Agents selling Mutual Funds often use terminology that investors find complicated to understand. Steering away from complicated terms, we are explaining the basics of mutual funds - how they work, and how best they can serve as an investment tool. So whether you are planning for your home, education of your children or marriage, your car or holidays, Mutual funds are excellent tools to support you, which are uncomplicated, tax efficient and effective to invest for these goals. Additionally, Mutual funds offer a wide bouquet of investment options – equity schemes, fixed income schemes, money market schemes, hybrid schemes, ETFs etc. which you can choose as per your requirements.
What is a Mutual Fund?
A mutual fund is a professionally-managed trust that pools the funds of many investors and invests them in securities like stocks, bonds, short-term money market instruments and commodities such as precious metals. Investors in mutual funds have a common financial goal and their money is invested in different asset classes in accordance with the fund’s investment objective. Investments in mutual funds entail comparatively small amounts, giving retail investors the advantage of having finance professionals control their money even if it is a few thousand rupees.
Mutual funds are pooled investments managed either by professional fund managers or passively tracked by an index or an industry. The funds are generally well diversified to counterbalance potential losses. Mutual funds offer an attractive way for savings to be managed in a passive manner without paying high fees or requiring constant attention from individual investors. These funds present an option for investors who lack the time or knowledge to make traditional and complex investment decisions. By putting your money in a mutual fund, you authorize the portfolio manager to make those crucial decisions for you.
How is a mutual fund set up?
A mutual fund is set up in the form of a trust that has Asset Management Companies (AMCs), trustees, sponsors, etc. The trust is established by sponsors who are like a promoter of a company and the said Trust is registered with the Securities and Exchange Board of India (SEBI) as a Mutual Fund. A Trustee of the mutual fund holds its property for the advantage of unitholders. An AMC (Asset Management Company) approved by SEBI manages the fund by making investments in different types of securities.
The trustees are vested with the common power of superintendence & direction over the AMC. They administer the performance and compliance of SEBI system by the mutual fund.
How does a mutual fund operate?
Mutual fund company pools in money from numerous investors, and invests it in different options like stocks, bonds, etc. This fund is managed by professionals who are aware of the market well and try to achieve growth by making strategic investments. Investors avail units of the mutual fund according to the amount they have invested. The AMC (Asset Management Company) is responsible for managing the investments for the various schemes operated by the mutual fund. It also undertakes activities such as advisory services, financial consulting, and customer services, accounting, marketing and sales functions for the schemes of the mutual fund.
What is Net Asset Value?
Net Asset Value (NAV) is the total asset value per unit of the fund and it is calculated by the AMCs. In order to calculate the NAV of a mutual fund, you need to take the current market value of the fund's assets minus the liabilities, if any and divide it by the number of shares outstanding. NAV is calculated as follows:
For instance, if the market value of securities of a Mutual Fund scheme is Rs. 500 lakhs and the Mutual Fund has issued 10 lakh units of Rs. 10 each to investors, then the NAV per unit of the fund is Rs 50.
What are the different types of mutual fund schemes?
Based on the maturity period
(1) Open-ended Fund
An open-ended fund is a type of mutual fund that is available for a subscription & can be redeemed on a continuous basis. It is accessible for subscription all through the year and investors can buy and sell units at NAV related prices. These funds do not have a fixed maturity date. The key feature of an open-ended mutual fund is liquidity.
(2) Close-ended Fund
a close-ended fund is that type of mutual fund that has a defined maturity period, for example, 3-6 years. These funds are open for subscription for a particular period at the time of initial launch. These funds are listed on a renowned stock exchange.
Based on investment objectives
(1) Equity/Growth Funds
Equity/Growth funds invest a major part of its corpus in stocks and the investment objective of these funds is long-term capital growth. When you buy shares of an equity mutual fund, you effectively become a part owner of each of the securities in your fund’s portfolio. Equity funds invest minimum of 65% of its corpus in equity and equity-related securities. These funds may invest in a wide range of industries or focus on one or more industry sectors. These types of funds are appropriate for investors with a long-term outlook & higher risk appetite.
(2) Debt/Income Funds
Debt/ Income funds generally invest in securities such as bonds, corporate debentures, government securities (gilts) and money market instruments. These funds invest minimum of 65% of its corpus in fixed income securities. These funds invest in debt which provides low risk and stable income to investors with preservation of capital. These funds tend to be less volatile than equity funds and produce regular income. These funds are suitable for investors whose main objective is the safety of capital with moderate growth.
(3) Balanced Funds
Balanced funds do investment in both equities and fixed income instruments in line with the pre-determined investment objective of the scheme. These funds provide both firmnesses of returns and capital appreciation to investors. These funds with an equal portion of equities and fixed income securities are ideal for investors looking for a combination of income and moderate growth. They generally have an investment pattern of investing around 60% in Equity and 40% in Debt instruments.
