What Are Mutual Funds- A Beginner’s Guide For Investment

We all have seen the advertisements of mutual funds that are enticing and yet come with a disclaimer. They look appealing as something that can give us high returns but are subject to market risks. This makes many potential investors feel intimidated about mutual funds as well as suspicious. They wonder whether they are a safe investment instrument or not or if it is more profitable or rather riskier. When unsure of which investment tool would work the best, investors usually opt to park their money in banks in the form of fixed deposits or recurring deposits to earn some interest on it. This is because it guarantees that their money is safe even if it has low-interest gains on it.

If at all some risk-bearing investors decide to invest in mutual fund plans, they feel confused about which scheme out of innumerable ones to go for. They also find it complicated to understand what mutual funds are and how they are different from stocks. This article attempts to give a wholesome picture of mutual funds in a simplified fashion for beginners and first-time investors.

What are Mutual Funds?

By definition, a mutual fund is a collective investment in which funds or money are pooled from various investors. The fund manager or the fund house looks after this pooled fund corpus and decides where and how to invest. It is invested in various money market instruments; for example, stocks of various companies to generate returns. The gains or income that are generated from the investments are distributed proportionately to the investors after the deduction of some managerial charges and other applicable expenses. To understand the concept of mutual funds, it is important to have clarity about equity and debt and how mutual funds differ from stocks.

Debt is money offered to a company for a certain time with an aim to receive it back with an interest on it. It is like a loan that investors lend. There are various debt instruments like debentures, bonds (government or corporate), commercial papers, medium-term notes, etc. Equity/share/stock investments imply that you have a percentage holding in the profit of the company as an owner of those shares. You may also suffer a loss, being the shareholder of the company when the market price of the share fluctuates and the company is at a loss. You may sell or buy shares, unlike the debt securities, to increase or decrease your shareholding respectively. Debt investment comes with relatively lower risk than equities. As a shareholder, you are a participant in both profit and loss. As a debt investor, you deserve guaranteed returns of your money.

Mutual funds consist of a mix of debt securities and equities where different schemes have different ratios of both. Also, the fund managers/fund houses invest in stocks, debt, and other securities of various companies of different sizes based on their capital structure.

How do Mutual Funds differ from Stocks?

When an investor purchases stocks of a company buying them at their trading price, s/he becomes the shareholder of the profits of that particular company. In mutual funds, the fund manager purchases stocks of several companies. It is a mix of large-sized, medium, and small companies according to their capitalization. The money is invested not only in equities but also in debt, bonds, and several money market instruments.

Like you buy shares of a company at a share price, you buy units of the mutual fund at its Net Asset Value (NAV). NAV is the market value of all units of a mutual fund on a given day. One unit’s value is the total NAV divided by the total number of units. The fund performance can also fluctuate based on the market conditions. Suppose a situation where the majority of companies in which the fund is invested are not performing well. This will automatically affect the mutual fund returns where it may go negative. Similarly, if the stock prices of majority companies rise, then the mutual fund’s gains will be more.

The fund houses that launch and manage various mutual funds are called Asset Management Companies (AMCs). They have a dedicated fund manager(s) and team(s) to manage every fund scheme, its corpus collection, as well as its return generation and distribution. They plan and make changes to the entire investment portfolio of the fund plan, unlike stocks where the individual investor decides for himself/herself.

Comparison between Mutual Funds and Stocks

Mutual Funds has certain advantages over stocks as listed below:

  • If you invest in a stock, your returns are completely dependent on that particular company’s stock market price and performance. Whereas, mutual funds invest in several company stocks and other instruments. Even if some stocks are performing negatively, the others that are performing well can counterbalance it. It is highly unlikely that all equities go experience market headwinds in the same proportion
  • Stocks are a single type of investment. On the other hand, mutual funds invest in various money market securities that include stocks. It is spread over various asset classes, sectors, and industries. It diversifies the investment and does not put all its eggs in one basket
  • When you invest in stocks, you have to keep an eye on their market performance. it is because you can sell them at the right time if you see a downward trend. But in mutual funds, you need not keep a tap on all stocks. Occasionally, you may check the overall performance of the funds but mutual funds are always suggested for long-term investments. Moreover, you have a fund manager who has professional knowledge of how, when, and in what securities to invest in

