Mutual funds, offering accessible, liquid, and professionally managed investment options, have emerged as a prominent investment avenue for modern-day investors. However, in India, only a fraction of the population has explored their potential. Let's understand the meaning of mutual funds, how mutual funds work, and the benefits offered.
What Are Mutual Funds?
Mutual funds are investment options that pool capital from multiple investors. This corpus is then invested in different asset classes, such as bonds, equities, gold, government securities, and others. These funds are managed by professional experts who allocate the corpus across various asset classes to avail capital gains and generate income for the investors.
The Asset Management Companies (AMCs) levy a charge known as the expense ratio to investors. The expense ratio is levied for the professional fund management and varies from one AMC to another. However, the Securities and Exchange Board of India (SEBI) has issued guidelines on the maximum expense ratio charged by AMCs based on total fund size.
NAV in Mutual Funds
The price of a mutual fund unit is valued as ‘Net Asset Value (NAV)’ per unit. The NAV is calculated by dividing the total value of the securities held by the fund with the total number of units held by investors. Whenever an investor wants, the mutual fund units are purchased or redeemed as per the current NAV, which is readjusted at the end of each trading day as per the closing price of the securities held on that day.
How Do Mutual Funds Work?
Mutual fund is a pool of money collected from a large number of investors that are invested in specific equities and assets by the mutual fund managers. Thus, technically when a person invests in a mutual fund, he or she acquires partial ownership of the fund in the form of units. As the fund grows in value, the value of the units owned by the investor also grow.
There are three main ways to earn through your mutual fund investment.
Dividends on stocks and interest on bonds are incomes earned by the fund. It then pays out almost all the income earned by it over the year to its investors in the form of a distribution. Investors can get payment as incomes or additional units as per their own choice. There are capital gains earned when the stocks held by a fund increase in value. These are also passed on as a part of distribution. With the growth in value of holdings of a fund, the NAV also increases. Investors can later on redeem their mutual fund units at a higher price and earn profit.
To gain a better understanding on how mutual funds work, being aware of the NAV will be beneficial. NAV is the price at which investors can buy or sell each unit of the mutual fund scheme. When an investor invests in mutual funds, they are allocated proportionate units on the basis of the prevailing NAV. For example, if an individual invests INR 25,000 at an NAV of INR 10, they receive 2500 units.
The NAV is dynamic and changes everyday based on the performance of the underlying assets. If the price of the asset rises, the NAV also increases and vice versa. Continuing the previous example, assume that the NAV increases to INR 20, the investment value rises to INR 50,000. This means the performance of the mutual fund schemes depends on the value of its underlying assets. If the individual redeems their holdings, the INR 25,000 profit generated is known as capital gains.
However, investments in mutual funds also have certain risks. The value of the underlying assets may also reduce, which negatively impacts the NAV and the investors may witness a decrease in their investment value.
Mutual fund profits incur capital gains tax. However, it is applicable only at the time of redemption. Secondly, the capital gains tax also depends on the type of mutual fund and holding period.
Types of Mutual Funds Based on Asset Class
There are various types of mutual funds depending upon the type of securities held by them in their portfolios and the type of returns targeted. There are funds for almost every industry and investment type. Let’s take a look at the most dominant categories of mutual funds.
Equity Funds -
Equity funds are the most common type of mutual funds. As the name indicates, these are the funds primarily investing in equities and equity related instruments.
Types of Equity Mutual Funds
Large-Cap Funds
In large ca [ funds, the corpus is invested in the top 100 companies based on the market capitalization. Large-cap funds invest at least 80% of the corpus in these companies. Such funds have the lowest risk in equity funds and offer stable and sustainable returns.
Mid-Cap Funds
In mid cap funds, the corpus is invested in companies that rank between 101 and 250 based on their market capitalization. A minimum of 65% is invested in these companies and may offer potentially higher returns when compared to large-cap funds.
Small-Cap Funds
Small cap funds invest in companies that rank beyond 250 based on the market capitalization. At least 65% of the corpus is invested in small-cap companies. These funds have high risks but may also deliver the highest returns.
Equity Linked Savings Schemes (ELSS)
ELSS are tax-saving mutual funds where at least 80% of the corpus is invested in equity and equity-related assets. Investors can take tax benefit of up to INR 1.5 lakh invested in ELSS funds under section 80C. ELSS offers tax benefits as well as capital growth.
Multi-Cap Funds
Multi cap funds invest the corpus across different companies with varying market capitalization. A minimum of 75% of the funds are invested in equity and related instruments. Based on the market conditions, the fund managers decide on the proportion of investments across different stocks.
