What are mutual funds? Meaning, types, and benefits

What are mutual funds? A beginner's guide

Here's the smartest way to begin creating wealth!

What are mutual funds? Meaning, types, and benefits AI-generated image

Investing can be overwhelming, especially if you're just starting out. With so many investment options to choose from, mutual funds offer an easy way to begin your wealth-building journey.

Mutual funds are baskets of stocks, bonds, or other assets. They are managed by experienced fund managers, who take care of the portfolio and ensure it stays on track. By investing in mutual funds, you can grow your wealth while minimizing the risks of holding individual stocks and/or other securities.

Not sure how mutual funds work? This guide will help you understand the basics and get you started on your investment path today.

What is a mutual fund?

A mutual fund is an investment vehicle that pools money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets. Professional fund managers handle these investments, making decisions to maximise returns based on the fund's objectives. These fund managers are appointed by an Asset Management Company (AMC), which is responsible for managing the mutual fund scheme and ensuring its smooth day-to-day functioning.

How do mutual funds work?

Every fund has an associated Net Asset Value (NAV), which represents the per-unit price of the mutual fund. It is calculated by dividing the total market value of the underlying securities and other assets - after accounting for liabilities - by the total number of units issued. In simple terms, this is the "price" at which you buy or sell a unit of a mutual fund scheme.

As the market value of the fund's underlying securities increases, the NAV rises, resulting in capital appreciation. This, in turn, leads to profits for investors. When you redeem your mutual fund units, the transaction is executed at the prevailing NAV.

Suggested read: What is mutual fund NAV?

What are the different types of mutual funds?

Understanding the different types of mutual funds can help you choose the right one for your investment goals. Let's walk through some basic fund categories:

Equity mutual funds

These funds invest primarily in stocks and are suited for long-term investors looking for high growth potential. However, the time horizon varies across categories. Here are the key fund types:

Large-cap funds: These are mutual funds that primarily invest in the top 100 companies in terms of market capitalisation - at least 80 per cent of their assets.
These companies are well-established, financially stable, and have a proven track record of consistent performance. As a result of their size and stability, large-cap funds tend to be less volatile compared to mid-cap or small-cap funds.
Mid-cap funds: These are mutual funds that invest in companies ranked between 101st and 250th in terms of market capitalisation - at least 65 per cent of their assets.
These companies are typically in their growth phase, offering the potential for higher returns than large-cap stocks. However, they also carry higher risk and volatility.
Small-cap funds: These funds invest in companies with a market capitalisation ranking below the 250th position - at least 65 per cent of their assets.
These companies are typically in the early stages of growth, which gives them the potential for high returns. As these businesses are still finding their feet, they come with higher volatility and risk compared to larger companies.
Flexi-cap funds: These funds have complete flexibility of investing in companies across market capitalisations. This allows them to provide broad market exposure, allowing investors to benefit from a variety of stock opportunities.
Sectoral and thematic funds: These funds aim to capitalise on the growth of a certain sector or theme. However, if that market segment goes through a downturn, the funds will be heavily impacted.

Debt mutual funds

These invest in fixed-income securities like bonds and government securities, offering lower risk but moderate returns. Some popular debt fund categories are:

Short-duration funds: These mutual funds are mandated to maintain a Macaulay duration of one to three years. They invest mainly in a mix of short-term government and corporate bonds..
Long-duration funds: These are mutual funds that primarily invest in long-term debt securities, such as government and corporate bonds, that have a maturity period of over 7 years. These funds invest in bonds with longer time horizons but are more sensitive to interest rate fluctuations.
Corporate bond funds: They invest primarily in corporate bonds. These funds pool money from multiple investors to create a diversified portfolio of bonds issued by companies across various sectors and credit ratings.
Gilt funds: Gilt funds are a type of mutual fund that primarily invests in government securities, such as bonds issued by the central or state government. These funds are considered low-risk in terms of credit risk because they are backed by the government. However, they remain subject to interest rate risk just like any other long-duration bond."

Hybrid mutual funds

A mix of equity and debt, these funds aim to strike a balance between risk and reward. Examples:

Aggressive hybrid funds: These mutual funds invest 65-80 per cent of their assets in equity and the rest in debt instruments. These are good long-term investments for people looking for higher returns with moderate risk.
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 carry limited equity risk, generating better returns than debt-only funds while managing volatility.. This makes them suitable for medium-term investors (3+ years) seeking stable growth.
Balanced advantage funds: These funds have flexibility in allocation across equity and debt ranging from 0 to 100 per cent in either asset class, depending on the fund's model and based on the market scenario. Suitable for investors looking for dynamic asset allocation with lower drawdowns.

Suggested read: Simple, very simple

Index funds & ETFs

Index funds: They are mutual funds designed to track the performance of a specific market index, such as the Nifty 50 or Sensex. These funds invest in the same stocks that make up the index in the same proportions. Since they aim to replicate the index's performance rather than beat it, index funds tend to have lower fees compared to actively managed funds.
ETFs: Exchange Traded Funds (ETFs) are similar to index funds in that they aim to mirror the performance of a specific index or sector. However, unlike index funds, ETFs are listed and traded on stock exchanges like regular stocks, allowing investors to buy and sell them at market prices throughout the trading day. With lower expense ratios and real-time trading flexibility, ETFs offer a cost-efficient and dynamic way to gain index exposure.

