UNIT 5: PORTFOLIO MANAGEMENT

5.1 Introduction

Portfolio – It is a combination of securities such as stocks, bonds and money market

instruments.

Portfolio construction - The process of blending together the broad asset classes so as to
obtain optimum return with minimum risk is called portfolio construction.

Diversification -

Portfolio Management - It is the art of selecting the right investment policy for the
individuals in terms of minimum risk and maximum return. In simple terms, it is managing
money of an individual under expert guidance of portfolio Managers.

5.1.1 Benefits of Portfolio Management:

- PM presents the best investment plan to the individuals as per their needs and
requirement in terms of income, budget, age and ability to undertake risks
- PM minimizes the risk involved in investing and also increases the returns within a
stipulated time period.
- Diversification of one’s holdings is intended to reduce risk in an economy.
- Most investors hope that if they hold several assets, even if one goes bad, the others
will provide some protection from an extreme loss.

5.1.2 Types of Portfolio Management (PM)

Types of Portfolio Management

Discretionary PM Non – discretionary PM Advisory PM

The individual issues Portfolio manager suggests Portfolio manager

money to portfolio investment ideas. Choice suggests only
manager who in turn and timings holds with investment ideas.
takes care of all his investor. However Decision taking and
investment needs, execution of trade is execution is carried
paper work, etc. carried out by portfolio out by investor.
manager.
5.1.3 Phases of Portfolio Management

5.2 Portfolio analysis

Investors make investment in various securities to diversify the investment to make it risk
averse. By selecting the different sets of securities and varying the amount of investments
in each security, various portfolios are designed. After identifying the range of possible
portfolios, the risk-return characteristics are measured and expressed quantitatively. It
involves the mathematically calculation of return and risk of each portfolio.

The TWO approaches in portfolio analysis are:-

5.2.1 Traditional approach

The traditional approach basically deals with two major decisions. They are:

(a) Determining the objectives of the portfolio.

(b) Selection of securities to be included in the portfolio.

Normally, this is carried out in four to six steps. Before formulating the objectives, the
constraints of the investor should be analyzed. Within the given framework of constraints,
objectives are formulated. Then based on the objectives, securities are selected. After that,
the risk and return of the securities should be studied. The investor has to assess the major
risk categories that he or she is trying to minimize. Compromise on risk and non-risk factors
has to be carried out. Finally relative portfolio weights are assigned to securities like bonds,
stocks and debentures and then diversification is carried out. The flow chart below explains
this.
Traditional approach (Fig)

Analysis of constraints

Determination of Objectives

Selection of Portfolio

Bond and Common stock Bond Common stock

Assessment of risk and return

Diversification

1. Analysis of constraints - The constraints normally discussed are:

Income needs : The investor’s need to meet all or part of the living expenses.
Liquidity : The investor should plan his cash drain and the need for net cash
inflows during the investment period.
Time horizon : It is the investment planning period of the investor.
Safety : Investing in bonds and debentures is safer than stocks
Tax considerations : From the tax point of view, the form in which the income is received
i.e. interest, dividend, short term capital gains and long term capital gains are
important. If the investor cannot avoid taxes, he can delay the taxes. Investing in
government bonds and NSC can avoid taxation.
Temperament : Temperament of the investor plays an important role in setting up of
objectives. Some may be risk taker, while few may be risk averse.

2. Determination of Objectives

The common objectives are stated below:

- Current income
 - Growth in income
- Capital appreciation
- Preservation of capital
The investor in general would like to achieve all the four objectives, nobody would like to
lose his investment. But, it is not possible to achieve all the four objectives simultaneously.
If the investor aims at capital appreciation, he should include risky securities where there is
an equal likelihood of losing the capital. Thus, there is a conflict among the objectives.

3. Portfolio Selection

Objectives and asset mix- If the main objective is getting adequate amount of current
income, sixty per cent of the investment is made on debts and 40 per cent on equities. The
proportions of investments on debt and equity differ according to the individual’s
preferences. Money is invested in short term debt and fixed income securities. Here the
growth of income becomes the secondary objective and stability of principal amount may
become the third. Even within the debt portfolio, the funds invested in short term bonds
depends on the need for stability of principal amount in comparison with the stability of
income. If the appreciation of capital is given third priority, instead of short term debt the
investor opts for long term debt. The period may not be a constraint.

