A mutual fund accumulates funds from thousands of investors and uses them to purchase securities with the aim of offering decent returns to investors. All the collected funds are pooled together to buy different stocks listed in the stock exchange, money market instruments, government securities, corporate bonds, etc.
In this scenario, as an investor, you will not directly receive the ownership of the stocks or securities. Instead, you will be offered units depending on the total amount of funds you have invested. More importantly, you also need to note that in a mutual fund, every single investor is liable to equally bear the profit and loss incurred by the investment pool.
The money you have invested in the mutual fund is handled by a fund manager and their team offering financial expertise while maintaining the regulatory compliances the Securities Exchange and Board of India or SEBI apply. These fund managers ensure that the investors receive the maximum benefit for investing their money into mutual funds.
This article covers:
- How Mutual Funds Work?
- Objectives of Mutual Funds
- Types of Mutual Funds
- Advantages of Mutual Funds
- Disadvantages of Mutual Funds
- How to Invest in Mutual Funds
- How Are Mutual Funds Priced?
- How Are Returns Calculated for Mutual Funds?
- What is a Mutual Fund in Simple Words- Quick Summary
- What is a Mutual Fund in Simple Words- FAQ
How Mutual Funds Work?
Mutual funds are managed by AMC or Asset Management Companies. An AMC or fund house accumulates money from multiple investors, and then they use that money to invest in different asset classes such as stocks, bonds, cash, gold, etc (after thorough market research and examination).
Objectives of Mutual Funds
The most important objective of mutual funds is that it should be managed by professionals who have good years of experience trading in the stock market. Hence, it offers professional management of investment to investors.
Other objectives of a mutual fund are mentioned below:
Income Generation
Investing in mutual funds can be a suitable investment option if your goal is to generate income. Mutual funds can offer various income-generating options such as dividend payouts, interest income, and capital gains. Based on your investment objectives, you can choose from different types of mutual funds that offer varying levels of income potential. For example, income funds invest in fixed income securities like bonds and provide regular income in the form of interest payments. Similarly, dividend yield funds invest in stocks that pay high dividends to generate income.
Diversification of Assets
Usually, mutual funds invest in a range of securities, and their overall portfolio is quite large, and investors can take advantage of this facility. A professional financial investor will always recommend not investing all your money into a single security or asset because if the market goes down, your investment may get heavily affected, and your portfolio’s overall value will significantly fall.
Due to the fact that mutual funds invest in a plethora of assets, the investors will be able to receive the imperative diversification that will ultimately protect their investment while a specific kind of security gets affected.
Growth of the Funds
If your primary goal is to beat inflation, you can opt for a mutual fund focusing mostly on growth. These types of mutual funds are known as equity funds and usually invest in common stocks. The risk associated with this type of mutual fund is a bit higher than the fixed-income funds, but they also provide handsome returns.
Capital Protection
Mutual funds can also protect your money, with some schemes specifically prioritizing capital safety. These low-risk funds may generate lower returns, and an example of such a fund is the money market mutual fund.
Types of Mutual Funds
There are mainly 4 types of mutual funds: equity mutual funds, bond mutual funds, target date mutual funds, and money market mutual funds. Each mutual fund type has distinct characteristics, risks, and potential returns.
Mutual funds Based on Asset Class
There are different types of mutual funds available in the market and these funds can be classified based on their underlying asset class. As an investor, you need to select mutual funds based on your financial needs and risk tolerance. Let us have a look at them in detail.
Equity Mutual Funds
As the name suggests, equity mutual funds invest the maximum amount of money from the fund into the stocks or shares of different companies, and for the same reason the equity mutual fund bears a higher amount of risk than any other type of mutual fund.
Equity mutual funds can be further classified into different categories which are mentioned below:
Depending on the Market Capitalization
- Large-cap equity funds: These kinds of mutual funds invest majorly in large-cap companies that are well established in the market and have clear as well as consistent track records. The fundamentals of these companies are extremely robust which is why they don’t heavily get influenced by the business cycles.
- Mid-cap equity funds: Mutual funds of this kind invest in mid-sized companies that are listed in the stock market. Although their stability is low in comparison to large-cap companies (which is why their risk factor is a bit higher) they have the potential for significant growth (which means higher returns).
- Small-cap equity funds: These mutual funds purchase the stocks of smaller companies with extremely high potential for growth but they can also fail in their venture. Although small-cap equity funds have the highest risk factors they also have the potential to offer the highest returns on investment.
- Multi-cap funds: As the name suggests this type of mutual fund investment scheme invests a certain amount of their money in all the market caps. The fund managers of this type of fund invest the funds based on current market conditions and use trend analysis to get the best results from volatility.
