What are Mutual Funds: A Comprehensive Guide

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What are Mutual Funds?

To understand “what are mutual funds” and what constitutes a mutual fund unit, let’s start with an example. To grasp the concept of a mutual fund unit, imagine a group of 4 friends wanting to buy a box of 12 chocolates costing ₹40. Each friend has only ₹10, so they pool their money to buy the box. Each friend gets 3 chocolates or 3 units based on their contribution, analogous to mutual fund units. 

The cost per unit is calculated by dividing the total amount by the total number of chocolates, which is 40/12 = 3.33. Thus, each friend is a unit holder in the box of chocolates, making them part-owners of the box.

What is Net Asset Value (NAV)?

Just like an equity share has a traded price, a mutual fund unit has a Net Asset Value (NAV). The NAV is the combined market value of the shares, bonds, and securities held by a fund on any given day, minus permitted expenses and charges. 

NAV=Total Assets−Total Liabilities / Number of Outstanding Shares

Here’s what each part means:

• Total Assets: All the investments the fund owns, like stocks, bonds, and cash.
• Total Liabilities: All the money the fund owes, including fees and expenses.
• Number of Outstanding Shares: The total number of shares held by investors.

Advantages of Investing in Mutual Funds

If you understand what mutual funds are you will know that it is also ideal for those investors who lack large sums for investment or don’t have the time to research the market, but still want to grow their wealth. 

Here are the advantages of investing in mutual funds:

• Diversification: Mutual funds spread your investment across various assets, reducing the risk of any one investment losing value. This is like not putting all your eggs in one basket. If one company you’ve invested in goes bankrupt, you won’t lose all your money.

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• Professional Management: Mutual funds are managed by experienced professionals who research and know all the answers to the question. This saves you time and effort, and you can benefit from their expertise.

• Affordability: Mutual funds allow you to invest in a variety of assets that you might not be able to afford to buy on your own. For example, you can invest a small amount of money in a mutual fund that invests in large, established companies.

• Liquidity: Most mutual funds are open-ended, which means you can buy and sell shares on a daily basis. This gives you access to your money when you need it.

• Convenience: You can invest online, through a robo-advisor, or with a financial advisor. You can also set up automatic investments so you can invest regularly without having to think about it.

• Tax Benefits: Investing in mutual funds provides tax advantages. For example, you can postpone capital gains taxes on mutual funds if you hold them for over a year.

CHECK THIS OUT: MUTUAL FUNDS VS EQUITY – WHICH IS BETTER?

Variety of Mutual Fund Schemes

The Indian mutual fund industry offers a plethora of schemes catering to different investor needs. These schemes help investors achieve various financial goals, such as post-retirement expenses, children’s education or marriage, and house purchases. Mutual funds provide an excellent avenue for retail investors to benefit from market uptrends. However, selecting the right fund requires proper due diligence, considering the risk-return trade-off and investment time horizon, or consulting a professional investment advisor.

Diversification: Key to Maximizing Benefits

To reap the maximum benefit from mutual fund investments, it is important to know-what are mutual funds, what are the different types of funds across different categories such as equity, debt, and gold. While investors can invest in securities markets on their own, mutual funds offer a packaged benefit, making them a better choice.

Types of Mutual Fund Schemes

Mutual fund schemes can be categorized into open-ended and closed-ended schemes and further into actively managed and passively managed funds.

1. Open-Ended Funds: These schemes are available for subscription and redemption throughout the year. They do not have a maturity date and operate similarly to a savings bank account, where one can deposit and withdraw money daily.

2. Closed-Ended Funds: These schemes are open for subscription only during the initial offer period and have a fixed maturity date. Units of closed-ended funds can only be redeemed upon maturity. However, these units are listed on a stock exchange, allowing investors to trade them like other stocks before maturity.
3. Actively Managed Funds: In these schemes, the fund manager actively manages the portfolio, making decisions on which stocks to buy, sell, or hold based on professional judgment and analytical research. The goal is to generate maximum returns and outperform the scheme’s benchmark.
4. Passively Managed Funds: These funds follow a market index, and the fund manager does not use discretion in managing the portfolio. Instead, they replicate or track the scheme’s benchmark index in the same proportion. Examples include Index Funds and Exchange-Traded Funds (ETFs). The aim is to match the returns of the index, not to outperform it.

Risk/Return Trade-Off by Mutual Fund Category

The risk/return trade-off is an important investing concept that shows the relationship between investment risk and expected return. Mutual funds have different levels of risk and return potential. Investors must understand this trade-off to make the right investment choices based on their financial goals, risk tolerance, and investment horizon.