Growth of income and asset mix- Here the investor requires a certain percentage of growth
in the income received from his investment. The investor’s portfolio may consist of 60 to
100 per cent equities and 0 to 40 per cent debt instrument. The debt portion of the portfolio
may consist of concession regarding tax exemption. Appreciation of principal amount is
given third priority. For example computer software, hardware and non-conventional energy
producing company shares provide good possibility of growth in dividend.

Capital appreciation and asset mix- Capital appreciation means that the value of the original
investment increases over the years. Investment in real estates like land and house may
provide a faster rate of capital appreciation but they lack liquidity. In the capital market, the
values of the shares are much higher than their original issue prices. For example Satyam
Computers, share value was Rs. 306 in April 1998 but in October 1999 the value was Rs.
1658. Likewise, several examples can be cited. The market capitalization also has increased.
Next to real assets, the stock markets provide best opportunity for capital appreciation. If
the investor’s objective is capital appreciation, 90 to 100 per cent of his portfolio may
consist of equities and 0-10% of debts. The growth of income becomes the secondary
objective.

Safety of principal and asset mix- Usually, the risk averse investors are very particular
about the stability of principal. According to the life cycle theory, people in the third stage of
life also give more importance to the safety of the principal. All the investors have this
objective in their mind. No one like to lose his money invested in different assets. But, the
degree may differ. The investor’s portfolio may consist more of debt instruments and within
the debt portfolio more would be on short term debts.

4. Risk and return analysis

The traditional approach to portfolio building has some basic assumptions. First, the
individual prefers larger to smaller returns from securities. To achieve this goal, the investor
has to take more risk. The ability to achieve higher returns is dependent upon his ability to
judge risk and his ability to take specific risks. The risks are namely interest rate risk,
purchasing power risk, financial risk and market risk. The investor analyses the varying
degrees of risk and constructs his portfolio. At first, he establishes the minimum income
that he must have to avoid hardships under most adverse economic condition and then he
decides risk of loss of income that can be tolerated. The investor makes a series of
compromises on risk and non-risk factors like taxation and marketability after he has
assessed the major risk categories, which he is trying to minimize. The methods of
calculating risk and return will be dealt later.

5. Diversification:

Once the asset mix is determined and the risk and return are analysed, the final step is the
diversification of portfolio. Financial risk can be minimised by commitments to top-quality
bonds, but these securities offer poor resistance to inflation. Stocks provide better inflation
protection than bonds but are more vulnerable to financial risks. Good quality convertibles
may balance the financial risk and purchasing power risk. According to the investor’s need
for income and risk tolerance level portfolio is diversified. In the bond portfolio, the
investor has to strike a balance between the short term and long term bonds. Short term
fixed income securities offer ore risk to income and long term fixed income securities offer
 more risk to principal. In the stock portfolio, he has to adopt the following steps which are
shown in the following figure.

5.2.2 Modern Approach

We have seen that the traditional approach is a comprehensive financial plan for the
individual. It takes into account the individual needs such as housing, life insurance and
pension plans. But these types of financial planning approaches are not done in the
Markowitz approach. Markowitz gives more attention to the process of selecting the
portfolio. His planning can be applied more in the selection of common stocks portfolio than
the bond portfolio. The stocks are not selected on the basis of need for income or
appreciation. But the selection is based on the risk and return analysis. Return includes the
market return and dividend. The investor needs return and it may be either in the form of
market return or dividend. They are assumed to be indifferent towards the form of return.
Among the list of stocks quoted at the Bombay Stock Exchange or at any other regional
stock exchange, the investor selects roughly some group of shares say of 10 or 15 stocks.
For these stocks’ expected return and risk would be calculated. The investor is assumed to
have the objective of maximising the expected return and minimising the risk. Further, it is
assumed that investors would take up risk in a situation when adequately rewarded for it.
This implies that individuals would prefer the portfolio of highest expected return for a given
level of risk.

In the modern approach, the final step is asset allocation process that is to choose the
portfolio that meets the requirement of the investor. The risk taker i.e. who are willing to
accept a higher probability of risk for getting the expected return would choose high risk
portfolio. Investor with lower tolerance for risk would choose low level risk portfolio. The
risk neutral investor would choose the medium level risk portfolio.

5.2.3 Markowitz Model/Theory

 In 1952, Henry Markowitz presented an essay on ‘Modern portfolio theory’ for which he
also received Noble prize in Economics. His findings greatly changed the asset
management industry, his theory is still considered as cutting-edge in portfolio
management.

