What is a Mutual Fund ?

A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. These investors may be retail or institutional in nature.

Mutual funds have advantages and disadvantages compared to direct investing in individual securities. The primary advantages of mutual funds are that they provide economies of scale, a higher level of diversification, they provide liquidity, and they are managed by professional investors. On the negative side, investors in a mutual fund must pay various fees and expenses.

Primary structures of mutual funds include open-end funds, unit investment trusts, and closed-end funds. Exchange-traded funds (ETFs) are open-end funds or unit investment trusts that trade on an exchange. Mutual funds are also classified by their principal investments as money market funds, bond or fixed income funds, stock or equity funds, hybrid funds or other. Funds may also be categorized as index funds, which are passively managed funds that match the performance of an index, or actively managed funds. Hedge funds are not mutual funds; hedge funds cannot be sold to the general public and are subject to different government regulations.

Mutual funds have advantages and disadvantages compared to investing directly in individual securities:

Advantages

Increased diversification: A fund diversifies holding many securities. This diversification decreases risk.
Daily liquidity: Shareholders of open-end funds and unit investment trusts may sell their holdings back to the fund at regular intervals at a price equal to the net asset value of the fund’s holdings. Most funds allow investors to redeem in this way at the close of every trading day.

Professional investment management: Open-and closed-end funds hire portfolio managers to supervise the fund’s investments.
Ability to participate in investments that may be available only to larger investors. For example, individual investors often find it difficult to invest directly in foreign markets.

Service and convenience: Funds often provide services such as check writing.
Government oversight: Mutual funds are regulated by a governmental body.
Transparency and ease of comparison: All mutual funds are required to report the same information to investors, which makes them easier to compare to each other.

Disadvantages

Mutual funds have disadvantages as well, which include:

  • Fees
  • Less control over timing of recognition of gains
  • Less predictable income
  • No opportunity to customize

Companies that create mutual fund schemes are called Fund Houses or Asset Management Companies (AMCs). The professionals who study the markets and pick companies to invest in are called Fund Managers. Fund managers spend a great deal of time analysing markets and studying different sectors of the economy to figure out which companies are most likely to turn a profit – in different time frames – and choose the best option.

There are thousands of mutual funds in India, under different categories, offered by hundreds of AMCs and Fund Houses. For fairness and transparency, global agencies exist that analyse and rate the performance of funds over time and make sure that investors are well informed before investing. It is mandatory for AMCs to declare a standard against which the performance of any given fund can be measured – this is called a benchmark. There are also regulatory bodies like AMFI and SEBI that ensure no investor ever gets scammed.

Mutual funds allow individuals to make their money work for them – meaning that they do not need to actively perform tasks for monetary gain. Any amount invested in mutual funds will either grow or shrink depending on market performance and the skill of the fund manager.

There are many different types of mutual funds available today, and can be categorised based on investment objective, structure and asset class. Apart from this, there are also specialised mutual funds

Types of mutual funds based on asset class:

Equity Funds:  The primary focus of equity funds is to invest at least 65% of the total corpus into equity (stocks) and equity related instruments of different companies. Stock market fluctuations affect the performance of these holdings and determine whether they make a profit or not – as such, equity funds are slightly riskier than other types of funds.

Diversification of the corpus between companies operating in different sectors of the economy and hands-on expert management serve to mitigate most of the risks involved.Equity funds are further sub-categorised based on the investment strategy (Value, dividend yield, focussed), whether the fund is managed actively or passively (Active/Index), the level of market capitalisation (small-cap, mid-cap, large-cap), or whether it’s a Sector or a Thematic Fund (that only invests in a particular sector like pharmaceuticals or petroleum or a theme such as services, healthcare, etc.).

Equity funds are recommended to those willing to wait at least 5 years to see substantial returns, and who don’t mind the inherent risk involved with equity investments. These funds operate at a higher risk, with the possibility of a greater reward. 