1. Equity Funds

Risk Level: High
Return Potential: High

Equity funds invest primarily in stocks and aim for capital appreciation over the long term. They can offer substantial returns but have higher volatility and risk due to market fluctuations. Within equity funds, there are various subcategories:

• Large-Cap Funds: Invest in large, well-established companies. They offer relatively stable returns with moderate risk.
• Mid-Cap Funds: Focus on medium-sized companies with high growth potential, offering higher returns but also higher risk.
• Small-Cap Funds: Invest in smaller companies, which can provide significant returns but are highly volatile and risky.
• Sector/Thematic Funds: Target specific sectors (e.g., technology, healthcare) or themes. They can yield high returns if the sector performs well but are riskier due to lack of diversification.

2. Debt Funds

Risk Level: Low to Moderate
Return Potential: Low to Moderate

Debt funds invest in fixed-income securities like bonds, government securities, and money market instruments. They are generally less volatile than equity funds and aim to provide steady returns with lower risk. Subcategories include:

• Liquid Funds: Invest in short-term instruments with high liquidity and low risk. Ideal for parking surplus funds for short durations.
• Short-Term and Ultra Short-Term Funds: Invest in debt instruments with short maturities, offering slightly higher returns than liquid funds with moderate risk.
• Income Funds: Invest in a mix of medium to long-term debt instruments, providing regular income with moderate risk.
• Gilt Funds: Invest in government securities with no credit risk but are subject to interest rate risk.

NOW READ: EQUITY VS DEBT MUTUAL FUNDS

3. Hybrid Funds

Risk Level: Moderate
Return Potential: Moderate to High

Hybrid funds, also known as balanced funds, invest in a mix of equities and debt instruments to balance risk and return. They cater to investors seeking a moderate risk-return profile. Key subcategories include:

• Aggressive Hybrid Funds: Allocate a higher proportion to equities (65-80%) and the rest to debt, offering higher returns with moderate risk.
• Conservative Hybrid Funds: Invest more in debt (70-90%) and a smaller portion in equities, providing stable returns with lower risk.
• Balanced Advantage Funds: Dynamically adjust the allocation between equity and debt based on market conditions, aiming to optimize returns while managing risk.

4. Index Funds and ETFs

Risk Level: Varies with the Index
Return Potential: Market-Linked

Index funds and Exchange Traded Funds (ETFs) replicate the performance of a specific market index (e.g., Nifty 50, S&P 500). They offer returns similar to the index they track and come with relatively lower management fees. The risk and return depend on the volatility of the underlying index. These funds are suitable for investors seeking market returns with lower costs.

5. Gold Funds

Risk Level: Moderate
Return Potential: Moderate

Gold funds invest in gold and related instruments, offering a way to invest in the precious metal without holding physical gold. They provide a hedge against inflation and currency fluctuations, making them a valuable part of a diversified portfolio. However, returns depend on gold prices, which can be volatile.

6. International Funds

Risk Level: High
Return Potential: High

International funds invest in stocks and securities of companies outside the investor’s home country. They offer exposure to global markets and diversification benefits but come with higher risks due to currency fluctuations, geopolitical factors, and differing market dynamics.

How to Invest in Mutual Funds

Investing in mutual funds is a straightforward process. 

• First, identify your financial goals and risk tolerance. Decide if you want to invest for short-term gains or long-term growth. Next, research all the details regarding – what mutual funds are and choose a mutual fund that aligns with your goals. You can compare mutual funds based on their past performance, risk level, and the fund manager’s expertise.
• Once you’ve selected a fund, open an account with a mutual fund company or through an online investment platform. You will need to complete a simple application form and submit necessary identification documents. After your account is set up, you can invest a lump sum or start a Systematic Investment Plan (SIP), where you invest a fixed amount regularly.
• Regularly monitor your investment to ensure it aligns with your objectives. If adjustments are necessary, you can modify your investments or seek advice from a SEBI-registered investment advisory

Risks of Investing in Mutual Funds

While mutual funds offer several benefits, they are not free from risks. Market volatility, interest rate changes, and economic factors can impact the performance of mutual funds. It is essential to research all the details regarding – what mutual funds are to navigate mutual funds investment risks and diversify your investments to reduce potential losses.

Conclusion

Mutual funds offer investors a way to pool their resources to gain access to a mix of asset classes. With a variety of schemes available, they cater to different financial goals and risk appetites. By understanding the basics of mutual funds, evaluating your financial objectives, and conducting proper due diligence, you can make informed investment decisions and achieve your financial goals efficiently.

*Disclaimer Note: The securities quoted, if any, are for illustration only and are not recommendatory. This article is for education purposes only and shall not be considered as recommendation or investment advice by Research & Ranking. We will not be liable for any losses that may occur. Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Registration granted by SEBI, membership of BASL, and certification from NISM in no way guarantee the performance of the intermediary or provide any assurance of returns to investors.

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