There are two main concepts in this model:

1. Any investor’s goal is to maximize return for any level of risk.
2. Risk can be reduced by creating a diversified portfolio of unrelated assets.

Before the development of Markowitz theory, investors followed simple diversification

method.

- According to this, a portfolio consisting of securities of a large number will always bring a
superior return than a portfolio consisting of ten securities because the portfolio is ten
times more diversified.
- Some experts have suggested that diversification at random does not bring the expected
return results, diversification should therefore be related to industries which are not related
to each other.
- A person having 8 securities may reduce risk, but there wouldn’t be any lead to gain.
- Investor will also find it difficult to manage large number of assets, their taxability, liquidity
of each investment, returns, etc.
- Random diversification will not lead to superior profits unless it is scientifically predicted.

Assumptions of Markowitz theory

The market is efficient. All the investors do have first hand information on the stock
market and so an investor can continuously make superior returns either by
adopting fundamental analysis or technical analysis or both. Thus, all investors are
equal in category.
The common goal of all the investors is the avoidance of risk, because all are risk
averse.
All investors would like to earn the maximum return rate that they can achieve from
their investments.
Assets are combined in such a way that lowest risk is correlated with highest
returns.
 Investors base their decision on the expected rate of return.
The investor can reduce his risk, if he adds investment to his portfolio.
An investor should be able to get higher return for each level of risk, ‘by
determining the efficient set of securities’.

Markowitz frontier

Each dot represents a portfolio. Those closest to the Efficient frontier have the potential
to produce the greatest return with the lowest degree of risk. The red dotted line is the
Efficient frontier, which is the optimal combination of risk and return. Standard deviation
is plotted on the x axis and return on the y axis. Tangency portfolio is the point where
the portfolio of only risky assets meet the combination of risky and risk-free assets. This
portfolio maximizes return for the given level of risk.

Markowitz Model
Markowitz model determines the efficient set of portfolio through three important variables
  Return
 Standard deviation
 Coefficient of correlation
Through this method, the investor can, with the help of a computer, find out the efficient set
of portfolio by finding out the trade-off between risk and return. According to this theory,
the effects of one security purchase over the effects of the other security purchase are
taken into consideration and then the results are evaluated.

Example:

Security Expected return (R) Proportion

1 10 25
2 20 75

The return on the portfolio by combining the two securities will be

Rp =R1X1 +R2X2
Rp = 0.10 *0.25 + 0.20*0.75
= 17.5%

5.3 Return risk analysis – CAPM (Capital Asset Pricing Model)

Comparative Analysis of Risk and Return Models

 The Capital Asset Pricing Model (CAPM)

 APM
 Multifactor model
 Proxy models
 Accounting and debt-based models

CAPM :
What Is the Capital Asset Pricing Model?

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk
and expected return for assets, particularly stocks. CAPM is widely used throughout finance
for pricing risky securities and generating expected returns for assets given the risk of those
assets and cost of capital.

Calculation
The formula for calculating the expected return of an asset given its risk is as follows:

ERi = Rf + βi (ERm – Rf)

ERi - Expected return of investment

Rf - Risk free rate
βi - Beta of the investment
ERm - Expected return of market
(ERm – Rf) - Market risk

Investors expect to be compensated for risk and the time value of money. The risk-free
rate in the CAPM formula accounts for the time value of money. The other components of
the CAPM formula account for the investor taking on additional risk.

The beta of a potential investment is a measure of how much risk the investment will add
to a portfolio that looks like the market. If a stock is riskier than the market, it will have a
beta greater than one. If a stock has a beta of less than one, the formula assumes it will
reduce the risk of a portfolio.

A stock’s beta is then multiplied by the market risk premium, which is the return expected
from the market above the risk-free rate. The risk-free rate is then added to the product of
the stock’s beta and the market risk premium. The result should give an investor
the required return or discount rate they can use to find the value of an asset.

The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk
and the time value of money are compared to its expected return.

Example

Imagine an investor is contemplating a stock worth $100 per share today that pays a 3%
annual dividend. The stock has a beta compared to the market of 1.3, which means it is
riskier than a market portfolio. Also, assume that the risk-free rate is 3% and this investor
expects the market to rise in value by 8% per year.

The expected return of the stock based on the CAPM formula is 9.5%.

