What Are Mutual Funds: Meaning, Types, Benefits And More

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Investing can be overwhelming, especially with so many options available. Mutual funds simplify the process by allowing individuals to invest in a diversified portfolio that professionals manage. So, whether you are looking for long-term growth, stable returns, or tax benefits, mutual funds offer a variety of choices to suit different financial goals. Let's learn more about these instruments. 

Mutual Funds in Simple Words

A mutual fund is an investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other assets. By doing this, mutual funds offer a way for everyday people to invest in a diversified portfolio, which can help to reduce risk. Thus, instead of trying to pick individual stocks, you are essentially letting experts manage your money for you, spreading it across many different investments.

Think of it like a community garden. Instead of each person trying to grow their own individual garden, everyone puts their money together to create one big garden. A professional gardener (the fund manager) then takes care of planting, watering, and harvesting a variety of crops (the investments). Each person who contributed gets a share of the harvest (the returns), based on how much they put in. This way, if one crop doesn't do well, the others might, and everyone still gets something. 

How Mutual Funds Work

Mutual funds are managed by professional fund managers who allocate the pooled money into different securities based on the fund’s objectives. Investors receive units or shares proportional to their investment, and the fund’s overall performance determines their returns. These funds generate returns through dividends, interest income, and capital appreciation.

Mutual funds are priced based on their Net Asset Value (NAV), which is calculated by:

NAV = (Total Assets−Total Liabilities) / Total Number of Outstanding Units​​

NAV represents the per-unit value of the mutual fund and is recalculated at the end of each trading day based on market fluctuations. So, NAV fluctuates daily based on market performance.

How to Invest in Mutual Funds

Investing in mutual funds involves some simple steps. Take a look: 

Step 1: Choose a Fund Type

• Equity Funds: Suitable for long-term growth but carry higher risk.
• Debt Funds: Ideal for stability and lower risk with fixed-income instruments.
• Hybrid Funds: A combination of equity and debt for balanced risk.
• Index Funds: Passive investments that track a market index.

Step 2: Select a Fund House

• Research asset management companies (AMCs) and their fund performance.
• Compare past returns, reputation, and fund manager experience.

Step 3: Open an Account

• You can invest directly with a fund house, through a bank, or a brokerage platform.
• Online platforms offer easier access and tracking.

Step 4: Decide Investment Mode

• Lump Sum: A one-time investment, suitable for those with surplus funds.
• Systematic Investment Plan (SIP): Allows regular contributions, reducing market timing risks.

Step 5: Complete KYC Requirements

• Submit PAN card, Aadhaar, and address proof.
• Complete in-person verification or e-KYC online.

Step 6: Monitor Performance

• Regularly check fund performance against benchmarks.
• Rebalance portfolio based on financial goals and market conditions.

Types of Mutual Funds

Mutual funds offer a diverse landscape of investment opportunities, catering to a wide spectrum of financial goals and risk tolerances. Understanding the different types of mutual funds is crucial for any investor seeking to build a well-rounded portfolio. Here are the different types of mutual funds:  

1. Equity Mutual Funds

Equity funds primarily invest in stocks and are best suited for investors seeking long-term capital growth. These funds come in various categories based on the type of stocks they invest in:

• Large-cap Funds: Invest in well-established companies with stable returns and lower risk.
• Mid-cap Funds: Focus on medium-sized companies with higher growth potential but moderate risk.
• Small-cap Funds: Invest in smaller companies, offering high growth but carrying significant risk.
• Multi-cap Funds: Diversify investments across large, mid, and small-cap stocks for balanced risk.

Read - What are Mid-Cap Funds in detail

2. Debt Mutual Funds

Debt funds invest in fixed-income securities such as government bonds, corporate bonds, and money market instruments. These funds are ideal for conservative investors looking for stable returns with minimal risk. Some popular types of debt funds include:

• Liquid Funds: Invest in short-term money market instruments and offer high liquidity.
• Gilt Funds: Invest in government securities and carry zero credit risk.
• Corporate Bond Funds: Focus on high-rated corporate debt for better returns than government bonds.

Read - What are Gilt Funds in detail

3. Hybrid Funds

Hybrid funds invest in both equity and debt instruments to balance risk and returns. These funds cater to investors who want exposure to equities while mitigating risks with debt instruments. Key categories include:

• Aggressive Hybrid Funds: Hold a higher proportion of equity (65-80%) and the rest in debt.
• Conservative Hybrid Funds: Prioritize debt (70-80%) with a small portion in equities.
• Balanced Hybrid Funds: Maintain a near-equal allocation between equity and debt.

4. Index Funds

Index funds are passively managed and aim to replicate the performance of a specific stock market index, such as NIFTY 50 or S&P 500. These funds have lower expense ratios since they do not require active management and are ideal for investors looking for market-matching returns with minimal costs.

5. Sectoral/Thematic Funds

These funds focus on specific industries or themes, such as technology, banking, or healthcare. While they can generate high returns during favorable market conditions, they also carry higher risk due to limited diversification.

