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What are mutual funds?

To many people, mutual funds might seem like a complicated concept. People are familiar with the traditional methods of increasing wealth like Fixed deposits which are as simple as they sound. Mutual funds, on the other hand, might appear to be complicated but function on a very simple principle.

How Mutual Funds Work

Unlike investment in stocks, mutual funds do not invest in a specific stock. Mutual fund investment takes place across several investment options so that the investor gets the maximum returns. An investor himself does not have to select the stocks for investment. Fund manager selects those stocks with top-performing investment options that can bring the best possible returns.

Definition of a mutual fund

A mutual fund is like a trust that pools money from different investors who share a mutual investment objective. This trust is managed by a professional fund manager. The manager uses these funds to invest in equities, stocks, and different money market instruments which help increase wealth. The income gained from this collective investment is then distributed amongst all the investors proportionately after deducting certain expenses.

Understand mutual funds with the help of an example

Imagine there is a box of 12 oranges which cost Rs.40. There are 4 friends, who want to buy this box but have only Rs.10 each. They decide to pool in their money and buy the box. Based on each of their contributions, they are entitled to get 3 oranges. Now try equating this example with mutual funds. The cost per unit is calculated simply by dividing the total amount of investment by the total number of shares/equities. Every investor is a part-owner of the fund and collectively they own the entire pool of money.

What is a Mutual Fund’s NAV?

Net Asset Value (NAV) is the price of the mutual fund which is essentially the combined market value of the securities, shares, and bonds held by a fund, after deducting all the expenses and charges. If you combine the market value of all the shares and securities in the fund and divide it by the total number of units from the fund, you'll arrive at the NAV per unit.

Who should invest in a mutual fund?

Ideally, anyone and everyone can invest in a mutual fund since the required investment amounts start as low as Rs.500 per month. For someone who is not averse to risk and wants to grow their wealth with a small sum of investment on a monthly basis, it can prove to be the perfect choice. Additionally, there are multiple product choices under mutual funds that cater to various objectives inclined with savings for example - education, marriage, retirement, etc. There are a myriad of options and schemes for people to pick and choose from.

Types of mutual funds

Broadly, mutual funds can be classified as open-ended and closed-ended funds. An open-ended mutual fund, as the name suggests has no bounds or restrictions, an investor can choose to enter or exit the fund at any given time. It is perpetual in nature and is available for subscription throughout the year, whereas a closed-ended mutual fund comes with a fixed maturity date and is open for subscription only during the initial offer period. An investor can redeem his/her investment on the maturity of the date.

The SEBI (Securities Exchange Board of India) has classified mutual funds under these four categories-

  • Equity Mutual Funds

    An equity fund is a type of mutual fund where at least 65% of the fund's corpus is dedicated to equity and equity-oriented investments. Equity mutual funds are known for their high-return potential. However, there are various type of equity funds, based on their characteristics and risk-reward potential.

    Small-Cap Funds

    Small-cap funds are those equity funds that invest your money in stocks of companies that have a market capitalization of less than Rs. 500 crores. On stock indices such as Sensex, small-cap companies are generally ones that are ranked below the 250th spot.

    Mid-Cap Funds

    Mid-cap funds are those equity funds that invest your money in stocks of companies that have a market capitalization of Rs. 500 crores to Rs. 10,000 crores. Mid-cap companies are ranked from 101 to 250 on stock indices.

    Large-Cap Funds

    Large-cap funds are those equity funds that invest your money in stocks of companies that have a large market capitalization. Large-cap companies are ranked from 1 to 100 on stock indices.

    Multi-Cap Funds

    Multi-Cap Funds are types of equity funds that invest in shares of companies of all market capitalizations. Asset allocation is changed by the fund manager based on market conditions to yield better returns.

    Equity-linked savings scheme (ELSS)

    ELSS is the type of mutual funds covered under Section 80C of the Income Tax Act, 1961. With investment in ELSS funds, an investor can claim tax deductions up to Rs. 1,50,000 per year.