9.5% = 3% + 1.3(8.0% - 3%)

The expected return of the CAPM formula is used to discount the expected dividends and
capital appreciation of the stock over the expected holding period. If the discounted value of
those future cash flows is equal to $100 then the CAPM formula indicates the stock is fairly
valued relative to risk.

Relationship between CAPM and the Efficient Frontier

The graph shows how greater expected returns (y-axis) require greater expected risk (x-
axis). Modern Portfolio Theory suggests that starting with the risk-free rate, the expected
return of a portfolio increases as the risk increases. Any portfolio that fits on the Capital
Market Line (CML) is better than any possible portfolio to the right of that line, but at some
point, a theoretical portfolio can be constructed on the CML with the best return for the
amount of risk being taken.

Capital Asset Pricing Model (CAPM) Summary

The CAPM uses the principles of Modern Portfolio Theory to determine if a security is fairly
valued. It relies on assumptions about investor behaviors, risk and return distributions, and
market fundamentals that don’t match reality. However, the underlying concepts of CAPM
and the associated efficient frontier can help investors understand the relationship between
expected risk and reward as they make better decisions about adding securities to a
portfolio.

5.4 Portfolio Revision

5.4.1 What is Portfolio Revision ?

Portfolio Revision is The art of changing the mix of securities in a portfolio is called as
portfolio revision.

The process of addition of more assets in an existing portfolio or changing the ratio of funds
invested is called as portfolio revision.

The sale and purchase of assets in an existing portfolio over a certain period of time to
maximize returns and minimize risk is called as Portfolio revision.

5.4.2 Need for Portfolio Revision

An individual at certain point of time might feel the need to invest more. The need for
portfolio revision arises when an individual has some additional money to invest.

Change in investment goal also gives rise to revision in portfolio. Depending on the cash
flow, an individual can modify his financial goal, eventually giving rise to changes in the
portfolio i.e. portfolio revision.

Financial market is subject to risks and uncertainty. An individual might sell off some of his
assets owing to fluctuations in the financial market.

5.4.3 Portfolio Revision Strategies

There are two types of Portfolio Revision Strategies.

Active Revision Strategy

Active Revision Strategy involves frequent changes in an existing portfolio over a certain
period of time for maximum returns and minimum risks.
Active Revision Strategy helps a portfolio manager to sell and purchase securities on a
regular basis for portfolio revision.

Passive Revision Strategy

Passive Revision Strategy involves rare changes in portfolio only under certain
predetermined rules. These predefined rules are known as formula plans.
According to passive revision strategy a portfolio manager can bring changes in the portfolio
as per the formula plans only.
5.4.4 What are Formula Plans ?
Formula Plans are certain predefined rules and regulations deciding when and how much
assets an individual can purchase or sell for portfolio revision. Securities can be purchased
and sold only when there are changes or fluctuations in the financial market.

Why Formula Plans ?

Formula plans help an investor to make the best possible use of fluctuations in the financial
market. One can purchase shares when the prices are less and sell off when market prices
are higher.
With the help of Formula plans an investor can divide his funds into aggressive and
defensive portfolio and easily transfer funds from one portfolio to other.

Aggressive Portfolio
Aggressive Portfolio consists of funds that appreciate quickly and guarantee maximum
returns to the investor.

Defensive Portfolio
Defensive portfolio consists of securities that do not fluctuate much and remain constant
over a period of time.

Formula plans facilitate an investor to transfer funds from aggressive to defensive portfolio
and vice a versa.

Three Different Types of Formula Plans (Numerical Example)

1. Constant-Rupee-Value Plan:

The constant rupee value plan specifies that the rupee value of the stock portion of the
portfolio will remain constant. Thus, as the value of the stock rises, the investor must
automatically sell some of the shares in order to keep the value of his aggressive portfolio
constant.

If the price of the stock falls, the investor must buy additional stock to keep the value of
aggressive portfolio constant.

By specifying that the aggressive portfolio will remain constant in money value, the plan
also specifies that remainder of the total fund be invested in the conservative fund. The
constant-rupee-value plan’s major advantage is its simplicity. The investor can clearly see
the amount that he needed to have invested.

However, the percentage of his total fund that this constant amount will represent in the
aggressive portfolio will remain at different levels of his stock’s values, investor must choose
predetermined action points sometimes called revaluation points, action points are the
times at which the investor will make the transfers called for to keep the constant rupee
value of the stock portfolio.

