What is Mutual Fund? Types, Benefits & How to Invest?

Mutual Funds are investment instruments that combine different instruments such as stocks or shares, bonds or both into a single product which is managed by an expert fund manager.

How do they work?
A number of investors with a common objective invest in a mutual fund product and their collectively pooled investment corpus is then invested into a desired combination of assets by a professional expert.

While investing in a mutual fund, you must look at the where the fund invests, the time horizon of your investment, the risk profile of the product, consistent historical performance across time horizons and more importantly, if the fund’s investment objective aligns with yours. A fund manager (a professional expert) then invests the money according to that pre-defined investment objective such as capital appreciation (looking for high growth in companies) or income (looking for more predictable investments such as debt securities) or a combination of both.

You can invest in mutual funds by making a one-time investment (lump sum) or via automated, periodic investments of fixed amounts (the highly popular Systematic Investment Plans).

Let’s look at the wide range of mutual funds available today.

Categories of mutual funds

Mutual fund schemes fall under two broad categories based on entry-exit restrictions:
1. Open-ended funds, in which the investor can buy and sell units at any point of time
2. Close-ended funds, which offer units to investors at the time of the initial launch only. Once the initial launch is over, the units are only listed on the stock exchange where investors can buy and sell them. They cannot be bought or sold directly from the asset management company after the initial launch period.
Open-ended funds technically exist till perpetuity while close-ended funds exist for a fixed duration of time.
In addition to being categorized as open-ended and close-ended, mutual funds are also generally categorized based on their underlying securities and investment objectives.
Types of mutual funds
There is a wide range of mutual funds that are suitable for different investors with differing needs and risk profiles.

  1. Debt funds or Fixed Income funds: Mutual funds which primarily invest in fixed income securities such as bonds, debentures, government securities, etc. are known as debt or fixed income funds. Debt funds are considered to carry low-to-moderate risk. They provide steady but modest returns relative to equity funds.
  2. The various types of debt funds include:

    • Income funds: These are funds which invest in a mix of corporate bonds and government issued securities. Income funds seek to provide returns in the form of income with potential capital appreciation.
    • Gilt funds: These funds invest in government securities of medium to long term maturities. Gilt funds do not carry default risk; however, prices and returns over the short term say less than one year, can be very sensitive to changes in interest rates.
    • Liquid funds: These are funds which invest in highly liquid money market instruments such as treasury bills, commercial papers and certificates of deposits. Liquid funds are suitable for investors who seek a high degree of liquidity and minimal risk. Their prices and therefore daily returns do not vary much, so they are considered a more stable form of investment that can offer moderate returns. Experts sometimes recommend liquid funds as a good alternative to fixed deposits.
    • Fixed Maturity Plans (FMPs): These are close-ended debt funds with a fixed tenure which is aligned with the maturity dates of the securities held by the fund. This synchronized maturing largely eliminates interest risk or reinvestment risk. They require you to remain invested for a finite period and unlike liquid funds they are not easily redeemable. But because the returns are more stable and predictable within a range they are also considered a great alternative to fixed deposits.
  3. Equity funds: Mutual funds which primarily invest in equity shares are known as equity funds. The primary objective of equity funds is to invest in equity stocks and equity oriented instruments to provide capital appreciation over the medium to long term.
  4. The various types of equity funds include:
    • Diversified equity funds: These funds invest in a wide range of stocks across various sectors and market capitalization levels, according to the investment objective. The aim of diversified equity funds is to provide long-term capital appreciation while reducing concentration risk i.e. high exposure to just one type of sector or asset class, that may carry a lopsided risk. Some diversified equity funds, if classified as an Equity Linked Savings Scheme (ELSS), can also help you save tax under Section 80c of the Indian Income Tax Act, 1961.
    • Focused funds: These funds invest only in equity securities of companies with certain defined market capitalization, or in those that operate in a single sector, or those that in general, fall within a pre-defined set of parameters.
    • Sectoral funds: These are funds which invest in stocks of a particular sector or industry (such as technology, banking, pharmaceuticals and infrastructure). Sectoral funds, though risky by virtue of investing in only a single sector, have the potential to outperform diversified equity funds in case the underlying sector registers higher growth than other industries.
    • Index funds: Equity funds which invest in all securities of a market index (such as the S&P BSE Sensex or Nifty 50) are known as index funds. These funds aim to replicate the returns of the underlying index as closely as possible. They provide broad exposure to the markets. Moreover, the portfolio turnover and operating costs of index funds are lower than other funds.
    • Capitalization based funds: Equity funds can also be classified based on the size of companies they invest in. If you’re willing to take high risk in the quest for higher returns, you may consider small or micro cap funds- these invest in small, largely undiscovered companies that have high potential over the long term. Alternatively, you can invest in large cap funds- those that invest in ‘blue-chip’ companies, or those companies that are well known, well researched and have existed and done well for many years already.
  5. Hybrid funds: Mutual funds which primarily invest in a mix of debt and equity instruments are known as hybrid funds or balanced funds. Hybrid funds aim to provide the best of both i.e. capital appreciation from equities and stable income from debt investments.
  6. The various types of hybrid funds include:
    • Balanced funds: These funds invest in both equity and debt instruments, with 65 per cent in equities and the rest in debt.
    • Monthly Income Plans: These are hybrid funds which aim to generate regular income through investments in debt instruments (which account for 75-100 per cent of the fund) and equities (which constitute 0-25 per cent of the fund).
    • Algorithmic funds: These are funds that are based on the idea of scientific asset allocation and rebalance their own portfolios automatically, based on a predefined formula or an algorithm. These generally check for the relative attractiveness of equity and fixed income and decide the right balance for an investor automatically.
  7. Gold Funds (Gold ETFs): These are exchange-traded funds which invest in gold. Generally, each unit of a Gold ETF represents approx one gram of gold. One can benefit from a rise in the Gold prices, without actually purchasing solid gold and then worrying about how or where to store it safely.
  8. Fund of Funds (FoFs): These are funds which invest in units of other mutual funds, thereby giving you benefit of multiple funds in one. These funds also help you access stocks or industries which may not be easily accessible, for you to invest directly. There are some fund-of-funds which act as feeder funds - which means, they invest in international stocks or mutual funds. For example, there are some popular fund of funds available in India today that can give you access to stocks from international markets such as the US, Brazil or even China. These funds are great options for those investors looking to invest in sectors that may not be easily accessible to investors in India.