    Index Funds

    Index Fund is a type of fund that invests in the index (Nifty50, Sensex, sectoral indices, etc.). Its performance tends to mirror that of the index it is replicating.

    Sector Funds

    Sectoral fund or thematic fund is a type of fund that invests in stocks of a particular sector or industry like Pharma and FMCG.

  • Debt Mutual Fund

    A debt fund is a mutual fund that generates returns for its investors by investing in a variety of fixed income bonds and deposits such as corporate bonds, treasury bills, government securities, etc. Given below are the types of debt funds:

    Income Funds

    Income debt funds invest in debt securities with varying maturity periods, but most are long-term investments with average maturity period around 5-6 years.

    Dynamic Bond Funds

    Dynamic Bond Funds move dynamically across long-term and short-term funds with different maturity profiles. Based on fluctuating interest regimes, dynamic bond funds move across all classes of debt and money market instruments.

    Short-Term Funds

    Short-term debt funds have a shorter maturity period ranging from 1 to 3 years. They invest in government securities, debt, and money market instruments.

    Ultra-Short-Term Funds

    Ultra-Short-Term Funds are debt funds with shorter maturity period but mostly less than a year.

    Liquid Funds

    Liquid debt funds can be converted into cash easily and have a very low maturity period of 91 days. The investment is made in Treasury Bills, CDs, or Certificate of Deposit.

    Fixed Maturity Plans

    Fixed Maturity Plans or FMPs have a fixed locked-in period. It could range from months to years. Because of the lock-in period, the FMPs are not affected by changing interest rates.

    GILT Funds

    Gilt debt funds only invest in securities issued by central and state governments. The maturity period ranges from medium to long-term.

    Credit Opportunities Fund

    Credit opportunities funds invest in different instruments. The investments range from short-term to long-term with a view to generating high interest.

  • Balanced or Hybrid Mutual Funds

    Balanced or hybrid mutual funds are a type of funds where a part of the corpus is invested in equity and the rest is invested in debt funds. A hybrid fund is balanced in such a way that the investor gets better returns than purely debt funds, but the risk of equity funds is greatly minimized.

    Equity Oriented Hybrid Funds

    Equity Oriented Hybrid Funds are the type of hybrid funds where more than 65% of the assets are allocated into equity while the rest is invested in debt funds and other fixed-income securities.

    Debt Oriented Hybrid Funds

    Debt oriented hybrid funds are those where 65% or more of the funds are allocated in fixed-income securities such as debt funds, debentures and treasury bills.

    Arbitrage Funds

    Arbitrage funds are those funds that focus on gaining more returns by buying securities in one market at a lower price and selling at a more rate in another market.

    Monthly Income Plans

    Monthly Income Plans are a special type of hybrid funds that are predominantly invested in debt funds, say about 80 to 90%. The remaining 10-20% is invested in equity.

  • Solution-oriented Mutual Funds

    Solutions-oriented mutual funds are those funds which are designed to achieve a specific financial goal. Examples are retirement funds, children funds etc.

Benefits of investing in mutual funds

Mutual funds come with various advantages. For starters, there's a fund manager who takes care of all your investments which can be a huge time-saver for you and comes with expertise.

It can be quite challenging to create a diversified portfolio for an investor with meagre sums but with mutual funds, each investor can stand to earn returns proportionate to his/her investments. Mutual funds are also diverse in nature in terms of investment portfolios. You're at a higher risk when you invest in a single security, but the more diverse your portfolio is, the lesser risk you are at

Before you go ahead and make an investment in mutual funds you must know that there are no guaranteed returns as they are heavily dependent on the market performance. There's also no assured capital protection, hence if you're considering investing in one, start with smaller investments and do your research accordingly.

However, as opposed to your traditional methods of savings and investment like investing in gold and FDs, mutual funds can help you multiply your wealth at a much faster rate. The better the market performance is, the better the returns are.