Of course, the portfolio’s value cannot be continuously the same, since this would
necessitate constant attention by the investor, innumerable action points, and excessive
transaction costs. In fact, the portfolio will have to be allowed to fluctuate to some extent
before action taken to readjust its value.
The action points may be sent according to prespecified periods of time, percentage
changes in some economic or market index, or – mostly ideally – percentage changes in the
value of the aggressive portfolio.
The timing of action points can have an important effect on the profits the investor obtains.
Action points placed dose together cause excessive costs that reduce profits.
If the action points are too far apart, however, the investor may completely miss the
opportunity to profit from fluctuations that take place between them. An example will help
to clarify the implementation of formula plans. We will use fractional shares and ignore
transaction costs to simplify the example.
Numerical Example:
To illustrate the constant rupee value plan, suppose an investor has Rs. 10,000 to invest.
The investor decides to begin the plan with balanced portions (Rs.5,000 aggressive,
Rs.5,000 defensive) and to rebalance the portfolio whenever the aggressive portion is 20
per cent above or below Rs.5,000.

On hundred shares of a Rs.50 each stock and Rs.5,000 in bonds are purchased. The first
column of Table-1 shows stock prices during one cycle of fluctuation below and back up to
the original price of Rs.50. The fifth column shows the adjustments called for by the 20 per
cent signal criterion.

The fourth column shows that by the end of the cycle the investor increased the total fund
from Rs.10,000 to Rs.10,209 even though starting and finishing prices were the same and
the stock never rose above the Rs.50 starting price.

Main limitation of the constant rupee value plan is that it requires some initial forecasting.
However, it does not require forecasting the extent to which upward fluctuations may reach.
In fact, a forecast of the extent of downward fluctuations is necessary since the
conservative portfolio must be large enough so that funds are always available for transfer
to the stock portfolio as its value shrinks. This step requires knowledge of how stock prices
might go.

Then the required size of the conservative portfolio can be determined if the investor can
start his constant rupee fund when the stocks he is acquiring are not priced too far above
the lowest values to which they might fluctuate, he can obtain better overall results from a
constant- rupee- value plan.

2. Constant Ratio Plan:

The constant ratio plan goes one step beyond the constant rupee plan by establishing a
fixed percentage relationship between the aggressive and defensive components. Under
both plans the portfolio is forced to sell stocks as their prices rise and to buy stocks as their
prices fall.
Under the constant ratio plan, however, both the aggressive and defensive portions remain
in constant percentage of the portfolio’s total value. The problem posed by re- balancing
may mean missing intermediate price movements.

The constant ratio plan holder can adjust portfolio balance either at fixed) intervals or when
the portfolio moves away from the desired ratio by a fixed percentage.

Numerical Example:
The chosen ratio of stock to bonds is 1:1 meaning that the defensive and aggressive
portions will each make 50 per cent of the portfolio.
Therefore, we divide the initial Rs.10,000 equally into stock and bond portions. When the
stock portion rises or falls by 10 per cent from the desired ratio, the original ratio is
restored.

The sixth column indicates the four adjustments required to restore the 50:50 balances.
Even though stock price dropped considerably before rising back to the starting level, this
portfolio still made a little bit of money.

The advantage of the constant ratio plan is the automatism with which it forces the
manager to adjust counter cyclically his portfolio. This approach does not eliminate the
necessary of selecting individual securities, nor does it perform well if the prices of the
selected securities do not move with the market.

The major limitation for the constant ratio plan, however, is the use of bonds as a haven
stocks and bonds are money and capital market instruments, they tend to respond to the
same interest rate considerations in the present discounted evaluation framework.
This means, at times, they may both rise and decline in value at approximately the same
time. There is a limited advantage to be gained from shifting out of the rising stocks into the
bonds if, in the downturn, both securities prices decline.

If the decline in bond prices is of the same magnitude as those in stock prices, most, if not
all, of the gains from the constant ratio plan are eliminated. If the constant ratio plan is
used, it must be coordinated between securities that do not tend to move simultaneously in
the same direction and in the same magnitude.

3. Variable Ratio Plan:

Instead of maintaining a constant rupee amount in stocks or a constant ratio of stocks to

bonds, the variable ratio plan user steadily lowers the aggressive portion of the total
portfolio as stock prices rise, and steadily increase the aggressive portion as stock prices
fall.

