What are mutual funds?

More people are choosing mutual funds as the starting point on their investment journey. Also, thanks to several campaigns and investor education initiatives, many people know what a mutual fund is.

A recent report by Computer Age Management Services (CAMS) highlighted that young people are increasingly adopting the mutual fund route. So, if you are a budding investor who wants to learn the basics of mutual funds, then this article will help.

What is a mutual fund?

Mutual funds are a pool of investor money. Fund houses invest this money across different financial instruments, including stocks, bonds, gold, government securities and other asset classes.

They are managed by experienced financial professionals - fund managers - who deploy the money to various asset classes in line with the fund objectives. Also, the decisions on when and where to make the investments rest with these fund managers.

How do mutual funds work?

Before we explain the features and workings of a mutual fund, you should start by understanding what is NAV. The NAV refers to the price at which you can buy or redeem your mutual fund investments.

Here's a quick example. Suppose you invest Rs 1,000 in a mutual fund scheme where the NAV is Rs 10. Then, you will be allotted 100 units of the fund.

Remember that a mutual fund's NAV changes daily based on the fund's underlying assets. If the underlying asset of a fund performs well, then the NAV will go up and vice versa.

So, based on the above example, if the NAV of your mutual fund increases to Rs 20, then your 100 units will amount to (100 units x Rs 20) = Rs 2,000. And if you redeem your units, you will receive Rs 2,000 against your initial investment of Rs 1,000.

Historically, the equity markets tend to offer a net positive return that beats inflation, bringing you true wealth compounding. Although fixed deposits (FDs) are still highly popular, even the best FD cannot rival mutual funds. Mutual funds have been able to yield returns between 12 and 15 per cent in the last 10-20 years.

So, if you invest in an equity mutual fund and stay invested for long, you can grow your money by several times and thus create wealth.

What are the categories of mutual funds?

Mutual funds can be classed based on a number of factors. For instance, based on whether a fund is managed by a manager, it can be classified into two broad categories.

• Actively managed funds: These are managed by an experienced fund manager. These managers hold expertise in market analysis and research. They devise the strategy of these funds in a way that helps them outperform the returns of a particular index.
  
• Passively managed funds: These funds are not managed by a fund manager. Instead, they are designed to follow an index. There are sub-categories like Exchange Traded Funds (ETFs), Index Funds, or even Funds of Funds (FoFs).

Similarly, all mutual funds can be separated into two categories based on entry and exit restrictions.

• Open-end funds: In open-end funds, you can sell and buy units anytime.
  
• Closed-end funds: In closed-end funds, you can buy units only during the initial launch of these funds. Once you invest in these mutual funds, you can withdraw the amount at the time of their maturity.

Types of open-end mutual funds

Open-end mutual funds are again classified based on their investment objectives and the underlying securities. Let's look through each type of fund.

Equity mutual funds

These funds invest around 65 per cent of the assets in various stocks. Due to the volatile nature of stock markets, it is better to have a long-term time horizon when investing in these funds - five years or more. While these funds can offer greater returns, they come with their fair share of risks.

Within equity mutual funds, there are a host of fund categories.

• Large-cap funds: As the name suggests, these funds invest around 80 per cent of their assets in large-cap stocks.
  
• Mid-cap funds: These funds invest around 65 per cent of their assets in mid-cap stocks.
  
• Small-cap funds: They invest around 65 per cent of their assets in small-cap stocks.
  
• Equity-linked Savings Scheme (ELSS): These are tax-saving equity mutual funds that invest around 80 per cent of their assets in stocks. ELSS schemes come with a lock-in period of three years from the date of your investments. Also, remember that with your ELSS investments, you can enjoy tax benefits under Section 80C of the Income Tax Act.
  
• Multi-cap funds: These funds invest in the stocks of companies across varying market caps. They invest at least 75 per cent of their assets in stocks.
  