That said, ETFs are prone to skewed pricing wherein the intrinsic NAV and the market price stray from each other. This is due to the impact of supply and demand dynamics over the stock exchange. Hence, when demand is high for an ETF, it will trade at a premium. And at a discount if the demand plummets for it.

Suggested read: What is a Nifty ETF?

International funds

These mutual funds invest in assets outside India, giving investors exposure to global markets.

While international funds offer diversification, they come with risks, such as currency fluctuations and geopolitical uncertainties. Also, you need to have a fair understanding of the market you're planning to invest in.

What are the benefits of investing in mutual funds?

Mutual funds offer multiple advantages, making them a preferred choice for both beginners and experienced investors. Here's why you should start investing:

Diversification

Mutual funds offer built-in diversification by pooling money from multiple investors and investing in a variety of assets, such as stocks, bonds, and other securities. This helps spread risk, so poor performance in one asset class may be offset by better performance in another, resulting in a more balanced and stable portfolio. Diversification reduces the overall risk for investors and increases the likelihood of achieving more consistent returns.

Professional management

They are managed by experienced fund managers who make investment decisions on behalf of the investors. These professionals use their expertise to analyse the market, evaluate companies, and select investment opportunities that align with the fund's objectives. This provides investors with access to professional management and sophisticated strategies, even if they do not have the time or knowledge to manage their own investments.

Liquidity

Mutual funds offer liquidity, allowing investors to place buy or sell requests on any business day. The transaction requests are processed at the fund's end-of-day Net Asset Value (NAV), provided the request is submitted before the cutoff time. Redemption proceeds are usually credited to the investor's bank account within 1 to 4 working days, depending on the fund type.

This flexibility allows investors to access their funds quickly, providing greater convenience compared to other less liquid investments like real estate or fixed deposits.

Tax benefits

Investing in Equity-Linked Savings Schemes (ELSS) funds offers tax-saving benefits under Section 80C of the Income Tax Act. ELSS funds allow individuals to claim a deduction of up to Rs 1.5 lakh per year, which helps reduce their taxable income. In addition to tax savings, these funds have a relatively short lock-in period of 3 years compared to other 80C investments.

Note: Section 80C benefits are available to investors opting for filling taxes under the Old Tax Regime.

Systematic Investment Plan (SIP)

This investment mechanism allows investors to contribute a fixed amount of money regularly (typically every month) into a mutual fund. This strategy fosters disciplined investing and helps average the cost of acquisition, reducing the impact of market volatility.

By investing consistently over a long period of time, investors can benefit from the power of compounding, leading to long-term wealth creation. SIPs make it easier for individuals to invest in mutual funds without needing to time the market, making them ideal for long-term financial goals.

Suggested read:What is an SIP?

What are the risks and costs involved?

While mutual funds are a great investment tool, they come with certain risks and costs:

Market risk: Performance depends on market movements, meaning returns aren't guaranteed. For instance, if you have invested in an equity fund, and the markets crash the very next day, you'll most likely make a loss. Similarly, if interest rates rise, the value of a debt fund will also depreciate. These investments are linked to market performance.
Expense ratio: It is a fee charged by fund houses to manage your investment. Higher expense ratios eat into returns over time.
Exit load: Some funds charge a fee if you redeem your investment within a specified time. Usually, it is for one year.
Lock-in period: ELSS funds have a 3-year lock-in, meaning you can't redeem your units before that. Most other mutual funds have no lock-in and can be redeemed anytime.

How to start investing in mutual funds

Where should beginners start?

Investing in mutual funds is easy, but the right approach matters. Follow these steps:

Open an account: You can start with a discount broker or an AMC; either way, you'll get the option to invest directly.
Decide between Direct and Regular Plans: By investing through a direct plan, you get to pay a lower expense ratio. This is because regular plans involve intermediaries, adding up hefty commissions to the expense ratio.
Select funds based on goals & risk tolerance: Define your investment horizon and risk appetite before choosing a fund.
Opt for SIP or Lump Sum Investment: SIPs are ideal for consistent investing, while lump sum investments suit those with surplus funds. That said, you'd ideally want to invest in equity or hybrid funds through an SIP. On the other hand, lump sums are more suitable for debt funds.

Suggested read: SIP vs lumpsum: There's one clear winner!

Common myths about mutual funds

Are mutual funds only for experts?

No, mutual funds are designed for all kinds of investors, including beginners. Fund managers handle your investments, so you don't need deep market knowledge.

Do I need a large sum to invest?

No, you can start investing with as little as Rs 250 through an SIP.

Do mutual funds guarantee returns?

No, mutual funds are subject to market risks, and returns fluctuate based on asset performance.

Conclusion

Mutual funds are a versatile and accessible investment option that caters to various financial goals. Whether you're looking for long-term growth, steady income, or tax savings, there's a mutual fund just right for you. By understanding the basics and making informed decisions, you can start your investment journey with confidence.

You may often be tempted to chase returns. But this isn't wise due to the following reasons: