What is a Mutual Fund?
Mutual Funds are one of the most comprehensive and flexible ways to build a diversified financial portfolio. They are known for generating high returns. Mutual funds carry low to moderate levels of risk but are typically safer than purchasing individual stocks.
Mutual funds may seem a bit complicated to some people. So, let us break it down and understand it from the fundamental level.
Understanding Mutual Funds
A mutual fund is a financial instrument where all the money collected is pooled together and invested in equities, bonds, and other money market instruments. Professional fund managers control the allocated assets and aim to maximise the capital gains for the investors. A mutual fund portfolio is managed in order to meet the investment objectives mentioned in the prospectus.
By investing in mutual funds, you can get access to professionally managed portfolios of shares, equities, and other assets. The performance of various assets is usually determined by the market value of the fund. Now that we have a good understanding of what is mutual funds, it is time to focus on how mutual funds work.
How Do Mutual Funds Work?
In a mutual fund, the money invested by individuals with a common investment objective is collected and put into various assets. The funds are allocated to financial instruments such as bonds, stocks, and other market-linked securities. Asset Management Companies (AMCs) make these investments in place of the investors. A team of fund managers pick the stocks into which the money will be put based on the defined investment objectives.
There are two ways you can invest in mutual funds—Systematic Investment Plan (SIP) and lumpsum. In the case of SIP, you need to invest a fixed amount regularly. In contrast, you only need to make a single payment if you choose the lump sum route. Learn more about SIP meaning and how to invest in SIP here.
Structure of a Mutual Fund
In India, the structure of a mutual fund consists of three tiers. They are — the sponsor, trustees, and the Asset Management Company (AMC). This structure was brought by SEBI (Securities and Exchange Board of India) Mutual Fund Regulations, 1996. Let us go through each of these tiers one by one.
- The Fund Sponsor – This is the first layer in the structure. A fund sponsor refers to a person or an entity that can establish a mutual fund and earn money by managing the funds. A fund sponsor must approach SEBI to get a permit to set up a mutual fund. After that, a Trust is formed, and the trustees are appointed to manage the asset management company.
- Trust and Trustees – A trust is created by the fund sponsor and managed by the trustees, who are answerable to the investors.
- Asset Management Company – This is the third layer in the mutual fund structure. The Asset Management Company acts as a fund manager for the trust. The AMC receives a small fee for managing the funds and is responsible for all the fund-related activities.
Types of Mutual Funds
There are different types of mutual funds available that have varying levels of risk. Let us take a look at some of them.
– Equity Funds
Equity funds invest their assets in stocks of various companies depending on the investment objective. This type of mutual fund is a great option for appreciating capital as they have the potential for creating wealth over time. If you want to gain exposure to the stock market and invest over the long term, you can go for equity funds.
– Fixed Income Funds
Now that we know what is equity mutual fund, let us focus on other significant mutual funds. A fixed income fund offers returns at regular intervals. The income earned is heavily determined by the performance of the funds. At the time of maturity, the investor is repaid the initial investment.
– Index Funds
Index funds are a type of mutual fund where the portfolio is constructed to track or match the components of a financial market index. It provides a wide market exposure, low portfolio turnover, and low operating expenses. They are designed to impersonate the performance and composition of the financial market index. Also, they follow a passive investment strategy.
The best index funds available are affordable, allow diversification and generate lucrative returns over time.
– Balanced Funds
A balanced fund typically consists of a component of bonds and stocks. It is also referred to as a blended fund. These funds invest in a fixed mix of debts and equities. Balanced funds are best suited for a medium-term horizon and are perfect for investors looking for safety, good capital appreciation, and income.
– Money Market Funds
Money market funds carry lower risk compared to other mutual funds. They are basically a type of debt fund that lends to companies for a period of 1 year. The design of these funds allows financial managers to keep the risk under control by adjusting the lending duration.
– Income Funds
Income funds are also a type of debt fund that invests in instruments such as corporate bonds, debentures, government securities, etc. They seek to generate income through dividends or interest payments. Some income funds also offer an opportunity for capital appreciation.
– International/Global Funds
An international fund invests in assets that are located outside the home country. However, with global funds, you can invest anywhere around the world. The volatility of these funds depends on the country’s economy and geopolitics.
– Specialty Funds
A type of mutual fund that especially invests in the securities of a specific industry or sector is known as a specialty fund. Their performance is largely decided by the performance of the industry where the money has been invested.
– Exchange Traded Funds (ETFs)
Exchange Traded Funds or ETFs are quite similar to index funds. However, they are listed and traded on the stock exchange. ETFs allow investors to get exposure to the stock markets in different countries. In simple terms, it is a basket of stocks composed of an index, like the Nifty or BSE Sensex. The trading value depends on the net asset value of the stocks that it represents. You can buy and sell this mutual fund in real-time throughout the day.