(4) Money Market or Liquid Funds
Money market or Liquid funds invest in safer short-term instruments such as Treasury Bills, Certificates of Deposit and Commercial Paper for a period of fewer than 91 days. The aim of Money Market /Liquid Funds is to provide easy liquidity, preservation of capital and moderate income. These funds are perfect for corporate and individual investors looking for moderate returns on their surplus funds.
(5) Gilt Funds
Gilt funds invest exclusively in government securities. Although these funds carry no credit risk, they are associated with interest rate risk. These funds are safer as they invest in government securities.
Some of the common types of mutual funds and what they typically invest in:
Type of Fund
Equity or Growth Fund
Equities like stocks
Fixed Income Fund
Fixed income securities like government and corporate bonds
Money Market Fund
Short-term fixed income securities like treasury bills
A mix of equities and fixed income securities
Sectors like IT, Pharma, Auto, etc.
Equities or Fixed income securities are chosen to replicate a specific Index, for example, S&P CNX Nifty
Fund of funds
Other mutual funds
(1) Tax-Saving ELSS (Equity Linked Savings Schemes) Funds
Tax-saving scheme ELSS offer tax rebates to investors under particular provisions of the Income Tax Act, 1961. These are growth-oriented mutual fund schemes and invest mainly in equities. Like an equity scheme, they mainly suit investors having a higher risk appetite and aim to create capital appreciation over the medium to long term.
(2) Index Funds
Index schemes replicate the performance of a particular index such as the BSE Sensex or the S&P CNX Nifty. The portfolio of index mutual fund schemes comprise only those stocks that represent the index and the weightage assigned to each stock is aligned to the stock’s weightage in the index. Hence, the returns from these funds are more or less similar to those generated by the Index.
(3) Sector-specific Funds or sectoral funds
Sectoral funds invest in the securities of only those sectors or industries as specified in the Scheme Information Document. The returns in these funds depend upon the performance of the respective sector/industries, for example, FMCG, Pharma, IT, etc. These funds enable investors to diversify holdings among many companies within an industry. Sectoral funds are considered riskier as their performance is reliant on particular sectors although this also results in higher returns generated by these funds.
What are the benefits of investing in a mutual fund?
when you make an investment in a mutual fund, your fund is managed by finance professionals. Investors who do not have the skill or time to manage their own portfolio can go for mutual funds. By investing in mutual funds, you can get the services of professional fund managers, which would otherwise be expensive for an individual investor.
Mutual funds offer the benefit of diversification across diverse sectors and companies. Mutual funds extend investments across various industries and asset classes. Thus, by making investments in a mutual fund, you can gain from the benefits of diversification and asset allocation, without investing a large amount of money that would be required to build an individual portfolio.
Mutual funds are usually very liquid investments. Unless they have a pre-specified lock-in period, your money is available to you anytime you want subject to exit load if any. Normally funds take a couple of days for returning your money to you. Since they are well integrated with the banking system, most funds can transfer the money directly to your bank account.
Investors can get benefits of the ease and flexibility offered by mutual funds to invest in a wide range of schemes. The option of systematic investment and withdrawal is also offered to investors in most open-ended schemes. Depending on the individual’s inclinations & convenience you can invest or withdraw funds.
Low transaction cost
Due to economies of scale, mutual funds pay lower transaction costs. The benefits are passed on to mutual fund investors, which might not be enjoyed by an individual who enters the market directly.
A mutual fund offers investors with updated information pertaining to the markets and schemes through factsheets, offer documents, annual reports, etc.
Mutual funds in India are regulated and monitored by the Securities and Exchange Board of India (SEBI), which endeavors to protect the interests of investors. All Mutual funds are registered with SEBI & complete transparency is imposed. Mutual funds are required to provide investors with standard information about their investments, in addition to other disclosures like specific investments made by the scheme and the quantity of investment in each asset class.
What are the risks involved in investing in mutual funds?
Mutual funds invest in diverse securities like stocks or fixed income securities, which depends on the fund’s objectives. As a result, different schemes have different risks depending on the underlying portfolio. The value of an investment may turn down over a period of time because of economic alterations or other events that influence the overall market. Also, the government may implement new regulations, which may distress a particular industry or class of industries. All these factors affect the performance of Mutual Funds.
Risk & Rewards: The diversification that mutual funds provide can help ease risk by offsetting losses from some securities with gains in other securities. On the other hand, this could limit the upside potential that is provided by holding single security.
Lack of Control: Investors cannot determine the exact composition of a fund’s portfolio at any given time, nor can they directly influence which securities the fund manager buys.
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