What is a Mutual Fund?

Mutual fund is a financial instrument that pools money from different investors. The pooled money is then invested in securities like stocks of listed companies, government bonds, corporate bonds, and money market instruments.

As an investor, you don't directly own the company's stocks that mutual funds purchases. However, you share the profit or loss equally with the other investors of the pool. This is how the word "mutual" is associated with a mutual fund.

You get the advantage of the expertise of the fund manager and regulatory safety of the Securities Exchange and Board of India (SEBI). The professional fund manager ensures a maximum return to investors.

Now you get the understanding about mutual funds. Let's explore how it works.

How Do Mutual Funds Work?

Mutual fund investment is simple. You invest in a fund consisting of several assets. Thus, you need not risk putting all eggs in one basket.

Additionally, the headache of tracking market movements is not there. The mutual fund house takes care of the research, fund management, and market tracking. This makes the mutual fund a highly popular investment option for all types of investors.

A mutual fund is managed by the asset management company (AMC). Mutual fund investment starts with the pooling of money from several investors.

The pooled money is invested in a meticulously built portfolio of different asset classes like equity, debt, money market instruments, and other funds. Hence, you have the advantage of diversification, the time tested market mantra.

Additionally, your money is invested in instruments like Government bonds, that you wouldn't be able to afford individually.

The best part about mutual funds is that a team of experts along with the fund manager picks all the investments to build a portfolio. The investments are made according to the defined objective of the mutual fund.

Expert and professional fund management help you outperform the returns of traditional investment vehicles like a bank savings account and fixed deposits.

As an investor, you are allotted units for your contribution to the pooled fund.

The portfolio value depends on the price movements of the underlying assets. The portfolio value is net assets divided by the number of outstanding units which is called the net asset value or NAV.

The gains are reflected in higher NAV and lower NAV indicates a loss in portfolio value.

Different Types of Mutual Funds Based on Asset Class

Investors should pick mutual funds based on their financial objectives and risk appetite. Proper mutual fund selection helps you meet your life goals in the defined time period.

Mutual fund type depends on the defined objective and the underlying asset. The three broad categories of mutual funds are:

1. Equity Mutual Funds

Equity mutual funds invest the pooled money majorly in stocks of different companies. Hence, equity mutual funds have an inherent higher market risk. Factors like earnings, revenue forecasts, management changes, and company & economic policy impact price movements and the returns. Returns from equity mutual funds have high fluctuations. Hence, you should invest, if you have a fair understanding of the asset class risks associated with equity.

Types of Equity Funds

Equity fund can be further categorized depending on market capitalization and sectors.

Based on Market Capitalization

Large-cap Equity Funds - Invest in shares of large-cap companies that are well-established with a track record of performing consistently over a longer time period. These companies have sound fundamentals and are least affected by business cycles.

Mid-cap Equity funds - Invest in shares of mid-cap companies. Mid sized companies have relatively lower stability in terms of performance. But have the potential to grow more than the large-cap companies.

Small-cap Funds - Invest in shares of small-cap companies. Small-cap companies have the highest potential to grow or fail. Thus, small-cap funds have a high-risk exposure but also offer an opportunity to generate the highest returns.

Multi-cap funds - Invest in a defined proportion across all market caps. Based on cues and trend analysis, the fund manager allocates aggressively to capitalize on the volatility.

Sector Based Equity Funds: Sector based equity funds invest in stocks of a specific sector. For example, sectors like FMCG, technology, and pharma. Sector funds are prone to business cycle risk and sector getting out of focus.

2.Debt Mutual Funds

A debt mutual fund invests a major portion of the pooled corpus in debt instruments like government securities, corporate bonds, debentures, and money-market instruments. The bond issuers "borrow" from investors by giving an assurance of steady and regular interest income. Thus, debt funds are less risky compared to equity funds. The debt fund manager ensures that the fund is invested in the highest- rated securities. The best credit rating signifies the creditworthiness of the issuer in terms of regular interest payments and principal repayment.

Who Should Invest in Debt Funds?

Debt funds have less volatility and range bound returns as compared to equity funds. Thus, debt funds are safer for conservative investors who are looking to grow wealth with minimal risk. In fact, the interest income and maturity amount are known beforehand. Thus, debt funds are best for short-term (3 to 12 months) and medium-term (3 to 5 years) investment horizon.

Type of Debt Funds

Following are the debt funds available in India:

Dynamic Bond Funds: Dynamic bond fund investment basket comprises of both shorter and longer maturities. The debt fund manager aggressively tweaks the portfolio composition based on changing interest rate regime. This aggressiveness makes the debt fund dynamic, hence the name.

