What are Mutual Funds? – A Guide for Beginners
Here is a brief introduction to Mutual Funds (MFs) for the beginners:
As an investor education initiative, this article provides an in-depth understanding of what are mutual funds and its corresponding financial jargon to the wannabe investors to make their investment journey smooth.
India has one of the highest Gross Domestic Savings rates at 28% of GDP but one of the lowest mutual fund (MF) penetration levels at only 6% of GDP. Moreover, there are over 50,000 savings bank accounts per lakh of the population as against just 3,800 mutual fund portfolios. A Pricewaterhouse Coopers study found that inadequate financial knowledge & awareness among the retail investors as one of the reasons for this phenomenon.
Mutual Fund (MF) is an investment scheme wherein the Asset Management Company pools in money from a group of investors and makes investments in various assets. Each scheme allocates money in underlying asset classes like stocks, bonds, and other securities in a particular ratio. When you invest in a scheme, you get a specific number of units. The value of unit keeps fluctuating according to the performance of the underlying asset.
Let me take you through some important Terms used in Mutual Funds:
1. Net Asset Value (NAV)
NAV is the market value of assets underlying a particular Mutual Fund (MF) scheme. The NAV of the units changes daily or weekly on account of fluctuation in the value of the underlying assets.
NAV of one unit = Fund Assets – Fund Liabilities
Number of outstanding shares
Suppose Market Value of fund’s assets is Rs. 100 lakh & the fund has issued 10 lakh units of Rs 10 each then NAV of each unit is Rs. 10
2. Offer price
It is the price which you pay to the asset management company when you buy units under a Mutual Fund (MF) scheme.
3. Repurchase price
This is the price at which you sell the units of the scheme to the asset management company. At times it may be inclusive of exit load.
4. Front-end/entry load
It is the fee charged by the Mutual Fund (MF) scheme when you buy units of the scheme. Schemes that do not levy front-end load are called “no load” schemes. The loads reduce the amount invested towards buying units. From August 2009, SEBI removed all entry loads on mutual fund schemes.
5. Back-end/repurchase load
It is the fee charged by the Mutual Fund (MF) scheme when you sell units of the scheme. It is levied to dissuade investors from exiting the scheme.
Features of Mutual Funds
1. Professional Management
Qualified professionals known as Fund Managers use your money towards building a portfolio. The portfolio consists of various asset classes i.e. equity, bonds or other securities. They select the securities based on quantitative & qualitative analysis & also regularly monitor the portfolio to ensure that you get the desired returns.
2. Fund Ownership
Unlike investing in stocks directly, here you get units of the Mutual Fund (MF) instead of individual securities. You may start an investment with a small amount but benefit from being a contributor towards a large pool of money. You share the fund’s profits & losses in proportion to your investment in the fund.
Diversification involves the creation of a portfolio which consists of securities of uncorrelated nature to minimise the overall risk significantly. The diversification prevents you from losing money by balancing out downs in one asset with the ups in another asset.
The objective of the fund determines rationale of investment & composition of the portfolio. The objective may be long-term wealth maximisation, steady returns or regular income. The risk-return profile of the portfolio would vary by its objectives. Thus, you as an investor need to make sure that objective of the scheme is in line with your requirements.
Types of Mutual Funds
You need to understand that each Mutual Fund (MF) offers different risks & rewards. The basic thumb rule says that higher returns attract greater risk of loss & vice versa. The volatility of return assesses the risk inherent in a fund. Usually, some funds have lower risk component than others.
Following categories of Mutual Funds are available in India:
I. Based on Maturity Period
i. Open-Ended Funds
You can enter & exit these schemes at any time of the year because these don’t have fixed maturity dates. The scheme declares Net Asset Value (NAV) on a daily basis. These schemes are highly liquid as these allow you to buy & sell units at the prevailing NAV as per your convenience.
ii. Close-Ended Funds
This scheme remains open for subscription only for a fixed period. You can buy units of this scheme at the time of New Fund Offer (NFO) i.e. when it launches for the first time for the subscription. Afterwards, you can buy/sell units of the scheme on the stock exchange. The company provides repurchase option for those schemes which are not listed on the stock exchange. Repurchase implies buy back of units by the fund house from the investor at the current NAV. The NAV in these schemes is declared on a weekly basis.
II. Based on Investment Objectives
i. Equity Funds
This fund is relevant if you enjoy risk-taking & have an investment horizon of more than five years. This fund enables wealth creation via appreciation of capital through a majority investment in equity. While applying for the scheme, you may choose from different investment options like dividend option, growth option, etc. You are allowed to change your option while you remain invested. Go for such schemes only if you can stay invested for a long term, as ad-hoc exits could result in loss of principal as well.