6. ELSS (Equity-Linked Savings Scheme)

ELSS funds are tax-saving mutual funds that offer deductions under Section 80C of the Income Tax Act. They come with a mandatory lock-in period of three years and primarily invest in equities, providing both tax benefits and growth potential.

Top Mutual Funds

The best mutual funds vary based on performance, risk appetite, and market trends. It is advisable to check financial platforms for up-to-date rankings based on:

• Returns: Short-term and long-term performance.
• Expense Ratios: Lower fees mean better net returns.
• Fund Manager Expertise: Their track record in managing funds.

Mutual Funds vs. Index Funds and ETFs

Mutual funds, index funds, and ETFs all offer diversified investment, but they differ in structure and trading. Mutual funds are actively or passively managed pools of assets, priced once daily. Index funds are a type of mutual fund that passively track a specific market index, aiming to replicate its performance. ETFs (Exchange-Traded Funds) are similar to index funds in tracking an index, but they trade like stocks on exchanges, offering intraday liquidity and often lower expense ratios.

While mutual funds provide professional management and ease of access, index funds and ETFs emphasize cost-efficiency and trading flexibility. Let's take a look at their differences: 

Mutual Funds vs. Index Funds

Mutual Funds vs. ETFs

How Are Earnings Calculated for Mutual Funds?

Mutual fund earnings are derived from several sources, all contributing to the fund's overall performance and, consequently, the returns you receive as an investor.

Dividends & Interest

If a mutual fund holds stocks, it receives dividends distributed by the companies in which it invests. Similarly, if it holds bonds, it earns interest payments. These income streams are passed on to the fund's investors.

These earnings are typically distributed as dividends to unit holders, or reinvested back into the fund, increasing its Net Asset Value (NAV).

Capital Gains

When the fund manager sells securities (stocks, bonds, etc.) at a price higher than their purchase price, the fund realizes a capital gain.

These gains are also distributed to investors, often as capital gain distributions, or reinvested.

NAV Appreciation

The Net Asset Value (NAV) of a mutual fund represents the market value of its assets minus its liabilities, divided by the number of outstanding units.

As the market value of the fund's holdings increases over time, the NAV appreciates. This appreciation reflects the overall performance of the underlying investments.

Essentially, even if the fund does not sell any assets, the value of the assets it holds can increase, and this increase in value is reflected in the NAV.

Pros and Cons of Investing in Mutual Funds

Before investing in mutual funds, it is crucial to understand the advantages and disadvantages that one may encounter: 

Are mutual funds risk-proof?

It is important to note that mutual funds, while offering diversification, are not risk-free. Market fluctuations can significantly impact fund values, especially equity-focused ones. The risks boil down to: 

• Market Risk: The general ups and downs of the stock or bond markets.
• Credit Risk: If the fund holds bonds, the issuer might default.
• Interest Rate Risk: Bond values change when interest rates change.
• Liquidity Risk: Difficulty selling fund units quickly.
• Management Risk: The fund manager's decisions might not perform well. 

Different Ways of Evaluating Mutual Funds

To make informed investment decisions, it's crucial to evaluate mutual funds based on several key factors:

Historical Performance

• Analyze the fund's past performance relative to its benchmark index.
• However, remember that past performance is not indicative of future results.

Expense Ratio

• Compare the expense ratios of different funds within the same category.
• Lower expense ratios generally result in higher net returns.

Fund Manager Expertise

• Research the fund manager's experience, track record, and investment philosophy.
• A skilled fund manager can significantly impact a fund's performance.

Risk Profile

• Assess the fund's risk profile (e.g., standard deviation, Sharpe ratio) and ensure it aligns with your risk tolerance.
• Understand the funds volatility.

Portfolio Composition

• Examine the fund's asset allocation (e.g., equity, debt) and diversification.
• Ensure the portfolio aligns with your investment goals and risk tolerance.
• Review the funds holdings.

To conclude, mutual funds are a way to invest your money with other people, letting experts do the work for you. They offer a good way to spread out your risk and make investing easier. But, like anything, there are good and bad things about them. To make smart choices, you need to look at how the fund has done in the past, how much they charge you, who's managing the money, and what kind of risks you're comfortable with. If you do your homework and think about your goals, mutual funds can be a useful tool to help you grow your money over time.

Time for a little quiz!

Frequently Asked Questions

1. Are mutual funds safe?

Mutual funds carry risk depending on the type of fund. Equity funds have higher risk, while debt funds are more stable.

2. Can I withdraw money from a mutual fund anytime?

Yes, unless it’s a closed-ended or ELSS fund with a lock-in period.

3. What is the minimum amount needed to invest in mutual funds?

You can start with as low as INR 500 through SIPs.

4. How long should I stay invested in mutual funds?

Ideally, long-term (5+ years) for better returns, but this depends on your financial goals.

5. How do I track my mutual fund investments?

Use online platforms, mutual fund apps, or statements from your fund house.

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