In this article we cover
1) What are Mutual Funds?
2) How Does a Mutual Fund Work?
3) Why Does the Value of Mutual Funds Change?
4) Are Mutual Funds Safe?
5) What are the Advantages of Mutual Funds?
6) What are the Different Types of Mutual Funds In India?
7) What are the Different Options In Mutual Funds?
8) How are Mutual Funds Taxed?
9) Why Should You Invest In Mutual Funds?
What are Mutual Funds?
A mutual fund pools money from lakhs of investors having the same investment objective. Mutual funds are managed by expert fund managers. These fund managers are financial experts and take investment decisions on behalf of the investors. In exchange they charge a small fee, known as expense ratio. Fund managers are appointed by Asset Management Companies (AMC’s).
In a mutual fund, the cost of investment is shared by all investors. The profits and losses are also shared by all investors. Hence the name ‘mutual’ fund.
How Does a Mutual Fund Work?
Suppose you wanted to buy a pizza. The cost of the pizza is ₹ 100. But you only have ₹ 10. So, you and your 9 friends decide to contribute ₹ 10 each to buy the pizza. Each of you gets 1 slice of the pizza.
In this example, pizza slices represent units of a mutual fund scheme. You and your 9 friends become unitholders of a mutual fund scheme. The pizza company is the fund house. Types of pizzas are types of mutual funds offered to investors.
The price you paid to buy 1 pizza slice is the Net Asset Value, (NAV) of the fund. NAV is the market price of 1 mutual fund unit. When you multiply the total number of units with the NAV, you will get the current market price of your investment.
But what does fund manager do with the collected money?
The collected money is invested in various asset classes depending upon the type of mutual fund scheme:
- Equity Mutual Funds: In case of equity mutual funds, the pooled money is invested in stocks of various companies.
- Debt Mutual Funds: In case of debt mutual funds, the pooled money is invested in private and government securities.
- Hybrid Mutual Funds: In case of hybrid mutual funds, the pooled money is invested in a mix of stocks and fixed income instruments.
Each mutual fund type has a distinct investment objective and risk profile. Equity mutual funds are very risky. Debt mutual funds are comparatively less risky than equity funds. Hybrid mutual funds carry medium-risk.
Once the objective of the fund is decided, the fund manager then picks top companies for investment. This step is very critical. Proper stock selection is the backbone of a fund’s performance.
Once the segment is decided, the fund manager then divides the collected amount into smaller portions and invests across stocks or debt instruments. The process of dividing the investment amount and investing smaller portions in various stocks is known as ‘Diversification’. Diversification helps in reducing overall portfolio risk.
Let us see how diversification works in mutual funds.
Suppose you wanted to invest ₹ 100. You have two options -
- Invest the entire ₹ 100 in one company.
- Invest ₹ 10 in 10 different companies.
There are more than 4,500 stocks in the market. What are the chances that you will end up selecting the best stock? It’s 1 in 4,500 or next to impossible.
But if you select 10 stocks, then there is a slightly higher chance that some of them might be best stocks.
To help improve their chances, fund managers invest in many stocks. So that even if one stock performs poorly, good performance of the remaining stocks can help them average the gains or losses.
So, diversification not only helps in spreading the risk, it also ensures that you maximise your profits.
Why Does the Value of Mutual Funds Change?
The NAV of equity mutual funds fluctuate when your fund manager buys and sells the underlying shares on the stock exchange.
There is a direct relationship between stock prices and the fund's NAV.
- If share prices increase - your funds NAV will increase.
- If share prices decrease - your funds NAV will decrease.
Are Mutual Funds Safe?
Every investor looks for safety while investing. Afterall, we are investing our hard-earned money. In this regard, mutual funds are quite misunderstood. Just because they have ‘fund’ in their name, people compare them with chit funds.
But you will be surprised to know that mutual funds are highly secured. In India, mutual funds are regulated by the Securities and Exchange Board of India (SEBI). Additionally, the Association of Mutual Funds in India (AMFI) also regulates and monitors the mutual fund industry.
SEBI’s aim is to safeguard the interest of common investors. So, in terms of your money vanishing overnight, be rest assured that this will never happen. Unit Trust of India (UTI) is the first mutual fund launched in India in 1963. In the last 58 years, no mutual fund company has vanished with investors’ money.
So, mutual funds are highly secured.
What are the Advantages of Mutual Funds? - Why Should you Invest in Mutual Funds?
Mutual Funds are the perfect investment option for investors with little knowledge or experience of the stock markets. The main advantages of mutual funds are:
Professionally Managed: The biggest advantage of mutual funds is that they are professionally managed by expert fund managers. These managers have dedicated research teams which discover lucrative investment opportunities.
Fund managers take investment decisions on behalf of investors. In return, they charge fund management fees. This fee is adjusted against the fund’s NAV. The aim of the fund manager is to beat the fund’s benchmark and generate superior returns for unitholders.
Diversification: Mutual funds divide and invest the pooled amount into various companies. By doing this, they reduce their overall risk while increasing their profit possibilities. Diversification helps investors participate in the growth of multiple companies with a single fund.
- Highly Liquid: Liquidity refers to how quickly you can sell an investment for cash.
Bases on liquidity, mutual funds are of two types -
- Open ended funds
- Close ended funds
Open ended mutual funds are highly liquid. You can sell your units within 1 day of investment also. But in such cases, exit load and taxation is applicable. More on this later.
Convenient: Mutual Funds are highly convenient. Investors can invest the entire capital at one go known as lumpsum investing. Or they can invest small amounts every month, known as Systematic Investment Plan (SIP).
Lumpsum investing is more suited to investors who can time the market. Whereas SIP is perfect for retail investors. SIP helps in creating investment discipline as a fixed amount is automatically deducted every month on a pre decided date.
- Affordable: One of the biggest advantages of mutual funds is that they are very affordable. You can start investing in mutual funds with as little as ₹ 500 per month via SIP. In case of lumpsum investing, the minimum investment amount varies between ₹ 1,000 - ₹ 5,000.
- High Variety: There are more than 29 different types of mutual funds in India. There are distinct mutual fund schemes to match all various types of risk profiles and investment objectives.
What are the Different Types of Mutual Funds In India?
As mentioned earlier, there are more than 29 different types of mutual funds in India. These 29 types of mutual funds can be categorised into 3 broad types:
- Equity Mutual Funds: Equity mutual funds invest in ‘stocks’ of companies. These companies can be large cap, midcap or small cap. Equity mutual funds can be actively managed or passively managed.
- Debt Mutual Funds: Debt mutual funds invest in securities issued by private and public companies as well as the government. Debt mutual funds can be close-ended like FMPs or open-ended.
Hybrid Mutual Funds: Hybrid mutual funds invest in both stocks and debt instruments. The mix of equity and debt can change as per the scheme’s investment objectives. Aggressive hybrid funds invest 80% in stocks. Conservative hybrid funds invest more than 65% in debt instruments.
The below chart shows the various types of mutual funds in India. We will discuss these types of mutual funds in later sections.
What are the Different Options In Mutual Funds?
Another reason why mutual funds are popular is because they offer both growth and regular income.
There are two types of options in mutual funds:
- Growth Option
- Dividend Option
Growth Option: In the growth option, you do not get regular income. Instead, all the profits are reinvested back in the fund itself.
For example: Imagine you invested ₹ 100 on 1st April 2020. On 1st December 2020, the market value of your investment is ₹ 150. The ₹ 50 profit is your ‘capital appreciation’.
Growth option is perfect for long term mutual fund investors. Mutual fund beginners should select growth option to earn higher capital appreciation.
Dividend Option: In the dividend option profits are paid to you at regular intervals. The intervals can be weekly, monthly, quarterly or yearly.
In the above example, if you selected the dividend option then the profit (₹ 50) will be given to you as per your selected frequency. Dividend option is perfect for senior citizens or retirees who need regular income.
How are Mutual Funds Taxed?
Mutual funds are taxed as per the assets that they invest in. Mutual fund taxation is of two types:
- Equity Taxation: Equity funds and aggressive hybrid funds follow equity taxation. The holding period for equity taxation is 12 months (1 year)
- Debt Taxation: Debt funds, liquid funds and conservative hybrid funds follow debt taxation. The holding period for debt taxation is 36 months (3 years)
Here is a snapshot of how equity and debt mutual funds are taxed. We will discuss mutual fund taxation in detail in later sections.
Why Should you Invest In Mutual Funds?
- Did you know that about ₹ 79 million of the mutual fund industry’s AUM is held with retail investors?
- Or that the average AUM of mutual fund schemes has grown 3 times in the last 5 years?!
Yes, the above facts prove that mutual funds are the preferred investment option for retail investors.
Mutual funds are perfect for retail investors who do not have the time or resources to study the market. They are professionally managed and generate superior returns than other investment options.
The below charts show the performance of different types of mutual fund categories over a 10 year period.
10 Year Performance of Equity Funds
10-Years Performance of Debt Funds
10-Years Performance of Hybrid Funds
So, there you go. You get superior returns, expert management and affordability all packed into 1 box - The mutual fund box.
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