• Index funds: This fund simply tracks a particular index, i.e., it invests in the companies in that index. For example, if you invest in an index fund that tracks Sensex, the fund will deploy your money to the same companies that are a part of Sensex and in the same proportion.
  These funds try to replicate the returns of their underlying indices closely. Unlike other funds, these funds' operating costs and portfolio turnover are quite low.
  
• International funds: These mutual funds invest in companies listed in other indices of other countries. It helps bring geographical diversification to your portfolio.

Debt mutual funds

Debt funds mainly invest in fixed-income instruments, including government securities, debentures, bonds and so on. Unlike equity funds, they are not impacted by the volatility of the stock market, and therefore, they provide more stable returns. While they are unaffected by stock market fluctuations, they do come with some risk, although much less.

Debt mutual funds are classified into different types based on the maturity period of their underlying securities. Here are a few of them.

• Liquid funds: These funds invest in highly liquid instruments, such as certificates of deposits, treasury bills and commercial papers, that have a maturity period of less than 91 days. Therefore, these funds are less risky. You can also park your emergency funds in liquid funds.
  
• Short-duration funds: These mutual funds are mandated to maintain a Macaulay duration of one to three years.Short-duration funds mainly invest in a mix of government and corporate bonds of different varieties.
  
• Overnight funds: As their name suggests, overnight funds invest in overnight securities or assets that come with a maturity of a day.

Hybrid mutual funds

These mutual funds invest in a mix of equity and debt instruments based on the fund's objectives. With hybrid funds, you get to simplify your asset allocation needs. While you get capital appreciation from the equity component during zooming markets, the debt part protects you during a market downturn. In the market of mutual funds in India, you will find different types of hybrid funds, some of which include:

• Aggressive hybrid funds: These mutual funds invest 65-80 per cent of their assets in equity and the rest in debt instruments. In addition to the mix of debt and equity, aggressive hybrid funds take advantage of an arbitrage opportunity. In arbitrage, the fund manager buys securities at a low price in one stock exchange and sells them at a higher price in the other. Hence, the gains are accrued as a result of the price differential.
  
• Conservative hybrid funds: Unlike aggressive hybrids, these funds invest around 75-90 per cent of their assets in debt securities and the rest in equity. Hence, conservative hybrid funds are stabler than aggressive hybrid funds.
  
• Balanced advantage funds: These funds maintain a balance between equity and debt when it comes to asset allocation; in a bid to minimise risks while maximising gains, balanced advantage funds keep changing their asset allocation based on market movements.

Glossary of mutual fund terms

When you go through a mutual fund document or are scanning through various options, then here are some terms you might come across.

• NAV - Net Asset Value: It is the total value of the fund's portfolio divided by the number of investors. In short, it is the price at which you can buy or sell a mutual fund unit.
  
• AMC - Asset Management Company: An Asset Management Company (AMC) collects funds from individual investors and invests them in different asset classes, including debt, equity, cash, and so on. In other words, it is a fund house.
  
• AUM - Assets Under Management: It refers to the total market value of all the assets, comprising bonds, securities and stocks, managed by a fund house on behalf of their investors.
  
• NFO - New Fund Offer: The NFO is a subscription offer provided by the AMC to start a new fund.
  
• ETF - Exchange Traded Fund: An ETF is an open-end mutual fund scheme that tracks and follows its underlying index's performance.
  
• RTA - Registrar and Transfer Agents: They help mutual fund companies maintain records. They provide investors with a one-stop reference for all information related to their investments in mutual funds.
  
• SIP - Systematic Investment Plan: This investment mode enables investors to invest a fixed amount in a mutual fund regularly at a fixed frequency.
  
• STP - Systematic Transfer Plan: Under the STP, you can transfer a specific amount regularly from one mutual fund scheme (where you have made a lump sum investment) to another.
  
• SWP - Systematic Withdrawal Plan: You can withdraw a fixed amount of money from your mutual funds at regular intervals by opting for the SWP mode.

Also read: Your first mutual fund