By changing the proportions of defensive aggressive holdings, the investor is in effect

buying stock more aggressively as stock prices fall and selling stock more aggressively as
stock prices rise,

Numerical Example:
It illustrates another variable ratio plan. Starting price is Rs.50 per share. The portfolio is
divided into two equal portions as before, with Rs.5,000 in each portion. As the market price
drops, the value of the stock portion and the percentage of stock in the total portfolio
decline.

When the market price reaches Rs.50, a portfolio adjustment is triggered. The purchase of
57.5 shares raises the stock percentage to 70. As the stock price rises, the value of the
stock portion increases until a new portfolio adjustment is triggered. The sale of 51.76
shares reduced the percentage of stock in the portfolio back to 50.

In the example, the portfolio was adjusted for a 20 per cent drop and when the price
returned to Rs.50. Other adjustment criteria would produce different outcomes. The highest
under this plan results from the larger transactions in the portfolio’s stock portion.
 The portfolio adjustment section of (sixth column) may be compared with the same
columns. The variable ratio plan subjects the investor to more risk than the constant ratio
plan does. But with accurate forecasts the variable ratio plan designed to take greater
advantage of price fluctuations than the constant ratio plan does.

5.5 Portfolio Evaluation

The objective of modern portfolio theory is maximization of return or minimization of

risk. In this context the research studies have tried to evolve a composite index to
measure risk based return. The credit for evaluating the systematic, unsystematic and
residual risk goes to Sharpe, Treynor and Jensen.

The portfolio performance evaluation can be made based on the following methods:

Sharpe’s Measure
Treynor’s Measure
Jensen’s Measure

1. Sharpe’s Measure

Sharpe’s Index measure total risk by calculating standard deviation. The method
adopted by Sharpe is to rank all portfolios on the basis of evaluation measure. Reward
is in the numerator as risk premium. Total risk is in the denominator as standard
deviation of its return. We will get a measure of portfolio’s total risk and variability of
return in relation to the risk premium. The measure of a portfolio can be done by the
following formula:

SI =(Rt – Rf)/σf

Where,

 SI = Sharpe’s Index
 Rt = Average return on portfolio
 Rf = Risk free return
 σf = Standard deviation of the portfolio return.

2. Treynor’s Measure

The Treynor’s measure related a portfolio’s excess return to non-diversifiable or

systematic risk. The Treynor’s measure employs beta. The Treynor based his formula
on the concept of characteristic line. It is the risk measure of standard deviation,
namely the total risk of the portfolio is replaced by beta. The equation can be presented
as follow:

Tn =(Rn – Rf)/βm

Where,
 Tn = Treynor’s measure of performance
 Rn = Return on the portfolio
 Rf = Risk free rate of return
 βm = Beta of the portfolio ( A measure of systematic risk)

3. Jensen’s Measure

Jensen attempts to construct a measure of absolute performance on a risk adjusted

basis. This measure is based on Capital Asset Pricing Model (CAPM) model. It measures
the portfolio manager’s predictive ability to achieve higher return than expected for the
accepted riskiness. The ability to earn returns through successful prediction of security
prices on a standard measurement. The Jensen measure of the performance of portfolio
can be calculated by applying the following formula:

Rp = Rf + (RMI – Rf) x β

Where,

 Rp = Return on portfolio
 RMI = Return on market index
 Rf = Risk free rate of return

5.6 Mutual Funds

What Is a Mutual Fund?

A mutual fund is a type of financial vehicle made up of a pool of money collected from many
investors to invest in securities like stocks, bonds, money market instruments, and other
assets. Mutual funds are operated by professional money managers, who allocate the fund's
assets and attempt to produce capital gains or income for the fund's investors. A mutual
fund's portfolio is structured and maintained to match the investment objectives stated in
its prospectus.

Mutual funds give small or individual investors access to professionally managed portfolios
of equities, bonds and other securities. Each shareholder, therefore, participates
proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of
securities, and performance is usually tracked as the change in the total market cap of the
fund—derived by the aggregating performance of the underlying investments.

