huge, with increased opportunities sprouting daily. Mutual funds offer investors with little income to tap into the varying benefits available in the capital market and, in turn, provide considerable capital for large corporations.