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For individuals looking to take their first steps into the world of investing, mutual funds offer a promising avenue. These investment vehicles pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets. Whether planning for retirement, saving for a major purchase, or simply looking to grow wealth, understanding the basics of mutual funds is crucial for successful investing. In this blog, we will find out about the fundamental concepts and strategies to help individuals get started with confidence in mutual fund investing.
Table of Contents
Defining a Mutual Fund
A mutual fund is a professionally managed fund, where money pooled from many investors is collectively invested and managed by a fund manager. This money is invested in various assets like stocks, bonds, short term money market instruments, commodities (especially precious metals), and virtually anything that local regulation may allow, including real estate as well.
Simply put, a mutual fund is a basket of financial assets that is managed by a professional fund manager on one’s behalf, and which is bought and maintained using a common pool of funds contributed by many thousands of investors.
Investors in a mutual fund have a common financial goal. Based on this, as well as the fund’s investment objective, their money is invested in different asset classes. Since the funds are well diversified, they tend to offset potential losses better. Also, as mutual funds are actively managed by professional fund managers, they’re a great option for investors who lack the time or knowledge to make their own investment decisions.
Types of Mutual Funds
1. Open-Ended Funds
In an open-ended mutual fund, an investor can invest, enter and redeem, or exit at any point in time. It does not have a fixed maturity period.
2. Close-Ended Funds
Close-ended mutual funds are characterised by a fixed maturity date, restricting investors from entering or investing in these schemes solely during the initial period, known as the new fund offer (NFO) period. Upon the maturity date, investments are automatically redeemed. Additionally, close-ended mutual funds are listed on the stock exchange(s).
3. Equity or Growth Schemes
Equity mutual funds rank among the most popular schemes, enabling investors to engage in stock markets. Despite being classified as high-risk, they boast considerable return potential over the long term. Ideal for investors in their prime earning stage, these funds facilitate portfolio building with the potential for superior returns over time, although without absolute certainty.
Equity funds can be further divided into three categories:
- Sector-Specific Funds (Medium–High Risk): These are mutual funds that invest in a specific sector. These can be industrial sectors like infrastructure, banking, mining, etc. or specific segments like mid-cap, small-cap or large-cap segments. Since they are concentrated on a specific market segment, these funds are suitable for investors having a higher risk appetite. Know about the difference between small, mid, and large cap funds.
- Index funds (Medium Risk): Index funds offer a solution for investors seeking exposure to equity mutual funds without relying solely on fund managers’ strategies. These funds track the performance of specific indices, mirroring their growth trajectory. For instance, an index fund following the BSE Sensex Index would allocate capital in line with the index’s weightage, promising returns aligned with the index they replicate. Additionally, they limit losses to the proportional loss of the index, making them suitable for investors with a medium risk appetite.
- Tax Saving Funds (Low–Medium Risk): Along with growth potential, these funds also enable investors to avail income tax benefits. They invest in equities and are also called equity linked saving schemes (ELSS). These types of schemes typically have a 3-year lock-in period. In India, such investments made in the scheme are eligible for tax deduction for an individual or HUF a deduction from total income of up to Rs. 1.5 lacs under Sec 80C of the Income Tax Act, 1961.
4. Money Market Funds or Liquid Funds
These funds invest in short term debt instruments, looking to give a reasonable return to investors over a short period of time. These funds are suitable for investors with a low-risk appetite who are looking at parking their surplus funds over the short term. These are an alternative to putting money in a savings or fixed deposit bank account.
5. Fixed Income or Debt Mutual Funds
These funds invest a majority of the money in debt–fixed income, i.e., fixed coupon bearing instruments like government securities, bonds, debentures, etc. They have a low-risk-low-return outlook and are ideal for investors with a low-risk appetite looking at generating a steady income. However, they still are subject to credit risk.