International Funds
International funds invest in companies listed on international exchanges. Some schemes invest in specific countries or regions while others may invest across the globe. Investors may face some volatility in the short-term; however, these funds potentially offer stability when held for a longer period.
Index Funds -
Index funds have gained popularity in recent years. These types of funds aim at buying stocks belonging to a specific market index such as Nifty 50 etc. This strategy requires less research as they target a specific category of stocks and comes with lower cost.
Debt Funds -
A debt fund is a fund that invests primarily in bonds or other debt securities that are less risky and offer capital appreciation.
Types of Debt Mutual Funds
Like other schemes, open-ended funds also have fund managers to make investment decisions on behalf of the investors.
Liquid Funds
In liquid funds, the corpus is invested in securities with a maturity duration of less than 91 days. Investors who want to temporarily park their surplus funds for a few days may invest in these funds. Liquid funds deliver steady returns with minimal volatility.
Overnight Funds
In overnight funds, the corpus is invested in overnight securities, which are money market instruments. The primary objective is to offer convenience and liquidity with a lower focus on returns.
Money Market Funds
Such schemes invest the fund corpus in money market instruments with a maturity of up to one year. The objective is income via interest earnings with some potential capital appreciation.
Banking and PSU Funds
In banking and PSU funds, at least 80% of the fund is invested in debt instruments issued by banks, public sector undertakings, municipal bonds, and public financial institutions. The goal is offering a moderate-risk investment option balancing liquidity, safety, and yield.
Gilt Funds
In Gilt funds, a minimum of 80% of the total corpus is invested in government securities with varying maturities. These may either be short or long duration and have no default risk.
Short Duration Funds
In short duration funds, the corpus is invested in short and long-term debt instruments with different credit ratings. Investors with a holding period between one and three years may benefit from these funds as the returns are higher when compared to liquid funds but may have fluctuating NAVs.
Hybrid Mutual Funds-
What if an individual wants to invest in equity as well as debt funds? Hybrid funds offer an excellent option. These funds invest the corpus in equity and fixed income securities. Depending on the allocation between equity and fixed income securities, hybrid funds are further classified in different categories.
Exchange Traded Funds (ETFs) -
A relatively newer and popular type of investment is the ETF. An ETF is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. These funds are traded as a listed company on the stock exchanges. Thus, they are bought and sold like shares of other companies throughout the trading day on the stock exchanges.
Types of Mutual Funds Based on Structure
Open Ended Funds-
Open ended funds can be purchased or sold on any working day throughout its existence. It is similar to a savings bank account where the accountholders can deposit and withdraw funds on all working days. Open-ended funds are perpetual and do not have a fixed maturity date.
Close Ended Funds-
Close ended funds can be purchased only during its offer period and has a fixed tenure and maturity date like a fixed deposit. Pre-mature redemption of close-ended funds is not allowed. These funds are listed on stock exchanges after the end of the New Fund Offer period. Close-ended funds are traded on these exchanges and investors looking to redeem their holdings before the maturity date can sell these on the stock exchanges.
Ways to Invest in Mutual Funds
Mutual fund investments can either be lumpsum or systematic investment-
Lumpsum
The entire investible capital is invested at one point in time. For example, if an investor has an investible surplus of INR 2 lakh, they may choose a lumpsum option and invest the entire amount in mutual fund schemes as per their preference. The units are allotted based on the prevailing NAV as on the purchase date.
Systematic Investment Plan (SIP)
Under this option, a fixed amount is invested in the chosen fund at regular intervals. SIP brings in investment discipline and enables us to start investing even with a smaller amount. SIPs also average the acquisition cost and investors don’t need to time the market. Over the long-term, SIPs can help investors to build a sizeable corpus.
How to Invest in Mutual Funds?
Investing in mutual funds is simple and effortless. Here are the basic steps to start investing-
Through AMC Website
Sign up and create an account
Complete the KYC formalities
Input the required details
Select the scheme and transfer the amount
Through Mutual Fund Distributor
Consult an AMFI-registered distributor
Understand the different schemes
Choose the fund as per your requirements
Transfer the amount
Benefits of Investing in Mutual Funds
Final Words - What Are Mutual Funds
By investing in mutual funds, investors can benefit in multiple ways. They get to enjoy portfolio diversification which have the potential to make investment safer as they are spread over a large number of stocks. The risk is relatively lower, but the income potential is higher. Mutual fund investments and redemption has become quite easy nowadays, and that is highly encouraging for the investors. Last, but not the least, mutual funds are managed by professional management teams that ensure that your money works for you even when you sleep.
Therefore, it is not wrong to say that ‘Mutual Funds Sahi Hai’.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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