Understanding Mutual Funds – For Beginners

I believe that mutual funds should always be a part of an individual’s investment portfolio. I myself have been investing in mutual funds for more than half a decade.

But, there are many individuals who are still not fully aware of mutual funds. To date one of the most commonly asked questions about personal finance is, what are mutual funds? A mutual fund is a fund created by collecting money from a large number of investors. This pool of money is managed by a professional fund manager. The money of this fund is invested in various assets to generate income/capital gains for the investors. The assets in which money is invested is determined on the basis of pre-agreed and declared objectives of the fund. For example, an equity fund invests the majority of the money in stocks.

How Do Mutual Funds work?

As stated earlier a mutual fund is a pool of money collected from a large number of investors. The money is collected by an Asset Management Company (AMC). The AMC hires professionals who manage and invest the money collected into various types of assets. The money can be invested in stocks, bonds, etc. But in reality, the fund manager is allowed to invest only in those assets which satisfy the pre-declared conditions and objectives of the fund, as mentioned in the offer document.

The AMC is allowed to use a certain percentage of the money for expenses like salaries, commissions, etc. This is known as the expense ratio and in India, it is regulated by SEBI. The expense ratio can not be more than the limit set by SEBI.

The value of your investment increases when the fund makes a profit, this happens in two manners. Firstly, the money might have been invested in some dividend-yielding stocks or some interest-paying instrument. When this dividend/interest is received it adds to the value of the fund. Secondly, the fund manager might decide to sell some securities at a higher price than at which they were bought. This profit is considered as capital gain and this also adds to the value of the fund.

The net value of the assets owned by the fund is divided into individual units called NAV Units (Net Asset Value Units). Depending upon how much money an investor has invested in the fund, a certain number of units are allocated to that investor. As the fund makes more profit the value of these NAV units increases.

How Investors Make Money from Mutual Funds?

To understand this, first, you have to have a clear picture of the Growth and Dividend options in Mutual Funds.

Growth and Dividend Option

When the value of the Net Asset Value of the fund increases to a certain level, depending upon the option you have chosen, one of the two things happens.

• Growth Option: If you have chosen the growth option while investing, all the gains/profits made by the fund are reinvested. The value of your NAV units keeps on increases until the day you decide to sell them. The profit you make is capital gain.
• Dividend Option: In this option, a part of the gain/profit is paid out as a dividend. While the remaining part is reinvested. You receive a certain amount as dividends whenever the AMC declares a dividend payment (depending on the number of NAV units you have). Also, the value of our NAV units increases (much less than growth option) so you can make money as capital gains when you decide to sell your NAV units.

Although the dividend option may look attractive based on this simple explanation. But, in reality, the growth option is far better due to the following reasons.

• The dividend payout is not extra money, it is taken out from your gains and paid. In the growth option, the entire amount is reinvested.
• The taxes on the profit of the dividend option are quite high in comparison to the growth option.

For a more detailed comparison, you can read our article about Dividend Option

So there are two ways an investor can make money from a mutual fund.

• If the investor has a dividend option, they receive dividend payment whenever AMC declares a dividend payout
• Whenever an investor decides to withdraw his fund or sell his NAV units. He makes capital gains on his investment.

Types of Mutual Funds

If you do a detailed analysis you will find that no two funds are the same. Thus it becomes essential to categorize mutual funds. Here, I am explaining some of the common categories in which mutual funds are usually classified.

Close-Ended and Open-Ended Mutual funds

Close-Ended Mutual Funds: An investor can only invest in these funds within a limited period when the New Fund Offer (NFO) is declared. After the expiry of this period, no new investor can directly invest. Although some of these funds are traded on the stock exchange allowing the buying and selling of NAV units. These funds usually have a fixed maturity period.

Open-Ended Mutual Funds: An open-ended fund allows new investors to invest at any time. Their overall asset value changes more frequently than close-ended funds. This is because apart from the value of assets the money brought in by new investors also increases the asset value. The investors sell or buy NAV units directly from AMC. These funds do not have a fixed maturity value.

Classification Based on Management Style (Actively Managed and Passively Managed Funds)

Actively Managed Funds: An actively managed fund is one in which a fund manager and/or a team actively monitor and manage the investments. The main aim is to outperform the associated benchmark (the benchmark is the index used to compare the performance of the fund like the NIFTY Index is used for equity funds). To achieve this aim, assets are bought and sold as frequently as required, based on market and economic trends. The expense ratio of these funds is higher as a higher amount is spent to ensure a highly qualified management team.

Passively Managed Funds: Passively managed funds mainly refer to index funds. The main aim is to mimic the underlying benchmark and deliver the same performance. As the manager only needs to follow the benchmark and make changes only when the changes are made to the benchmark, lower expenses are made on the management of these funds. This ensures a low expense ratio of these funds. These funds are comparatively less risky than active funds as there is no quest for generating extra returns, which can only be accomplished by taking a higher risk.

