Mutual Funds are financial vehicles in which multiple investors pool in money for long term gains. These collected funds are then invested in stocks, bonds, money market instruments, commercial paper, and other assets.
The minimum amount for investing in a mutual fund is also not very high. Most funds allow even a 500 INR investment. One can invest only once or one can regularly invest a fixed amount through what is known as SIP (systematic investment plan).
A professional fund manager manages a mutual fund. It is the job of the fund manager to set the fund’s investment objectives and then follow them by making investment decisions. Furthermore, the fund manager will allocate money to generate returns that are in line with the mutual fund’s objectives.
Mutual funds are an easy way for small individual retail investors to get access to the services of a professional portfolio manager. Even companies can invest in mutual funds. Hence, everyone from a wealthy person to an average-income earner can invest in mutual funds.
Every mutual fund investor is like a shareholder in a mutual fund
He/she participates in the profit and loss of the fund. The value of a mutual fund depends upon the stocks and other investments that the fund buys. When an investor invests in a mutual fund, he/she is buying a part of the mutual fund’s portfolio.
However, there is one key difference in buying mutual funds vs directly buying stocks. Even though mutual fund investors indirectly hold the stocks that the fund invests in, they do not have any voting rights associated with those stocks. In a nutshell, every unit of a mutual fund represents an investment in multiple stocks.
The price of each mutual fund unit is represented by Net Asset Value or NAV
The NAV of a unit of a mutual fund is calculated by dividing the total current market value of the fund’s portfolio (plus cash) by the total number of units that the fund has issued to its investors (similar to shares outstanding).
Any investor buying and selling mutual fund units essentially gets paid (or gets to purchase) at the prevailing NAV value. Furthermore, this NAV value is updated at the end of each trading day.
Mutual funds charge investors a fee for their service. This fee is normally a percentage of the total money pooled into a fund. This pooled money is called Assets Under Management (AUM) and also, the fee charged by the fund every year is denoted by the Expense Ratio.
Benefits of investing in mutual funds
Rate of return – There are plenty of benefits of investing in mutual funds. The first and most important benefit is the superior rate of return. If you choose your mutual fund well after doing relevant research, then it is highly likely that your fund will generate returns in excess of a suitable benchmark like the Sensex or the Nifty. In general, mutual funds are known to generate return significantly higher than the returns of an FD or a bank deposit.
Access to a diversified portfolio – The second important benefit of investing in a mutual fund is the access to a large, diverse, and well-researched portfolio. If an investor were to pick his/her own stocks/bonds and invest directly without any help, then he/she would have to personally analyze, study, and carefully select stocks and bonds.
Most importantly, great care has to be taken in making selections which will not go bust and evaporate all the investor’s hard-earned money.
Another problem is that of diversification
An investor has to know how to spread financial risk and not invest in one narrow theme or sector. A third conundrum would be that of asset allocation.
How much money to invest in a particular stock?
These tasks are some of the most challenging exercises in the world. Even the best of the best investors get almost half of their calls wrong. Therefore, investing directly requires a full-time commitment and total dedication towards studying businesses every single day.
Moreover, not every person has the time and the resources to analyze stocks for hours and hours each day. This is because a mutual fund shifts the responsibility of the research, stock selection, and asset allocation to a fund manager.
Not every person has the skill to be an astute fund manager. A mutual fund fills the skill gap as well. The fund basically gives you a readymade investment portfolio. All the investor has to do is pick the right fund and then invest regularly.
The returns and performance will take care of themselves over time
Liquidity – Mutual funds are relatively liquid when compared to real estate or business investments. If you want to sell your mutual fund units, you can do that immediately, and you will receive the money in one or two days at most. Certain funds like interval funds may have some conditions on when an investor can sell out the units, but those are narrow and specific cases.
Also, you do not have to worry about finding any buyers for your portfolio stocks or bonds. It is the fund’s responsibility to do that (except in FMP and close-ended funds). The fund will simply hand you back your money whenever you decide to sell your units. Thus, mutual fund investments are quite liquid.
There may be some exceptions as to how much you can withdraw in one request.
But, most investors normally do not hit those limits in regular circumstances.
Economies of scale – The advantages of scale exist in the world of investing as well. The most apparent benefit from the large base or scale of a mutual fund would be lower transaction costs. Furthermore, if an individual investor were to buy low quantities of all the stocks that a mutual fund has, that investor would have to pay a lot of fees to execute those transactions. With mutual funds, those fees and overhead expenses get spread out over a larger base, thus reducing transaction cost per investor.
The other benefit of scale would be the ability of a mutual fund to take large positions. Being an institutional investor, a mutual fund gets access to IPO placements.
Focused investing – Since every mutual fund has an investment objective, investors can achieve their financial goals by investing in mutual funds. If an investor invests for meeting significant expenses like marriage or a child’s education, then there are long term funds which provide the kind of capital appreciation than the investor hopes for.
If an investor needs a liquid investment to park some extra cash for a short duration, then there are mutual funds which do just that. Every financial goal or situation has a suitable mutual fund that can fit the purpose. Therefore, Mutual funds allow investors to invest in a focused and goal-oriented way.
Regulated by SEBI – Mutual funds are regulated in India by the Securities and Exchange Board of India. To clarify, it means that the regulatory body has to look at the investor’s interest and protect it. To clarify, it has to prevent any wrongdoing and mitigate any structural risk from the point of view of how mutual funds are operated by asset management companies (AMCs).