  Debt Funds: The primary focus of debt mutual funds is to invest a majority of its corpus into fixed-income investments, such as treasury bills, money market instruments, corporate bonds and debentures, commercial papers, gilt,, government securities, and other debt securities. Debt funds are further sub-categorised based on how long their holdings will take to reach maturity (for example short-term debt funds, ultra-short-term debt funds, liquid funds, dynamic bond funds), instruments where they can invest (corporate bond funds, gilt funds, credit risk funds, banking and PSU funds, money market funds) Debt funds are recommended for those who don’t want to risk their capital for a chance to earn returns higher than bank deposits, but who’d rather invest their capital in order to earn a smaller, relatively stable returns with greater liquidity.   Hybrid Funds: The primary focus of hybrid funds is to invest in a portfolio as balanced as it is diverse, by channeling investments proportionally into equity and debt instruments. This is done in order to create long-term capital appreciation at lower risk/ with lower volatility. Hybrid funds can be of two major types – aggressive hybrid funds and conservative hybrid funds. An aggressive hybrid fund is an equity-oriented mutual fund will have 65%-80% of its corpus invested in stocks, shares, etc. and the remaining invested in debt instruments or money market instruments. A conservative hybrid fund is a debt-oriented mutual fund which will have 75%-90% of its corpus invested in debt instruments and the remainder in stocks, shares and other equity instruments. Hybrid funds also allow for a degree of liquidity, and divert part of the corpus into cash and cash-equivalent investments. Hybrid funds bridge the gap between long-term capital appreciation and short-term income requirements of investors. As such, they are popular among new investors and experienced conservative investors alike.    How do mutual funds work? Different types of mutual funds operate slightly differently from one another, but they all have some basic principles on which they operate that define them as mutual funds. The most basic way in which mutual funds operate is explained below: 1. An asset management company (AMC)/fund house identifies a potential earning possibility in the market and calculates the risk and potential reward involved in this particular investment. 2. The AMC studies other related investment opportunities that could boost the value of – or ensure the success of – the main opportunity. 3. The fund manager working for the AMC picks and chooses different investments in order to balance out the risk and total earning potential – balancing the right high risk-high reward equities with high safety-relatively consistent income securities. 4. All the details about the fund including risk factors are well documented and presented to the industry body SEBI for regulatory approval and to the public for consideration. 5. The fund scheme is made available to the public, who then buy into the fund by purchasing fund units. The more fund units are purchased, the larger the investment, and thus the greater the proportion of potential income. 6. The investments are made and, depending on the fund’s structure, the fund will either be passively or actively managed by a fund manager. 7. Under the dividend option, declared dividends are proportionally distributed amongst investors. Under the growth option, dividends are reinvested for capital appreciation. 8. At the end of the fund’s tenure, capital gains are paid out to the investors.   Now let’s understand basic mutual fund operation with an example: Let’s say that there’s a huge national demand for 50 lakh units of bottled water per month, but the water bottling plant can only produce 1 lakh units per month. Suppose that the bottling plant can meet this demand if it has a new bottling machine – it can earn a massive profit from supplying the demand. Unfortunately, the bottling plant does not have the funds to purchase this new machine – so it seeks investment. This is an opportunity for a win-win situation for any investor who has enough wealth to help the bottling plant purchase the machine. In most cases, individual investors won’t have the requisite funds to purchase large machinery, so, a few investors get together and pool their funds to buy the machine, and will split all profits equally amongst themselves, or in proportion of the amount they’ve invested. Once the machine has been purchased, the investors must wait for the bottling plant to integrate the new technology and start producing enough units to meet the demand. Now that the bottling plant has met the demand of 50 lakh bottles per month – which is a 50x increase in supply – it will obviously be earning a lot more income for the sale of its product. Since the expansion of this bottling plant was enabled by the purchase of a machine, which was enabled by the foresight of certain investors – the investors will get to claim a share of the new profits enjoyed by the bottling company. This basically explains how an investment helps a company grow, but mutual funds take it a step further. Mutual funds don’t just invest in one or two companies, but in hundreds of companies across different sectors of the economy. In addition to the bottling plant, the same mutual fund scheme may have invested in a transportation company, enabling quicker movement of bottled water from the factory to the distribution centres. In addition to the transportation company, the same mutual fund scheme could also have invested in an advertising agency that promotes the sale of this particular brand of bottled water – ensuring smooth sales from distribution centre to end customer. In this way, a mutual fund takes care of most aspects of its investment and tries to ensure its success. Now since it’s a mutual fund, it can have two options by which investors can enjoy their profits – growth or dividend. Under the growth option, all earnings made by the fund are reinvested in the fund itself, and the capital invested is allowed to grow until the tenure of the investment is completed or the investor chooses to redeem the investment. Under the dividend option, the bottling plant will declare income, and dividends will be distributed amongst the investors. Now, suppose that the demand for water suddenly dropped from 50 lakh units to 10 lakh units, but the machine had already been purchased and is now running on lower capacity, or the machine purchased was faulty, or there’s a labour strike preventing water from being bottled – the profits generated will not be as high as expected, and returns for investors will be low, and investors could also lose money. This is called a risk factor, and is one of the major defining characteristics of any mutual fund scheme. Risk must be thoroughly studied in order to mitigate it, and even then, great care must be taken to invest the right amount at the right time in the right place. This is basically how a mutual fund works – large amounts of money are pooled together to invest in companies/ government instruments that can generate a profit as a result of increased capacity, capability, etc. enabled by investments.  