Types of Mutual Funds

One of the complex questions for new investors is which mutual funds to invest in. There are various factors that you must consider before investing but first and foremost, you must know the type of mutual fund you put your money to. In India, the Securities and Exchange Board of India (SEBI) lays down the norms for the stock market as well as mutual funds. The categorization is also as per SEBI regulations. There are three basic types of mutual funds which can be further categorized into sub-categories:

1. Equity Mutual Funds

When the fund corpus of a mutual fund is majorly invested in stocks, like 65% or more, it is an equity mutual fund. The remaining percentage of funds is allocated to debt and other securities. They are suitable for investors with a higher risk appetite. Equity funds are characterized by high risk and high returns. If you seek wealth generation over some time, then you can consider investing in these funds.

2. Debt Funds

This is just the reverse of equity funds where the higher ratio of funds is invested in debt securities. The fund allocation to equities is less than 65% and with more debt investment, this fund comes with fixed returns. They carry lower risks than equity funds but also come with lower returns. Therefore, it is more suited for low-risk-tolerant investors.

3. Hybrid Funds

As the name suggests, hybrid funds are a mix of equities and debt in proportionate ratios to draw the advantage of both. Equity investments give high returns whereas debt securities make it less risky. Therefore, it can generate higher returns equivalent to equity funds but with a lower risk. Hybrid funds may invest in other asset classes as well such as gold or overseas securities.

Other than these three major categories, funds can also vary as per their management or redemption of units. All the above-mentioned types of funds can be actively or passively managed as well as can be open-ended or closed-ended funds. To elaborate, this means:

1. Actively or Passively Managed Funds

All funds are supposed to have fund managers, but some funds have managers who actively monitor their performance while some do not. Actively managed funds are those where the fund managers constantly track the fund performance to outdo the scheme’s benchmark. They use their professional knowledge to decide when and which stocks to sell, buy or hold. They are backed by their teams who do the analytical research and it is up to the discretion of the manager to make a judgment.

On the other hand, passively managed funds, as it suggests, are those funds where the managers are inactive. They passively manage the funds, which means they do not continuously track where to invest in but simply follow the market benchmark index. They try to replicate the same model of market index funds, in the same proportion to generate equivalent returns or if possible then outperform them.

2. Open-Ended and Closed-Ended Funds

Funds that investors can invest and redeem anytime are open-ended funds. You can unsubscribe and withdraw the money on any given day because there is no maturity date. Closed-ended funds have a maturity date or a kind of lock-in period before which you cannot redeem the fund units. Closed-ended funds have an initial offering period during which investors can buy the units and keep them for the given tenor. They are listed on the stock exchange and traded like stocks so that investors can sell off the units if they seek to exit the fund before its maturity date.

Wrapping it up:

In a nutshell, mutual funds are an investment that collects a huge corpus by inviting many investors and making them unitholders of the fund. Mutual fund managers are professional investors and experts who allocate the fund resources in more than one asset class like equities, debt, gold, etc. They know how to pick up the right stocks and invest accordingly to generate returns. These returns are distributed proportion-wise to each unitholder of the mutual fund, that is the investors.

So, amateur investors who do not have much understanding of the stocks should invest in mutual funds. This is because mutual funds are a mix of several asset classes, are invested in a variety of company stocks, and are professionally managed. Here, you need not track the daily performance of the stocks. Also, there are various types of mutual funds to suit both risk-bearing and risk-averse investors.

FAQs
What is the risk-return ratio of the mutual fund?
The risk-return ratio of the mutual fund depends on its type. Debt funds have a comparatively lower risk-return ratio than equity funds.
Why invest in mutual funds? Are they safe?
Investing in mutual funds can help capital generation over the long term, as it offers higher returns than bank deposits. They are susceptible to market risks but investment in a plethora of stocks and debentures keeps a balance. They are professionally managed and investors do not need to track them like stocks.
How to choose mutual funds for investment?
First of all, set your investment goals, capital generation with higher risks, or guaranteed returns with lower interest. Know if you are willing to invest for the long term or seek a short-term investment. Compare the associated risks.
Are there any tax benefits of mutual funds?
The taxation of mutual funds differs for long-term and short-term equity as well as debt funds. Equity Linked Saving Scheme (ELSS) is one type of mutual fund plan that has tax exemption up to Rs. 1.5 Lakh under Section 80C of the Income Tax Act.
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