Equity Fund has following four categories:
a. Index Funds
These funds imitate the investment mechanism of popular indices like Nifty, BSE Sensitive Index, etc. These funds invest in the asset classes in the same proportion as is done by the index. Consequently, the NAVs of these funds follow the price movements of securities listed on the index.
b. Sector-specific Funds
Here, investment is made in one of the sectors like IT, infrastructure, pharmaceuticals, FMCG, petroleum, etc. as mentioned in the offer document. The returns fluctuate in response to changes in the particular sector. These funds provide comparatively higher returns but at the same time are exposed to sector-specific risks. You should continuously monitor the performance of the industry & redeem your investment at the opportune time.
c. Tax-Saving Funds
These are also called Equity Linked Savings Scheme (ELSS) used to save taxes along with capital appreciation. These funds offer the shortest lock-in period of 3 years, and the portfolio diversifies into equities of small, mid & large caps as per fund structure. Before investing, do check the composition of securities in the portfolio in addition to other analytics.
d. Diversified Funds
Instead of sticking to a particular sector/company, these funds invest in a variety of sectors like the small, mid & large cap. The large caps provide a stable foundation for the portfolio while mid & small caps ensure a higher rate of return.
ii. Debt Funds
If regular income and steady returns on investment top your priority chart, then go for debt funds. These funds are lesser risky than equity funds as these extensively invest in fixed-income securities of the varied investment horizon. The NAV of these funds tends to fluctuate in response to changes in the interest rates.
Debt Fund has following five categories:
a. Liquid/Money Market Funds
If your investment horizon is up to one year, then park your money in these funds for liquidity, safety of capital & moderate returns. These funds invest in fixed-interest bearing short-term instruments i.e. treasury bills, commercial paper, certificate of deposit, etc.
b. GILT Funds
GILT funds invest primarily in G-sec i.e. government security of medium to long term maturity issued by the union & state governments. These securities have zero risks of default. However, NAV of these schemes tends to fluctuate in response to changes in the economy like a drop in overall interest rate.
c. Corporate Bond Funds
Corporate Bond Funds are a good option if you have a moderate risk appetite coupled with an investment horizon of around 5 to 10 years. You would get modest growth with regular income but at the same time be prepared to face credit risk & volatile returns. Also, the longer the maturity period, the more your investment would be exposed to market vulnerabilities.
d. Short Term Funds, Medium Term Funds & Long Term Funds
Short Term Funds primarily invest in short-term debt securities partly in long-term debt. Go for these funds when you want to fix your surplus funds for 1 to 9 months & require a marginal increase in your risk appetite.
If you are a conservative investor, then Medium Term Funds are suitable investment option. These funds invest mainly in debt securities having maturity period of up to 3 years & give higher returns in a rising interest rate regime.
Long Term Funds have investment tenure of more than a decade and the returns are affected by changes in the interest rate regime in the economy. It is advisable to enter the fund at the time of falling interest rates & monitor the interest rate movements to exit at a favorable time.
e. Dynamic Bond Funds
These funds largely invest in long-term debt securities i.e. corporate bonds & government securities which are highly sensitive to the interest rate regime. Your fund manager would track the interest rate movements & adjust the maturity profile of the portfolio. When the interest rates rise in the short-run, he may divert some funds in short-term papers to arrest interest rate risk.
iii. Hybrid/Balanced Funds
If you want moderate growth & steady returns, then invest in these funds. These funds invest in both equity & debt in a certain proportion as mentioned in the offer document. You would enjoy investing in this fund if you want higher returns corresponding to increased risk as compared to regular debt fund.
Hybrid Fund has following three categories:
a. Monthly Income Plans (MIPs)
These funds allocate comparatively higher money in debt as compared to equity to provide periodic dividends coupled with benefits of long-term growth.
b. Fixed Maturity Plans
These are close-ended schemes which aim at protection of capital & moderate growth by investment in both debt & equity. The allocation in debt ensures that you get back the original investment amount upon maturity & equity portion of allocation provides the return for risk-taking. These plans need to secure mandatory rating from at least one rating agency.
c. Capital Appreciation Plans
These are close-ended schemes which invest both in rated debt instruments & shares of companies. The aim is capital appreciation via participation in the growth of these companies.
Mutual funds offer multiple benefits like convenience, diversification, professional management, flexibility and transparency under a single umbrella. Investing in mutual funds has become very simple with Systematic Investment Plans wherein you can start your investment journey with an amount as less as Rs. 500. You may afterwards step-up your investments alongside an increase in your income. So, get into investment mode as soon as possible & enjoy as your money grows with time.
Also read: SIP vs Lumpsum Investment