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Shaking hands with mutual funds

Unless you are willing to devote a lot of time and effort to research, the best way to invest in equity is through equity mutual funds

Shaking hands with mutual funds

A mutual fund comes into the picture when you seek help from an expert called a 'fund manager' to build your investment portfolio, decide what to buy, when to buy and when to sell. And like all other service providers such as a lawyer for your legal matters, a chartered accountant for your income tax returns, an architect for your house, fund managers charge a fee for their services. But there is one difference; unlike other professionals, the service is being rendered to a large group of investors together.

Shaking hands with mutual funds

Many people like you might want to invest in equity, but they need an experienced person to do that on their behalf. Suppose there are 1,000 such people and all are willing to invest Rs 10,000. The fund manager would now invest this pooled money of Rs 1 crore (10,000*1,000) and build a portfolio of stocks based on their team's research. This one crore is called assets under management (AUM) of the fund.

It increases or decreases because of two factors:
(i) fresh investments/withdrawal of money by investors, or
(ii) change in the market value of stocks that the fund has invested in

So while you are busy with your day-to-day life and your job, you have resources in the form of professional fund managers whose full-time job is managing money to look after your investments. For over three decades, mutual funds have been in India, and they have proven their worth by delivering superior returns with great convenience.

At this point, your mind might be exploding with a lot of questions about mutual funds. Let's go through them one by one.

ABC of mutual funds

What is a mutual fund & how it works?

  • As explained above, a mutual fund is a pooled investment vehicle. When you invest in a bank fixed deposit, the bank issues an FD certificate which entitles you to the maturity amount at the end of FD tenure. In a mutual fund, you deposit a sum of money in a mutual fund scheme, and in return, you are allotted units of the scheme to represent your share of ownership in the AUM of the fund.
  • Shaking hands with mutual funds

  • The price of each unit is called NAV. Over time, as this NAV grows, so does the value of your investment. You can easily get the NAV of your units at the end of each day, so you know the exact worth of your investment. Not only that, at the end of each month, you can even see where your fund manager has invested your money. Thus, it is entirely transparent.
  • The mutual fund units do not have a maturity date, but you can render them back to the mutual fund anytime to get the value of your investment at the prevailing NAV. For example, if you invested Rs 10,000 in a mutual fund scheme when its NAV was Rs 25, you would've got 400 units. Five years later, you decide to take your money out. By then, the NAV has grown to Rs 40. You can now put in a request to redeem your units, and Rs 16,000 (400*40) will hit your bank account in about 3-5 days.

Shaking hands with mutual funds

Thus, your gain per unit is the difference between NAV at the time of selling and buying the unit. So from the investors' point of view, only the percentage change in the NAV is important, not the actual number.

This is, in essence, what a mutual fund is and how it works.

Who runs mutual funds?
Mutual funds are run by mutual fund houses, known as Asset Management Companies (AMCs). Mutual fund & its registration is regulated by SEBI (Securities and Exchange Board of India). Just anybody cannot start an AMC. There are a lot of requirements to be met, such as a capital of at least Rs 50 crore. Once all stipulated requirements are complied with, SEBI grants registration certification as a mutual fund and approves the applicant (AMC).

Are mutual funds safe?

  • Yes, structurally, they are safe. SEBI regulates the fund industry very tightly, just like RBI regulates banks. Also, mutual funds are obligated by law to release comprehensive data about their operations and investments periodically. It is a regulated product where the people you give your money to manage will not run away with it.
  • Having said that, don't mistake safety for a guarantee of returns. A mutual fund can inflict losses by making poor investment decisions on your behalf. But don't worry too much about that. Because though it is true that equity doesn't guarantee returns and can subject you to sharp ups and downs on a day-to-day basis, the risk diminishes substantially over a longer time frame of five years or more. In the last five years (as on November 15, 2021), even the worst diversified equity fund has delivered returns at the rate of 10-11% per annum. So you see, even after making a poor choice, you would have been better off than any fixed-income investment alternative!

What is the minimum amount that needs to be invested?
For most funds, it is possible to start investing with as little as Rs 500-1,000. On your own, you can't buy even a single share of many good companies for that low an amount. Thus, with mutual funds, one can get the benefit of a diversified portfolio of 25-30 stocks or more with a small amount of money.

Shaking hands with mutual funds

Is it possible to withdraw money anytime?
Unlike many other investments, mutual fund investments are highly 'liquid.' 'Liquid' means an investment that can be withdrawn without any delay. You can easily withdraw any amount from mutual funds. These redemptions can be made directly to your bank account and take no more than three working days. Of course, withdrawal is not the intent when you are saving and investing to build long-term wealth, but at least you have an exit route available if it is needed.

What are the costs?
Investors pay mutual funds a percentage of their investment amount every year to manage their money. This is called the 'expense ratio.' It includes the fund management fee, agent commissions, selling and promotion expenses, and other fees incurred by the fund. In simple words, if a fund earns returns equal to 12 per cent and has a total expense ratio of 2 per cent, then as an investor, you will make a return of 10 per cent. SEBI has stipulated the upper limit of 2.25 per cent that a fund can charge as an expense ratio.

A mutual fund for every need

Shaking hands with mutual funds

Mutual funds are available for all types of return potential, risk level, and also for every kind of time horizon suitable as per your needs. No matter what type of investment you want, there's likely to be a variety of funds that suit you.

To understand the universe of mutual funds in a simplified manner, let's take an example of a clothing store.

Shaking hands with mutual funds

Equity funds invest in equity shares. Debt funds invest in fixed income securities like bonds (bonds can be issued by a company or the government and carry a fixed interest and a promise of the return of principal on a specified date). Hybrid funds invest in a mix of both equity and debt instruments.

Before you start feeling overwhelmed about choosing the right fund, let us clear the clutter. For starters, there is no need to pay attention to all the categories of mutual funds. In school, you did not study all the stuff in class 1 itself, right? You made systematic progress till class 12. The same goes for investing. You need to start simple, and other things will follow over time. The following section of this course will focus on equity investing with the help of mutual funds.

If you feel clueless about which equity mutual fund you should begin your journey with and how to pick one from the various AMCs' funds available, don't worry. We have a simple and effective plan for you in the next chapter!