Depending on the Industry or Sector
Sector-based equity funds invest their money in a specific sector. For example, you can come across mutual funds that have solely invested in the pharmaceutical sector, FMCG, IT, etc. You also need to note that sector-based equity funds can easily get influenced by the business cycle.
Debt Mutual Funds
In debt mutual funds the majority of the pooled funds are invested in debt instruments which include money market instruments, corporate bonds, government securities, debentures, etc. Debt mutual funds are less riskier than equity mutual funds and it also offers a steady income through interest.
Different types of Debt Mutual Funds
- Credit opportunities funds: It is a riskier investment fund because it deals with riskier assets that promise higher returns while ratings of the bonds are low.
- Liquid funds: These types of funds mostly invest in short-term securities and you can redeem your fund almost immediately from here.
- Short-term and ultra-short-term debt funds: As the name suggests, the underlying securities in this mutual fund have a 1 to 3 years maturity period.
- Income funds: This type of fund comprises securities that have at least a 5 to 6 years maturity period.
- Dynamic bond funds: It is an aggressive type of mutual fund where the fund manager makes changes in the portfolio according to the interest rate of the market.
- Fixed maturity plans: It is a close-ended mutual fund investment scheme that mainly invests in corporate bonds and government bonds. In this mutual fund, the investors’ money remains locked in for a fixed period of time (which can be months or even years).
- Gilt funds: This type of fund has zero risk associated with it because it majorly invests in high-rated government securities.
Advantages of Mutual Funds
The biggest advantage of investing in mutual fund is that it allows you to invest in mutual funds at low cost. Let us have a look at the advantages investors receive from mutual funds:
Extremely Low-Cost
Fund houses of mutual funds charge something called an ‘expense ratio’ which is no more than 2.5% of your total investment. If we consider the expertise of the fund managers who are helping you to grow your wealth then it is an extremely small fee.
Diversification of your Investment
Asset diversification is something that is hard to achieve for individual investors but mutual funds make it possible for them. The funds you have invested along with other investors are spread across different asset classes so that you can earn and grow your wealth through maximum exposure while keeping the financial risks at bay.
Sound Money Management
One of the primary advantages of investing your money into mutual funds is that your investment funds get managed by top financial experts who will help you grow your wealth. All the hard work is done by fund managers who are responsible for researching, allocating, purchasing, and selling the assets under the mutual fund investment scheme.
Easy to Invest and Redeem
Due to the drastic technological developments, investing and selling your unit in a mutual fund has become extremely easy. While redeeming your money all you have to do is put forward a redemption request and after your request gets approved by the fund house your money will be directly deposited into your registered bank account.
Availability of SIP
Mutual funds have become a popular investment option for investors because of the availability of SIP or systematic investment plans. SIP comes with flexibility which means you can decide to invest a specific amount of money weekly or monthly. The SIP amount starts at Rs. 500 and you can increase it according to your preferences.
Lock-in Period
If you invest in close-ended mutual fund schemes then you will not be able to withdraw the money from the investment fund until the lock-in period is over. In this scenario, you will get the benefit of tax exemption in the form of long-term capital gains.
Switch to Different Funds
Mutual funds offer you the option to switch funds if you are satisfied with the performance of a particular mutual fund scheme.
Tax Benefits
Some specific mutual funds such as ELSS or Equity Linked Saving Schemes are regarded as tax-saving mutual funds. This type of mutual fund offers both the facility of wealth generation as well as tax saving. If you choose to invest in this type of fund then you can receive a tax deduction of Rs. 150000 (maximum limit) every year under Section 80C of the Income Tax Act.
Disadvantages of Mutual Funds
Similar to other financial instruments, mutual funds also come with certain disadvantages which every investor should be aware of. Some of them are mentioned below:
- You will not be able to receive guaranteed returns or fixed returns from mutual fund investments because the investment goes through major price fluctuations (due to its underlying assets being related to the stock market).
- All the mutual funds are managed by the fund managers which means you do not have any direct control over your funds. All the major decisions concerning your investment fund will be made by the fund managers.
- The previous performance of the mutual fund does not guarantee that it will perform the same way in the future.
How to Invest in Mutual Funds
You can easily invest in a mutual fund online through Alice Blue. It is a popular online stock trading platform, that offers a convenient and easy way to invest in mutual funds.
The most common way to invest in a mutual fund is to obtain the application form from the Alice Blue or their Registrar & Transfer Agent (RTA), fill in the application form completely and accurately, provide all the necessary information, and then submit the form. Make the payment at the nearest branch office or Investor Service Centre (ISC) of the mutual fund company or their RTA.