6. Balanced Funds
As one may have guessed from the name, these are mutual fund schemes that divide their investments between equity and debt. The allocation may keep changing based on market risks and the fund manager’s decisions. They are more suitable for investors who are looking at a combination of moderate returns with comparatively low risk.
7. Hybrid or Monthly Income Plans (MIP)
It is a kind of mutual fund wherein the investment is allocated proportionally between the equity and debt markets. They are especially suitable for investors who are retired and want a regular income with comparatively low risk.
8. Gilt Funds
These funds invest primarily in government securities. They are preferred by investors who are risk averse and want no credit risk associated with their investment. However, they are subject to high interest rate risk.
Mutual Funds Vs Stocks: Making the Right Investment Choice
Among the reasons why an individual may choose to buy mutual funds instead of individual stocks are diversification, convenience, and lower costs.
Diversification
Ask any investment professional, and they’ll likely say that one of the most important ways to reduce one’s risk is through diversification. Mutual funds offer investors a great way to diversify their holdings instantly. Unlike stocks, investors can put a small amount of money into one or more funds and access a diverse pool of investment options.
Mutual funds also invest in a variety of different sectors. So a large cap fund may invest across different industries like financials, technology, health care, and material.
Convenience
Some investors find that buying a few shares of a mutual fund that meets their basic investment criteria is easier than finding out what the companies the fund invests in actually do, and if they are good quality investments. They’d prefer to leave the research and decision-making up to someone else.
Cost Effective
Mutual funds spread trading costs among multiple investors, reducing individual expenses. The ‘expense ratio’ represents the percentage of assets paid to the fund manager for maintenance. This fee covers operational expenses, including managing assets, analysts’ work, and advertising, aimed at maximising returns and managing risks.
Process of Investing in Mutual funds Online
- Understand risk capacity and tolerance through risk profiling.
- Allocate assets between different classes, balancing equity and debt instruments.
- Identify mutual funds aligning with each asset class, considering investment objectives and past performance.
- Shortlist mutual fund schemes and apply online via ShareIndia’s web portal or mobile apps, following KYC verification.
- Ensure diversification of investments and conduct regular follow-ups for optimal returns.
Risks Associated with Mutual Funds Investments
Though mutual funds offer broader diversification and value-for-money to an individual, there are a few risks associated with investing in mutual funds. Risk arises in mutual funds owing to the reason that mutual funds invest in a variety of financial instruments such as equities, debt, corporate bonds, government securities and many more. The price of these instruments keeps fluctuating owing to a lot of factors which may result in losses, the different types of risks are:
Market Risk
Market risk is a risk which may result in losses for any investor due to multiple factors that impact the performance of different financial instruments listed in the markets. A few examples are natural disasters, uncontrolled inflation, recession, political unrest, fluctuation of interest rates, and so on. Market risk is also known as systematic risk.
Interest Rate Risk
Mutual fund investments are subject to interest rate risk due to the rise or fall in interest rates. Since there is no way to predict the interest rate, it becomes the most important mutual funds risk to be aware of.
Credit Risk
This applies to the underlying fixed income securities of mutual funds. When the issuer of the bonds is unable to pay what was promised as interest, then the issuer has defaulted or committed credit loss, making it a loss in investment.
Lack of Control
Undoubtedly mutual funds offer the convenience of investing, but the biggest risk is that the investors cannot determine the exact composition of a fund’s portfolio, nor can they directly influence which securities the fund manager can buy.
Conclusion
Gaining a fundamental understanding of mutual fund investing is essential for those venturing into investments. Mutual funds provide a diversified and professionally managed approach across various asset classes, catering to investors of all levels. These investment vehicles pool money from multiple investors to purchase a diversified portfolio of securities, overseen by professional fund managers. Portfolio rebalancing ensures investments align with goals. In the dynamic stock market landscape, mutual funds retain their value for wealth-building and financial security. Starting with a grasp of mutual fund basics sets the foundation for successful investing.