AMCs are the company that initiates and operates a mutual fund. The SEBI regulation makes the mutual fund industry a mature and stable one. Furthermore, the level of transparency is high, and it increases investor confidence.
What are the different types of mutual funds?
There are three main categories of mutual funds: equity funds, debt funds, hybrid funds, and solution-oriented funds.
Equity funds are funds which invest a minimum of 65% of its assets in equity and equity-related instruments. The remaining 35% or less can be invested in debt or be held as cash. Based on the size of the companies that equity funds invest in, they are further grouped into small-cap, mid-cap, and large-cap.
There are multicap funds as well, which invest in companies of all sizes. Then there are sector-based funds investing in a particular industry or sector. Another popular category is ELSS, which has to invest 80% of its assets in equities. Also, ELSS investors are eligible for a tax deduction of up to 1.5 lakhs under section 80C.
Equity funds do provide the highest returns among all types of debt funds, but they are also the most volatile. Hence, the equity fund category is considered to be the riskiest type of mutual fund category.
Debt funds primarily invest in debt instruments. A mutual fund which invests less than 65% of its total assets in equities is considered to be a debt fund. Debt, as an asset class, is less volatile than equity. Hence, debt funds are considered to be less risky than equity funds.
There are 8 different types of debt funds. The primary criterion for these 8 groups is the duration of the debt securities in which the Funds invest. Some funds invest in debt instruments that have a maturity of 1 day, while some funds invest in debt securities that mature after 3, 4, and even 7 years.
The rate of return of debt fund varies according to the type of debt it invests in. Generally speaking, debt securities of higher duration tend to give a higher return. But, this is not always the case, and the trend is dependent on the economy and the macro-economic policies of the country’s central bank.
Hybrid funds invest in a variety of asset classes like equities, debt, money market instruments, gold, etc. A combination of equity and debt lowers the volatility as compared to a pure equity investment. It lowers the risk for the investor as most investors tend to construct a portfolio of equity and debt funds. Consequently, a hybrid fund creates that portfolio through an investment in one fund.
A popular type of hybrid fund is known as a Dynamic Asset Allocation Fund. It aims to maintain a ratio of equity to debt. If the equity component appreciates, then it will sell some of it and rebalance the ratio. If the equity market falls, then the fund buys equity and rebalances its equity to debt ratio.
Solution-oriented funds, as the name suggest, are designed for specific goals or financial solutions like retirement or child’s education. Furthermore, these funds tend to have a mandatory lock-in period of 5 years, or sometimes they are linked to a child becoming a major or the investor officially reaching retirement.
How exactly do I invest in Mutual Funds?
So, you have read a lot about mutual funds, know the different types of funds, and find the idea quite convincing. You now want to start investing in mutual funds. What are the next steps?
There are three ways to invest in mutual funds. You can either invest directly, go through a financial advisor, or make investments online. But before you do any of that, the first thing you need to do is prepare a financial plan.
Figure out how much money you need in the future and for what purpose. If it is a child’s education or your child’s marriage, then you need to figure out the time duration for your investment. If you know that you need a specific amount, say 15 years down the line, then you can back work and calculate how much money you need to start investing from today to reach your goal.
You also need to figure out how much risk you are willing to take. Certain expenses which are going to come up soon cannot support high risk. In such cases, you may want to invest in debt funds for those financial goals. Moreover, certain other goals, like retirement, which could be 30 years away if you are young, can allow you to take on more risk for greater appreciation. If the investment goes bad, you still have enough time to make up the losses (if you are still young).
If you are comfortable with doing your own research and are confident that you have the ability to select the right funds and allocate the right amount of money to each fund, then go ahead with direct investments. Also, you can invest in direct plans and save on brokerage/commissions, which can be a good percentage or a percentage and a half. Direct plans are available with the AMC or fund house. Contact them directly.
Be careful with the direct option as you really need to know what you are doing. One wrong step could lead to serious losses. You not only have to perform research before investing, but you also have to keep monitoring the funds, the economy, and the financial climate in general. You have to make decisions every year on whether to stay invested or move into a different fund if things change fundamentally.
Perhaps the safest option for a beginner is to invest through a financial advisor. The advisor’s job is to study the mutual funds and the market all day every day. Hence, they will know exactly the appropriate fund that fits your financial goals.
However, the biggest responsibility on your end would be to select the right financial advisor or agent. You want to select someone who is credible, well-qualified, and whose interests are aligned with yours. You do not want to work with someone who will make you invest in any fund simply because that fund pays him/her a higher commission.
Platforms like PayTM, Cleartax, and Zerodha offer a convenient and easy way to invest in mutual funds. Even mutual fund AMCs have websites where you can sign up and start investing. With online, all your investments are easily seen on one dashboard. Moreover, it is convenient to buy and sell and monitor the progress of your investments from a computer or a mobile phone.
However, the online option is similar to the first option of investing directly in some critical ways. You will have to do your own research with online and know exactly what funds you are selecting for your investments.
You can work with a financial advisor and pay him/her a fee in return for a list of funds in which you can invest. Then, you can go online or purchase a direct plan to save on the commissions.
Regular plans charge commissions every year
With a fee for advice model, you only pay the advisor a fee once (and then periodically if you do annual reviews of your portfolio). It would be a good way to get the benefit of professional advice while still investing directly or online.
To start investing in mutual funds, you will have to go through a KYC process with the AMC that you invest with. Then, you will open an account with the AMC and link your bank account to it. If you work with a distributor, then you may need to open a Demat account with them and link your bank account with that Demat account.