Liquid Funds: The short maturity of the underlying securities (not more than 91 days) makes the liquid funds almost risk free. It is better than parking funds in saving bank accounts as it gives better returns with much-needed liquidity. You can redeem liquid funds almost instantly. If you are short-term investors then debt funds like liquid funds could be better as you get returns in the range of 6.5 to 8%. Liquid funds are an effective tool to meet emergency fund needs.

Income Funds: Fund managers invest majorly in securities with longer maturities to have more stability and regular interest income flow. Most of the income funds have an average maturity of 5 to 6 years. Short-Term and Ultra Short-Term Debt Funds: There is another category in the maturity range of 1 to 3 years. The fund manager takes a call on interest rate regime and invests in securities with maturity of the said range. This is suitable for those investors who are risk averse and looking for interest rate movement safety.

Gilt Funds: Gilt funds invest only in high rated government securities. Since the government rarely defaults, it has zero risks. You can park your money in this instrument to have assured returns in longer maturity range.

Credit Opportunities Funds: Credit Opportunities Funds are a relatively riskier instrument that focuses more on higher returns by holding low-rated bonds or taking a call on credit risks. The fund manager of credit opportunity funds relies more on interest rate volatility to earn higher returns.

Fixed Maturity Plans: These closed ended debt funds invest in fixed income securities like government bonds and corporate bonds. You invest only during the initial offer period and your money remains locked-in for a fixed tenure, which could be months or years.

Different Types of Mutual Fund Based on Investment Objectives

Since mutual funds are all about the mutuality of common goals, mutual fund schemes are also categorized based on the objectives of investors.

Here are some popular types of mutual funds based on investor objectives:

#1. Growth Oriented Scheme

As the name suggests the primary goal of this type of mutual fund is to ensure wealth creation in the medium and long-term.

Aligned with the objective, the fund manager allocates the corpus predominantly (over 65%) in equities. With a focus on higher returns, the manager aggressively shuffles the portfolio to reap the benefits of market movements.

#2. Income Oriented Scheme

The objective of the regular income could be achieved only when the underlying assets assure a steady return.

To meet the objective, fund manager of income funds allocate a major portion of the corpus in fixed income securities such as government securities, bonds, corporate debentures, and money market instruments.

Lesser risks and assured return makes it safe for regular income as dividends. However, these products have very limited potential for wealth creation in the defined period.

#3. Balanced Fund

The name comes from the asset allocation as the fund is allocated in both equities and debt instruments in defined proportions. The objective of the balanced fund is to have reasonable growth and regular income with the lowest possible risk.

Fund managers of these funds normally allocated approx 60% in equities and rest on debt instruments. NAV of balanced funds is less volatile as compared to equity funds.

The balanced objective is suitable for those who want to have advantages of market movements and the safety of the debt market.

#4. Liquid Fund

The objective of these schemes is to ensure liquidity, capital protection, and reasonable income in the short-term.

Most of the pooled fund is invested in short term safe instruments like government securities, treasury bills, certificates of deposit, commercial paper, and inter-bank call money.

Since there isn't much volatility, these funds are suitable for investors who want to park money for short-term and earn better returns compared to savings bank accounts.

Advantages of Investing in Mutual Funds

There are over 8000 mutual funds in different categories to meet the objectives of all types of investors. The right mix of growth, income, and safety makes mutual funds suitable for everyone.

Below are the advantages of investing in mutual funds:

#1. Expert Money Management

Your pooled money is managed by a team of experts. So, you have the advantage of expert guidance in creating wealth. The fund manager does meticulous research in deciding equities, sectors, allocation, and of course the buy and sell.

#2. Low Cost

If you calculate the benefits of expertise, diversity, and other options of return, then mutual funds are definitely a very cost effective instrument of investment.

There is a regulatory cap of 2.5% on the expense ratio.

#3. SIP Option

Systematic Investment Plan gives you the flexibility to invest at an agreed interval which could be weekly, monthly, quarterly. You can start investing in mutual funds with an amount as low as Rs. 500.

#4. Switch Funds

If you are not happy with the performance of a particular mutual fund scheme, then some mutual funds do offer you an option to switch funds. However, you need to be very cautious while opting to switch.

#5. Diversification

Mutual funds offer you the benefit of diversification in such asset class which otherwise isn't possible for an individual investor. You reap the dividend of maximum exposure with minimum risk.

#6. Ease of Investing and Redemption

Now, it is pretty easy to buy, sell, and redeem fund units at NAV. Just place the redemption request and you will get your money in the desired bank account within a few days.

#7. Tax Benefit

Under the ELSS, tax-saving mutual fund you have the double benefit of tax saving and wealth creation. Under Section 80C of the Income Tax Act, you can have a deduction of a maximum of Rs. 1,50,000 a year.