How Mutual Funds Work

A mutual fund is both an investment and an actual company. This dual nature may seem
strange, but it is no different from how a share of AAPL is a representation of Apple Inc.
When an investor buys Apple stock, he is buying partial ownership of the company and its
assets. Similarly, a mutual fund investor is buying partial ownership of the mutual fund
company and its assets. The difference is that Apple is in the business of making
smartphones and tablets, while a mutual fund company is in the business of making
investments.
Investors typically earn a return from a mutual fund in three ways:

1. Income is earned from dividends on stocks and interest on bonds held in the fund’s
portfolio. A fund pays out nearly all of the income it receives over the year to fund
owners in the form of a distribution. Funds often give investors a choice either to
receive a check for distributions or to reinvest the earnings and get more shares.
2. If the fund sells securities that have increased in price, the fund has a capital gain.
Most funds also pass on these gains to investors in a distribution.
3. If fund holdings increase in price but are not sold by the fund manager, the fund's
shares increase in price. You can then sell your mutual fund shares for a profit in the
market.

Types of mutual funds

Equity Funds
The largest category is that of equity or stock funds. As the name implies, this sort of fund
invests principally in stocks. Within this group are various sub-categories. Some equity
funds are named for the size of the companies they invest in: small-, mid- or large-cap.
Others are named by their investment approach: aggressive growth, income-oriented,
value, and others. Equity funds are also categorized by whether they invest in domestic
(U.S.) stocks or foreign equities. There are so many different types of equity funds because
there are many different types of equities.

Fixed-Income Funds
Another big group is the fixed income category. A fixed income mutual fund focuses on
investments that pay a set rate of return, such as government bonds, corporate bonds, or
other debt instruments. The idea is that the fund portfolio generates interest income, which
then passes on to shareholders.

Index Funds
Another group, which has become extremely popular in the last few years, falls under the
moniker "index funds." Their investment strategy is based on the belief that it is very hard,
and often expensive, to try to beat the market consistently. So, the index fund manager
buys stocks that correspond with a major market index such as the S&P 500 or the Dow
Jones Industrial Average (DJIA). This strategy requires less research from analysts and
advisors, so there are fewer expenses to eat up returns before they are passed on to
shareholders. These funds are often designed with cost-sensitive investors in mind.

Balanced Funds
Balanced funds invest in both stocks and bonds to reduce the risk of exposure to one asset
class or another. Another name for this type of mutual fund is "asset allocation fund." An
investor may expect to find the allocation of these funds among asset classes relatively
unchanging, though it will differ among funds. This fund's goal is asset appreciation with
lower risk. However, these funds carry the same risk and can be as subject to fluctuation as
other classifications of funds.

Money Market Funds

The money market consists of safe (risk-free), short-term debt instruments, mostly
government Treasury bills. This is a safe place to park your money. You won't get
substantial returns, but you won't have to worry about losing your principal. A typical return
is a little more than the amount you would earn in a regular checking or savings account
and a little less than the average certificate of deposit (CD). While money market funds
invest in ultra-safe assets, during the 2008 financial crisis, some money market funds did
experience losses after the share price of these funds, typically pegged at $1, fell below that
level and broke the buck.

Income Funds
Income funds are named for their purpose: to provide current income on a steady basis.
These funds invest primarily in government and high-quality corporate debt, holding these
bonds until maturity in order to provide interest streams. While fund holdings may
appreciate in value, the primary objective of these funds is to provide steady cash flow to
investors. As such, the audience for these funds consists of conservative investors and
retirees. Because they produce regular income, tax-conscious investors may want to avoid
these funds

International/Global Funds
An international fund (or foreign fund) invests only in assets located outside your home
country. Global funds, meanwhile, can invest anywhere around the world, including within
your home country. It's tough to classify these funds as either riskier or safer than domestic
investments, but they have tended to be more volatile and have unique country and political
risks. On the flip side, they can, as part of a well-balanced portfolio, actually reduce risk by
increasing diversification, since the returns in foreign countries may be uncorrelated with
returns at home. Although the world's economies are becoming more interrelated, it is still
likely that another economy somewhere is outperforming the economy of your home
country.

Specialty Funds
This classification of mutual funds is more of an all-encompassing category that consists of
funds that have proved to be popular but don't necessarily belong to the more rigid
categories we've described so far. These types of mutual funds forgo broad diversification to
concentrate on a certain segment of the economy or a targeted strategy. Sector funds are
targeted strategy funds aimed at specific sectors of the economy such as financial,
technology, health, and so on. Sector funds can, therefore, be extremely volatile since the
stocks in a given sector tend to be highly correlated with each other. There is a greater
possibility for large gains, but also a sector may collapse (for example, the financial
sector in 2008 and 2009).