Get to know the basics of Mutual Funds
The article defines mutual funds and their function. It lists the different types of mutual funds available to potential investors, depending upon their goals and capacity to invest, and the various ways by which they earn returns from a mutual fund.
Besides outlining the advantages and disadvantages of investing in mutual funds, the article also unpacks the meaning of a few key terms related to mutual fund investment.
What Is a Mutual Fund?
A mutual fund is a collective fund that consists of money gathered from several investors and invested in securities. A few common examples of securities are stocks, bonds, money market instruments, and different types of assets. Money managers or fund managers—professionals who operate mutual funds—are in charge of allocating the accumulated funds to ensure a profitable return to the investors.
How Does a Mutual Fund Work?
A mutual fund earns returns for its investors in three ways. These are:
- Dividends: In this form of return, a mutual fund pays out of the income it makes over a year to its investor. The stocks invested and the interest earned on bonds make the income. The investor can either get physical returns or reinvest in more funds.
- Capital gains: In this form of return, a mutual fund shares the gains it has made by selling securities at a profit with its investor.
- Increase in the price of mutual fund shares: There may be a situation where the value of the fund increases and the fund manager decides to hold on to the funds. In such a scenario, the investor may sell the mutual funds at an increased price.
What Is NAV?
NAV stands for Net Asset Value. It is the core parameter to ascertain the performance of a mutual fund. In simple terms, NAV is the market value of the securities held by a fund. Since the funds are invested in the securities market, their price can fluctuate. Hence, the NAV of the fund changes daily.
The NAV of a fund is calculated as:
NAV = Market value of securities/total no. of securities
Different Types of Mutual Funds
Different categories of mutual funds are available depending on the risk appetite of potential investors.
The categories of mutual funds are described as:
- Open-ended funds: These funds do not have a prefixed maturity date. These are the most liquid funds available in the market. Investors can sell or buy them as and when they want. These are the most popular form of mutual funds.
- Close-ended funds: As the name suggests, close-ended funds have a predetermined maturity date. Investors may invest in such types of funds only at the time of their launch. However, some close-ended funds do give investors the option to sell their funds to MF companies when the window for repurchase opens.
- Interval funds: These are a mix of open- and close-ended funds. The scheme structure of an interval fund allows an investor to trade units at preset intervals.
Classifications of Mutual Funds
Depending on the investment strategy adopted by the fund manager, mutual funds are classified under different categories. Let us have a look at them.
- Equity schemes: Under this investment option, also known as a growth fund, the fund manager invests mainly in stocks and equities of various companies. The funds are invested in large-cap, mid-cap, or small-cap companies. Large-cap companies are those that come in the top 100 list and have a notable market share. If the company ranks between 101-250 in terms of market capitalisation, it is a mid-cap company. Any company that ranks 251 or lower is a small-cap company.
- Debt schemes: Mutual fund schemes under which the collected fund gets invested in instruments such as government bonds, corporate bonds, and debt securities that yield capital appreciation are called debt funds.
- Hybrid schemes: If the accumulated fund is invested across different asset classes like equity, debt, etc., it is called a hybrid scheme. The fund is invested in a diverse portfolio, thereby mitigating the risk of loss.
- Retirement schemes: These are also called pension funds. Under such schemes, a portion of the portfolio is invested in pension-related instruments to ensure the investor is adequately provided for when the regular inflow of income ceases. Retirement schemes come with a lock-in period of five years or the age of retirement, whichever comes first.
- Children’s funds: In such cases, investments in mutual funds are made in the child’s name. Children’s funds come with a lock-in period. The lock-in period in such schemes is either five years or once the child comes of age, whichever occurs first.
Advantages of Mutual Funds
The prime advantage of mutual funds is their diverse nature. By investing in different categories of companies, the investor gets the advantage of returns on investment without getting too exposed to the volatility of the stock market.
Mutual funds give you the flexibility to invest over multiple stock options and instruments like debt or gold. You can also invest in a mutual fund without opening a DEMAT account.
One can start investing with a meagre amount and then build up the portfolio over some time. You can begin by investing with an amount as low as Rs. 500 in the form of SIP.
Fund managers are governed by the Securities and Exchange Board of India (SEBI). This offers a lot of transparency and security to the investor as funds are managed professionally.
Mutual funds also offer liquidity in the event of any unforeseen requirement.
Disadvantages of Mutual Funds
One must remember that mutual funds come with a component of uncertainty. As funds are in the share market, there is a chance that the NAV of the funds may depreciate. There are no guaranteed returns as far as mutual funds are concerned.
- What is a mutual fund?
Money collected from different investors and invested in the market under various instruments is called a mutual fund.
- What are dividends in mutual funds?
When the fund earns a return on its investment made in stocks, the income is distributed among the investors. This is called a dividend.
- What are capital gains?
Capital gains is a situation where the fund shares profit with its investors when it makes gains by selling securities at a profit.
- What is NAV?
NAV or Net Asset Value of a mutual fund is its net worth on any given day. It is the key indicator of a fund’s performance.
- What are the different types of mutual funds?
There are three types of mutual funds: open-ended funds, close-ended funds, and interval funds.
- What are equity schemes?
Under the option of equity schemes, the funds are invested mainly in stock markets across large-cap, mid-cap and small-cap companies.
- What are debt schemes?
Under this option, the fund managers invest the gathered fund in instruments like government bonds.
- What are the advantages of a mutual fund?
Mutual funds offer high-return benefits of a stock market and insulate the investor from the volatility of the market by offering a diversified portfolio.
- What are the disadvantages of mutual funds?
Mutual funds have an element of uncertainty and do not offer guaranteed returns as the NAV of a fund may move up and down, depending on market conditions.
Ultimately, as an investor, the decision to invest in a mutual fund lies with you. The type of fund you would like to invest in and the quantum of investment will depend on your financial plans and appetite for savings. There are apps like ShePays that can educate you in making investment decisions and guide you in becoming a prudent investor.