What are mutual funds?
Mutual funds are an investment vehicle that pool money from multiple investors to buy various assets like stocks, bonds, and money market instruments. Managed by investment professionals and regulated by the Securities and Exchange Board of India (SEBI), mutual funds offer diversification, which helps spread risk across different investments for potential returns. By pooling funds, they aim to provide investors with growth and reduce individual investment risk.
How do mutual funds work?
Pooling of funds: Mutual funds pool money from many investors. This pooled money forms a larger fund, allowing investors to access a diversified portfolio of investments that they might not be able to afford individually.
Professional management: Mutual funds are managed by professional fund managers or investment teams. These managers have expertise in analysing markets, selecting investments, and managing the fund’s portfolio. Their goal is to achieve the fund’s objectives, such as growth, income, or a balanced approach.
Diversification: Mutual funds invest in a variety of securities, such as stocks, bonds, and other assets. By spreading investments across different sectors, industries, and geographic regions, mutual funds reduce the risk of significant losses from any single investment. Diversification helps balance potential gains and losses, aiming to provide relatively stable returns over time.
Investor units: When you invest in a mutual fund, you buy units of the fund. The value of these units is based on the fund’s net assets divided by the number of units outstanding. Investors can buy or sell units at the current Net Asset Value (NAV) price, which is typically calculated at the end of each trading day.
Net Asset Value (NAV): NAV represents the per-unit value of the mutual fund. It is calculated by subtracting the fund’s liabilities from its assets and dividing the result by the number of outstanding units. NAV changes daily based on the performance of the fund’s investments.
Liquidity: Mutual funds offer liquidity, allowing investors to buy or sell their units at any time (subject to market conditions). The ease of liquidity provides flexibility for investors who may need to access their money quickly.
Returns and distributions: Mutual funds generate returns through dividends received, interest income, or capital gains from the securities held in the portfolio. These returns are distributed to investors in the form of Income Distribution cum Capital Withdrawal (IDCW) or reinvested to buy more units. Investors may receive regular income from IDCW or benefit from capital appreciation when the fund’s investments increase in value.
In summary, mutual funds simplify investing by pooling funds from multiple investors, employing professional management to diversify investments, offering liquidity for easy access to funds, and distributing returns to investors based on the fund’s performance.
Features of mutual funds
- Diversification: First of all, mutual funds spread your investment across various assets, reducing the risk compared to investing in individual stocks.
- Professional management: Secondly, mutual funds are managed by experienced fund managers who optimize returns while managing risks.
- Transparency: Investors can access detailed Scheme Information Documents and daily NAVs, ensuring clear insight into their investments’ performance.
- Liquidity: Mutual funds, especially open-ended ones, offer high liquidity, allowing you to redeem investments quickly, typically within 1-3 business days.
- Well-regulated industry: Finally, mutual funds operate under strict regulations set by SEBI, ensuring investor protection, risk mitigation, liquidity, and fair valuation.
Different types of mutual funds
Some of the types of mutual funds are mentioned below:
- Equity funds: These funds invest in stocks, including large-cap, mid-cap, and small-cap categories, to achieve long-term capital growth.
- Debt funds: These funds focus on fixed-income securities like government and corporate bonds, offering regular income with relatively lower risk.
- Hybrid funds: These funds invest in both equity and debt instruments, balancing growth potential with relative stability.
- Index funds: These funds seek to replicate the performance of a specific stock market index, subject to tracking error, offering low-cost broad market exposure with minimal fees.
- Sector funds: These funds focus on specific economic sectors, such as technology or healthcare, and provide targeted exposure to industries with growth potential.
- Tax-saving funds (ELSS): Tax-saving funds, or ELSS, provide tax benefits under Section 80C of the Income Tax Act, 1961, and have a mandatory lock-in period of three years.
- Retirement funds: Designed to help save for retirement, these funds often offer tax benefits and align with long-term retirement goals.
- Dividend yield funds: These funds invest in stocks that offer high dividend payouts, aiming for regular income and potential capital growth.
Modes of investing in mutual funds
- Lumpsum investment: A lumpsum investment means putting a large amount of money into a mutual fund all at once. For example, if you have ₹20 lakh, you can invest this entire amount in a single transaction. This method is simple and can be beneficial if you have a substantial amount ready and are confident in your investment choice.
- Systematic Investment Plan (SIP): A Systematic Investment Plan (SIP) allows for regular, smaller investments over time. For instance, you might invest Rs. 2,000 per month for a year. SIPs encourage consistent investing and utilize rupee cost averaging, which helps mitigate market volatility by spreading your investments.
Pros of mutual fund investing
- Liquidity: Mutual funds offer high liquidity, allowing you to buy or sell units easily and access your money whenever you need it.
- Affordable: Mutual funds are accessible with small investment amounts, making them practical for both new and seasoned investors.
- Transparent: Mutual funds are regulated by SEBI to ensure transparency and promote fair practices.
- Flexible investment options: Mutual funds provide various investment options to suit different budgets and preferences, catering to diverse financial goals.
- Quick and hassle-free process: Investing in mutual funds is an easy and efficient process. Starting out is quick, and diversifying your investment portfolio is easy.
- Suited to financial goals: Mutual funds cater to various financial goals with different types of funds, accommodating both short-term savings and long-term growth objectives.