Here are the steps to invest in mutual fund:
- If you do not have a Demat account with Alice Blue, you will need to open one. You can do this online by visiting the website and filling out the account opening form. You will need to provide your personal and financial details, as well as your PAN card and bank account information.
- Before you can invest in mutual funds, you will need to complete the Know Your Customer (KYC) process. You can do this online by providing your Aadhaar card and PAN card details, along with your photograph and signature.
- Once your account is opened and your KYC process is complete, you can log in. The platform can be accessed from the Alice Blue website or through the Alice Blue mobile app.
- You can choose the mutual fund you want to invest in by filtering the mutual funds based on various criteria such as investment objective, risk profile, and past performance.
- Once you have chosen the mutual fund, you can make the investment by entering the investment amount and completing the transaction through net banking or UPI.
How Are Mutual Funds Priced?
The price of a mutual fund is determined by its NAV or Net Asset Value. Although the mutual fund invests in stocks and other securities, the price does not rapidly fluctuate like shares. Instead, the changes in the mutual funds are reflected at the end of the day through NAV.
The NAV of a mutual fund is received by deducting the liabilities of the funds with its assets and then dividing the result by the total number of outstanding shares. The units allocated to an investor who has put their money into the mutual fund depend on the NAV of the mutual fund. Similarly, if you want to withdraw money from your mutual fund scheme then the money you will receive will also depend on the NAV.
How Are Returns Calculated for Mutual Funds?
The returns on mutual funds are calculated by comparing the change in the NAV of the fund over a period of time. Although the NAV of the mutual fund suggests its current value, there are a total of four methods through which the mutual fund returns can be calculated.
The methods are as follows:
- Absolute Return = ( Final Investment Value — Initial Amount Invested) * 100 / Initial Amount Invested
- Annualized Return = (Final Investment Value ÷ Initial Amount Invested)^ (1/number of years) – 1
- CAGR = (Ending Value ÷ Beginning Value) ^ (1 ÷ Number of Periods) – 1
- =XIRR(values, dates,[guess]) (to be used in Excel spreadsheet)
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What is a Mutual Fund in Simple Words- Quick Summary
- Mutual funds are pooled investment funds where multiple investors deposit their money in the hopes of growing their wealth substantially. These funds are managed by professional fund managers who use these funds to invest in different asset classes.
- Investing in a mutual fund is extremely simple and the AMC is responsible for handling your funds. They will also help you increase your wealth during your entire investment tenure.
- Mutual funds offer several objectives including income generation, diversification of assets, growth of funds, and capital protection.
- There are four main types of mutual funds: equity mutual funds, bond mutual funds, target date mutual funds, and money market mutual funds.
- There are various advantages of investing in a mutual fund scheme which include investment through SIP, tax benefits through ELSS, excellent fund management, etc.
- Some of the disadvantages of mutual funds include the lack of guaranteed or fixed returns, the lack of direct control over investments, and the fact that past performance is not an indicator of future results.
- There are various ways to invest in mutual funds, including through application forms, online platforms, Demat accounts, and mutual fund agents.
- Mutual funds are priced based on their NAV, which is calculated by deducting the liabilities of the fund from its assets and then dividing by the number of outstanding shares.
- There are multiple methods such as CAGR, XIRR, etc. that can assist you in calculating the returns on your investments from your chosen mutual fund scheme.
What is a Mutual Fund in Simple Words- Frequently Asked Questions
1. What is mutual fund in simple words?
A mutual fund collects money from a large number of investors and invests in a variety of assets such as stocks, bonds, gold, cash, etc. The fund is managed by experienced professionals called fund managers.
2. What is a mutual fund example?
Some examples of mutual funds are ICICI Pru Overnight Fund, Quant Small Cap Fund, Nippon India Small Cap Fund, Canara Rob Small Cap Fund, SBI Contra Fund, etc.
3. Why is it called a mutual fund?
Mutual fund schemes are regarded as mutual funds because it is a shared pool of funds to which multiple investors contribute their money.
4. How do mutual funds make money?
Mutual funds usually generate income by asking for commissions from the investors in the form of the expense ratio and exit load. The expense ratio also includes commission, allocation charges, management fees, etc. charges by the AUM.
5. Which mutual fund is best?
According to the previous year’s data, some of the best mutual funds available in the market include:
- ICICI Prudential Technology Direct Plan-Growth (5Y returns 22.17%),
- Quant Infrastructure Fund Direct-Growth (5Y returns 20.89%),.
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