Benefits of mutual funds

Mutual funds offer a number of benefits to investors:

  1. The process of investing in mutual funds, just like the product itself, is simple.
  2. You can start investing with very small amounts of money.
  3. There is a wide variety of products suitable for every investor with all kinds of needs.
  4. They provide you the benefit of a dedicated, professional expert fund manager and you don’t have to carry out fund management by yourself.
  5. Mutual funds offer you the benefit of multiple asset types, for example equity and fixed income. This means that you not only have the opportunity to make great returns, but you can do so while managing your risk well.
  6. You know exactly what’s going on with your money. You get regular updates and stay well-informed on investments made by the fund, the expenses incurred, the change in prices (NAVs) and any change in the fund’s management. In other words, there is full transparency.
  7. Your mutual fund investments can be easily monitored through specialist websites that track mutual funds or even on the website of your Asset Management Company (AMC). The websites usually provide information like returns of the scheme compared with category average and benchmark, expense ratio, past performance, etc.
  8. Mutual funds are closely regulated by the Securities and Exchange Board of India, or SEBI, the capital market watchdog.
  9. You can invest smartly using a number of investment strategies such as Systematic Investment Plan, or SIP, Systematic Transfer Plan, or STP, thematic investing, etc.
  10. There are also smart tax benefits of investing in mutual funds, relative to other financial instruments. Consult a financial advisor for more on this.

How to invest?

Investing in mutual funds is a simple process. The various ways through which you can invest in mutual funds include:

  • Direct investment by approaching the sales office of the fund house
  • Investment through authorized agents and distributors
  • Online investment through the website of the fund house or through distributor websites
  • Investment through the stock exchange
What do you need to know?
  • When you invest in a mutual fund, you get units at the NAV (NAV stands for Net Asset Value). NAV represents the market value of all the securities that the mutual fund has invested in.
  • Before you invest in a mutual fund, you must check about the minimum investment amount, the scheme’s expense ratio (the higher the expense ratio, the more costly it is to invest in the scheme), the scheme’s investment objective, the scheme’s past performance, etc. It is important that you spend some time understanding these elements before investing.
  • To guide you with your investments in mutual funds and help you make informed decisions, you should consult an investment advisor who can provide you with advice suitable to your circumstances.

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Key Takeaways

  1. Mutual Funds are a great investment instrument and combine the benefits of many different investment instruments into one single product.

  2. There are many different types available and there is a mutual fund available for most investor needs.

  3. There are many advantages of mutual funds, including their variety, simplicity, affordability, ease of purchase, easy buying and selling, regulation, in-build diversification, tax benefits etc.