Classification Based on Asset Type (Equity, Debt and Hybrid Funds)

Mutual funds are also classified based on the type of securities/assets the money is being invested in.

Equity Funds: The money is mainly invested in the stocks of companies listed on the stock market. These are associated with a higher risk. The performance of these is directly linked to the performance of the stocks. Although the risk is higher, the return is also quite high in comparison to other mutual funds.

Debt Funds: These funds usually invest in bonds (both government and corporate bonds), debentures, treasury bills, commodities, etc. These have a lower risk than equity funds. But, do not take the risk associated with them for granted, they can be quite volatile and you can lose money in them. You should learn about credit risk and interest rate risk before investing in them.

Hybrid Funds: These are also referred to as balanced funds. These funds invest in both types of assets. The main purpose is to decrease the risk by investing a certain portion of capital in bonds and other debt fund assets. At the same time, these funds aim at a higher return than debt fund by investing the rest in equity. But you should always keep an eye on the total equity exposure of the fund, some hybrid funds like Aggressive Hybrid funds should be treated as an equity term due to the high percentage of equity exposure.

Tax Saving Funds

Most popularly known as Equity Linked Saving Scheme (ELSS). The investment made in these funds can be used to claim tax exemption under Sec 80C of the Income Tax Act. They have a lock-in period which is usually 3 years. As money is mainly invested in stocks they have a higher risk, but can also provide higher returns. One information that is not very well known is that these funds have to invest a minimum of 80% of their assets in equity, they are quite risky products. The lock-in even stops you from pulling out your money if you anticipate a downward tend

I have also written an article that gives a brief introduction to all 36 categories of mutual funds, as defined by SEBI. You can read it here.

Benefits of Mutual Funds

There are many benefits of mutual funds which have contributed to their popularity. If used wisely the mutual fund can prove to be highly beneficial.

Simplicity: Creating, monitoring and managing a portfolio requires a lot of time and deep knowledge of fundamental and technical analysis. An individual finds it difficult to do this on their own. Mutual funds provide a simpler way to have a professionally managed and monitored fund. An investor can select mutual funds after attaining basic knowledge and do not require in-depth knowledge essential for portfolio management.

Diversification: “Do not put all your eggs in a single basket.” This may be the most heard phrase in the financial world. Diversification is equally applicable to an individual as it is for large investment companies and hedge funds. Mutual funds allow you to achieve a well-diversified portfolio in a very simple manner. If you want to invest in equity, you will end up doing a lot of research and will require a significant amount of money for just 10 good stocks. But if you research equity mutual funds and finalize one, even a small investment of Rs. 500/- can provide you with a well-diversified portfolio.

Returns: Some of the mutual funds have offered the highest returns when compared to other instruments of investment. Only direct equity investment has resulted in better returns. But, always remember that mutual funds also have risk involved and thus investment should not be made solely on the basis of past returns. Rather risk management should be a prime concern when investing in mutual funds

Versatility: We have already mentioned and explained the type of mutual funds. But, in reality, there is a huge variety among mutual funds. This if used properly can be effective for your financial success. You can have ample options that suit your goals and investment strategy. But, this doesn’t mean that you should start investing in every type of mutual fund there is. This only means whatever might be your investment style you will find a few funds suiting your need.

What are the Risks Associated with Mutual Funds?

Mutual funds invest in a wide variety of assets. Be it bonds, stocks, commodities, etc all of them involve a certain amount of market risk. Some assets come with assured maturity value, but these have a low rate of returns. Thus, mutual funds always invest in other assets along with these assured maturity ones.

Depending upon the assets of the mutual fund the risk can vary among various mutual funds. Liquid funds have quite a low risk and thus can be used for short term investment. On the other hand, equity funds have high risk and witness large fluctuations in the short and medium-term, thus should be used for long term investment.

In simple terms.

• The risk associated with mutual funds depends on the assets in which money has been invested.
• Higher returns are usually accompanied by higher risks.
• Higher the risk more should be the term of the investment.
• Debt mutual funds are not risk-free.
• The risk associated with different types of assets should be analyzed separately.

How to Invest in Mutual Funds?

There are two ways to invest in mutual funds. First is the Regular funds, wherein you approach a registered mutual fund distributor and through him, you invest in mutual funds. The AMC pays a commission to the distributor. The second way is the Direct funds, where you directly approach the AMC to invest in one or more of their funds. As no intermediatory is involved no commission is paid which adds up to your returns.

If you are capable of researching and finalizing a mutual fund, you should go for a direct fund. But, if you are completely new to mutual funds you should take the services of a mutual fund distributor you can trust.

In the case of a direct fund, you can invest both offline and online. For online investment, you can visit the official website of the AMC, or you can make use of various platforms like Kuvera, Zerodha, Groww, etc. For offline investment, you have to visit the nearest office of the AMC.

This article is for the purpose of introducing a beginner to mutual funds, thus, a few things have been simplified. If you have any further queries please free to ask in the comment section.

You can use our Mutual Fund Calculator to plan your investment. This calculator can be used for both one-time investments and SIP.

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