Mutual Fund Fees
A team of market experts work collectively to manage the investments. Taking care of large investments every day requires expertise and experience in the subject. Therefore, the Asset Management Company charges a certain fee from the investors and these charges are approved by SEBI.
The mutual fund fees consist of the costs such as operational costs, advisory fees, transfer agent and registrar fees, etc. The total expense involved in managing the mutual funds is together termed as total expense ratio (TER). It is basically a fee charged by the scheme to manage the investor’s money. This ration is charged on an annual basis and its major components contain administrative costs, distribution fees, and management fees. According to the SEBI guidelines, the increase in Asset Under Management (AUM) should lead to a decrease in TER and vice versa.
Tax Saving Mutual Funds
A tax-saving mutual fund is similar to standard mutual funds but with added tax benefits. The investments made under these mutual funds are eligible for tax benefits under section 80C of the Income Tax Act of India. Most of these funds are Equity Linked Savings Schemes (ELSS) and invest in the equity market that has good growth potential. These schemes usually come with a lock-in period of 3 years, which means that you cannot make any premature withdrawals.
If you do not want to lose money in taxes, investing in ELSS through Systematic Investment Plans (SIPs) can be a good idea. It will not only generate high returns in the future but also save taxes. You can claim tax deductions of up to Rs. 1.5 lakh under section 80C of the IT Act. This tax saving SIP helps inculcate a habit of investing and ensures systematic management of investments.
Advantages of Mutual Funds
Here are some of the key advantages of mutual funds: –
- Professional Management
The most significant advantage of investing in mutual funds is that your money is managed by qualified experts that are backed by a dedicated team which analyses the prospects and performance of companies and selects appropriate investments.
- Portfolio Diversification
The fundamental rule of investments is the diversification of the portfolio. The fund managers invest in various companies across different industries and sectors. This helps minimise the losses.
- High Returns
Investments made towards the best performing mutual funds over the medium to long term have the potential of generating high returns. It is mostly because the investments are diversified across different instruments. Learn more about the best mutual funds to invest in 2022.
Another significant benefit of mutual funds is that they are extremely liquid. As an investor, you can buy and sell shares at any time.
Mutual funds are transparent as the investors can go through the status of their investments by looking at the account statement. The documents also specify the asset allocation and investment strategy for each scheme.
Mutual funds offer many flexible features to investors. You can systematically withdraw and invest as per your needs.
- Systematically Regulated
Mutual funds are regulated by SEBI and must function as per the framed regulatory provisions. These are made to protect the interests of the investors.
Disadvantages of Mutual Funds
Just like any other investment, mutual funds have both advantages and disadvantages. Here are some of the disadvantages of investing in mutual funds: –
- Uncertain Returns
Mutual funds do not provide fixed or guaranteed returns. You need to be prepared for losses due to depreciation in the value of your chosen mutual fund.
Diversification of portfolio may be cited as an advantage. However, diversification may increase the operational cost of a fund as it demands higher due diligence.
The value of a mutual fund fluctuates with the market conditions. Moreover, you will not have to pay the fees to the fund managers if you buy the stocks and securities directly in the market.
- No Control
In mutual funds, your investment is managed by a team of analysts. This also means that you have no control over your investments. The major decisions related to your funds are taken by fund managers.
Example of a Mutual Fund
If you are confused about which mutual fund to invest in, here are the top 10 mutual funds available in India: –
- Axis Blue Chip Fund
- UTI Flexi Cap Fund
- SBI Small Cap Fund
- Mirae Asset Hybrid Equity Fund
- Kotak Emerging Equity Fund
- Axis Small Cap Fund
- Parag Parikh Long Term Equity Fund
- Axis Mid Cap Fund
- Mirae Asset Large Cap Fund
- SBI Equity Hybrid Fund
You can invest in any number of mutual funds without additional paperwork. You need to complete your KYC process only once. This can be done online as well as offline.
These are some of the factors you need to consider while investing in mutual funds: –
· Analyse financial ratios
· Check the expense ratio
· Examine the performance of the fund manager
· Look out for the mutual fund’s past record
The dividends earned from mutual funds are added to your overall income and taxed according to your income tax slab. The capital gains are taxed at varying rates depending on the type of fund and holding period.
A mutual fund asset can be converted into cash readily. You can exit a scheme at any time you like.
No, mutual funds do not offer guaranteed returns. While the returns may be high but there is no guarantee.
Source: https://www.sebi.gov.in/sebi_data/faqfiles/may-2017/1494501305219.pd https://www.etmoney.com/mf/what-is-mutual-fund