Should I invest in mutual funds?

Mutual fund investments are for anyone who wishes to be richer than they currently are – through smart investments.
Investors can begin with as little as Rs.1,000 to invest in really good mutual fund schemes, depending on their goals. Funds selected could vary in terms of time available to reach goals (short, medium, or long term), amount of funds ready to invest, amount expected at the end of the investment tenure, amount of risk the investor is prepared to undertake, type of industry diversification required, type of asset class desired. There are also funds called Equity Linked Savings Schemes or ELSS that allow investors to claim tax deductions under Section 80C of the Income Tax Act, 1961.
Mutual fund investments allow for wealth creation while offering several benefits of diversification, professional management, low cost, etc.
There are many different types of investors, some who like to take risks for the possibility of earning high returns, some who don’t like taking too many risks but wouldn’t mind mid-sized returns, and some who prefer little or no risk and only wish to earn relatively stable, but higher than bank interest from their investments. Whatever the type of investor, there are thousands of mutual funds out there to choose from.
Investing in mutual funds is no longer the ‘new’ way to get rich, it’s a tried and tested method with standard practices that have helped millions of people around the world meet their financial goals.
Funds can be held for the short-term, medium-term, or long-term. Investors can stay invested for as long as they like, although data has proved that staying invested for the long-term schemes minimises the chance of losses and can provide the greatest overall earnings thanks to the power of compounding! Small and medium term investments can help you meet short and medium term goals as well. 

 

 How to invest in mutual funds?

Once you’ve decided to invest in a mutual fund, you must decide which fund to invest in, and this is the most time-consuming part of the process.
Below is a step by step guide on how to choose the best fund for you:

1. Investment Goals:
Fully define your investment and financial goals – “I would like to have earned Rs.x in ‘x’ number of years. I can take ‘x’ degree of risk”

2. Risk Factor:
Understand how much risk you’re willing to take in order to reach your financial goals – understanding this is the key to choosing which type of mutual fund you will eventually invest in. High risk investments have the potential to provide the highest returns, but also come with the possibility that the invested capital could be lost. Medium risk investments will try their best not to lose the invested capital, but in doing so will reduce the amount of funds available to invest in growth-generating investments (which are risky by nature). Low risk investments will expose the capital to the lowest amount of risk possible. Understanding one’s risk appetite is vital to being investing correctly, and is called risk profiling.

3. Asset Allocation:
After discovering your risk profile and narrowing down your potential investments, you must decide which asset classes you wish to invest in.Stocks and shares of companies are the first and most popular asset class among risk takers – also called equity – investments in this asset class usually carries a greater amount of risk and also the potential for higher earnings. The second asset class is fixed-income securities or bonds, and is the most popular among risk-averse investors who prioritize the safety of their investments. These assets provide regular income and capital safety. The third asset class is money market instruments or cash equivalents which provide liquidity and a certain degree of safety. The fourth main asset class consists of commodities and real estate. A mutual fund will invest in all these asset classes proportionally, in order to provide safety as well as maximise growth potential.

4. Picking the right AMC:
Choosing the right asset management company (AMC)/fund house/bank/etc. can be as important as picking the right fund. Make sure that the company through which you’ve chosen to invest has a proven track record and has a roster of qualified and experience fund managers – this will ensure that your money is handled by capable professionals who have faced different market conditions in the past and can actively manage your fund and keep it away from danger. The right AMC will also have a large ‘family of funds’ to choose from, or to shift between, depending on the performance of your invested fund.

5. Picking the right fund:
Picking the right fund is a combination of understanding your investment goals, risk profile, asset allocation, and total investable corpus – and matching those to mutual fund schemes (among thousands available) which has the ability to provide returns in line with your goals. This is the most time consuming, but most rewarding part of the process, as you will learn about different funds and the different unique features that some of them offer. Once you’ve narrowed it down, you can also check how it’s performed against its benchmark and how consistently it has performed, before putting your hard earned money in it. will have to match the funds against a benchmark to see how they have performed in the last 5 to 10 years, and take historical performance into account as well.

6. Approaching the AMC/Fund House/Bank:
Once you’ve decided the fund you want, all you have to do is approach the AMC/bank,fund house offering the fund and purchase fund units in exchange for money.

Alternatively, you could invest online through a  fast, and secure platform like SRI HARI ASSOCIATES.