#8. Lock-in Period

Close-ended mutual funds have a lock-in period, meaning as an investor you are not allowed to redeem the fund before a certain. period.

You get benefits in terms of long-term capital gain tax.

Various modes of investing in Mutual Funds

Once you have understood your risk preference and finalized the schemes where you want to invest your money, it is important to understand the various modes of investing in mutual funds. In their endeavour to make investments simple and convenient, fund houses offer various modes of investment like:

Single investment or Lump sum investment

Systematic Investment Plan or SIP

Systematic Transfer Plan or STP

Dividend Transfer Plan or DTP

Systematic Withdrawal Plan or SWP

These plans are designed to help you find the mode of investment that best suits your income and investment goals. Let's look at each of them in detail:

One time investment or Lumpsum investment

Let's say that you have managed to accumulate a corpus of funds and are now looking at avenues to invest and earn returns. Or you are a working professional and have been awarded a good bonus this year and want to invest it rather than spend it on an extravagant vacation or an expensive gadget. You start looking at investment options and decide that mutual funds offer a good range of schemes to choose from. You analyse your risk preference, define your investment objective and start assessing individual schemes. Once you finalize the kind of schemes you want to invest in, you are faced with the question of whether you want to invest the entire corpus together or not.

A lump sum investment has its own set of pros and cons. While it creates a possibility of high returns if your timing of purchase is right, it can also exposure your investments to high risks (if you get the timing wrong). To hedge against this, it is important for lumpsum investors to have a longer time horizon of investments and invest in schemes that have a steady record.

Systematic Investment Plan or SIP

This is option is perfect for the people having a regular monthly income - the majority population of our country - the working class. If you don't have any savings but want to start creating wealth for your future expenses, then an SIP is a boon for you. You can start saving from as low as $500 a month if you choose the SIP mode of investing in Mutual funds.

This works similar to a recurring deposit where you deposit a fixed amount every month which gets added to your cumulative capital and earns compound interest. In the SIP mode of investment, units are purchased based on the NAV (Net Asset Value) of the scheme on the day of depositing the instalment. This helps you benefit from Rupee cost averaging since your funds are invested in the same scheme at different levels of the market. So when the markets are high, the number of units purchased are lesser as compared to the times when the markets are low.

Systematic Transfer Plan or STP

Transfer Plan (STP) is designed just for you! An STP If you have a corpus of funds but don't want to invest in lump sum and neither as an SIP, then a Systematic can help you invest in equities gradually by initially investing your funds in less risky options and systematically transferring funds from this scheme to a high return scheme (like equity) from the same fund house. They utilize the benefits of investing lump sum without the additional risks by exposing your corpus to less risky funds and the benefits of SIP by transferring small amounts to high-return schemes. It is the best of both the worlds and if used prudently, can help you realize your financial objectives. Dividend Transfer Plan or DTP.

Most investors are aware of a Dividend Reinvestment Plan (DRIP) where they no longer receive dividend payouts but the amount is reinvested into the scheme which had generated the dividend. A Dividend Transfer Plan (DTP) works similar to a DRIP but with a small change in structure.

In a DTP, the dividend can be reinvested in a scheme from a different asset class as compared to the scheme which generated the dividend. So, if you have received dividend income from a debt scheme, then you can 'transfer' it to an equity scheme and vice versa. This works well for low risk investors who have invested in a debt fund. They can choose to transfer their dividends to an equity fund and create a possibility of earning high returns without exposing their capital to any risk.

Systematic Withdrawal Plan or SWP

As the name suggests, this is more of a withdrawal mode than an investment mode but we thought it was worth a mention because investment is all about managing your future needs and expenses.

Picture this - you work through your life saving money and investing it meticulously to create a good nest egg. AT retirement, you receive the pay-out as planned and have a good corpus in your bank account. But, you are not so good at managing expenses and end up spending on unnecessary things. This exposes you to the possibility of utilizing the entire corpus and being left with no savings / investments at an old age. Certainly not a pleasing thought.

"WISE SPENDING IS A PART OF WISE INVESTING AND IT IS NEVER TOO LATE TO START"

A Systematic Withdrawal Plan (SWP) steps in right here and ensures that you live a financially healthy life post retirement and never run out of funds. Through this plan you pre-decide the amount of money you wish you withdraw monthly/ quarterly to meet your regular expenses. The remaining investment continues to earn returns prolonging the longevity of your funds.

Conclusion

Investment is not a rocket science but needs a lot of thought to ensure that your financial dreams are met and your savings work as hard as you do to create a life you desire. Choose the mode of investment only and synergize with your savings.