What Are Mutual Funds? A Beginner's Guide to Understanding Mutual Fund Investments

Mutual funds offer a structured way to invest in market-linked instruments through professional management. Whether the goal is wealth creation, retirement planning, funding a child's education, building an emergency corpus, or pursuing other long-term financial objectives, mutual funds provide investors with access to diversified portfolios across various asset classes.

This guide explains what mutual funds are, how they work, their benefits and risks, and the important terms every beginner should know.

What is a Mutual Fund?

It is a mechanism for pooling money in the form of units from investors and investing the funds in securities in accordance with the objectives set out in the offer document.
Source: SEBI

The pooled money is managed by professional fund managers who make investment decisions in line with the scheme's stated investment objective.

When investors invest in a mutual fund scheme, they receive units at the prevailing Net Asset Value (NAV). The value of these units may rise or fall depending on the performance of the underlying investments and market conditions.

How Do Mutual Funds Work?

The functioning of a mutual fund can be understood through simple steps:
Source: SEBI

• Pooling Money: Investors contribute money to a mutual fund and receive units based on the amount invested.

• Professional Management: A SEBI-approved Asset Management Company (AMC) invests the pooled money in securities like stocks, bonds, or gold according to the fund’s objective.

• Diversification: Investments are spread across multiple assets and sectors to reduce risk.

• Sharing Returns: Profits, interest, IDCW (Income Distribution cum Capital Withdrawal) and losses are distributed among investors in proportion to their holdings.

• NAV Calculation: The fund’s value is measured by its Net Asset Value (NAV), calculated daily based on the value of its assets minus liabilities, divided by the total units outstanding.

Who are the Main Participants in a Mutual Fund?

Here are those who actively participate in the investment process:

Investors

Individuals or institutions who invest money in mutual fund schemes.

Asset Management Company (AMC)

The organisation responsible for managing mutual fund schemes and overseeing investment operations.

Fund Manager

A professional responsible for making investment decisions and managing the portfolio according to the scheme's objective.

Trustee

Ensures that the mutual fund operates in the interests of investors and complies with regulatory requirements.

Custodian

Safeguards the securities and assets held by the mutual fund.

What are the Types of Mutual Funds?

Equity Funds

These schemes primarily invest in equities and equity-related instruments and are generally suited for investors seeking long-term capital appreciation.

Examples include:

• Large Cap Funds

• Mid Cap Funds

• Small Cap Funds

• Multi Cap Funds

• ELSS Funds

• Index Funds

Debt Funds

Debt funds invest mainly in fixed-income instruments such as bonds, treasury bills, and money market securities.

Examples include:

• Liquid Funds

• Overnight Funds

• Money Market Funds

• Banking & PSU Funds

• Gilt Funds

• Short Duration Funds

Hybrid Funds

Hybrid funds invest in a mix of equity and debt instruments, aiming to provide diversification across asset classes.

Exchange Traded Funds (ETFs)

ETFs track an index, commodity, or basket of securities and are traded on stock exchanges like shares.

What are the Benefits of Investing in Mutual Funds?

Professional Fund Management

Investment decisions are made by experienced fund managers supported by research teams.

Diversification

Mutual funds spread investments across multiple securities, sectors, or asset classes, helping reduce concentration risk.

Accessibility

Investors can begin with relatively small investment amounts depending on the scheme and investment mode.

Liquidity

Most open-ended mutual funds allow investors to redeem units on any business day, subject to scheme terms.

Investment Flexibility

Investors can choose between lump sum investments and Systematic Investment Plans (SIPs).

Goal-Based Investing

Mutual funds can be considered for various financial goals, including retirement planning, children's education, emergency corpus creation, and long-term wealth creation.

What are the Risks Associated with Mutual Funds?

While mutual funds offer several benefits, they also involve risks.

Market Risk

The value of investments can fluctuate due to market movements.

Interest Rate Risk

Debt-oriented schemes may be affected by changes in interest rates.

Credit Risk

Certain debt instruments may face the risk of delayed payments or defaults.

Liquidity Risk

Some securities within a portfolio may be difficult to sell quickly under specific market conditions.

Investors should carefully review the Scheme Information Document (SID), riskometer, and investment objective before investing.

Important Mutual Fund Terms Beginners Should Know

• NAV (Net Asset Value): It is the per-unit value of a mutual fund scheme and is calculated daily.

• SIP (Systematic Investment Plan): A SIP allows investors to invest a fixed amount at regular intervals, such as monthly or quarterly.

• Expense Ratio: The expense ratio represents the annual fee charged by the AMC for managing the scheme and meeting operational expenses.

• Exit Load: An exit load is a charge that may apply when units are redeemed within a specified period. The applicability varies by scheme.

• AUM (Assets Under Management): It is the total market value of assets managed by a mutual fund scheme or AMC.

Mutual Funds vs Direct Stock Investing

How to Invest in Mutual Funds?

Investing in mutual funds typically involves the following steps:

Step 1: Complete KYC

Investors must complete Know Your Customer (KYC) requirements.

Step 2: Define Financial Goals

Identify the purpose, investment horizon, and risk appetite.

Step 3: Select a Suitable Scheme

Choose a scheme aligned with your financial objectives.

Step 4: Choose Investment Mode

You may invest through:

• Lump Sum Investment

• Systematic Investment Plan (SIP)

Step 5: Invest Through an AMC or Registered Distributor

Investments can be made through AMC platforms, online investment platforms, or AMFI-registered mutual fund distributors.

Who Should Invest in Mutual Funds?

Mutual funds may be suitable for a wide range of investors depending on their financial goals, investment horizon, and risk tolerance.

• Salaried Individuals

• Beginners

• Long-term investors

• Tax-saving investors

Mutual funds may be considered for investors with specific goals like:

• Retirement planning

• Child education planning

• Long-term wealth creation

• Emergency corpus planning

Investors should select schemes that align with their financial objectives and risk profile.

Difference Between Direct Stock Investing and Mutual Funds

Direct stock investing involves purchasing shares of individual companies and managing the portfolio independently. This requires continuous research, monitoring, and stock selection.

Mutual funds, on the other hand, pool investments and provide professional management, diversification, and access to a broader range of securities. The suitability of either option depends on an investor's knowledge, risk appetite, investment goals, and time commitment.

Blog Disclaimer:

The information herein is meant only for general reading purposes, and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or a professional guide for the readers. The document has been prepared on the basis of publicly available information, internally developed data, and other sources believed to be reliable. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.