Mutual Fund Basics: What, When, Why and How?

Mutual fund is very much in trend among common people, the biggest reason for this is that it does not require knowledge of stock market.

In this article, we will discuss Mutual Fund in a simple and easy way and try to understand its various important aspects; So read this article till the end.

Note – If you want to understand the basics of share market from zero level then you should start with Part 1. – Share Market and Related

| What is Mutual Fund ?

As the name suggests, a mutual fund is a fund that is created when a large number of investors invest their money in it and the entire amount is invested by a management company in shares, bonds or other securities. 

The profit made from this is distributed among all the investors in the same ratio in which those people invested money.

For example, suppose the price of one share is Rs 10,000. There are some people who want to buy it but no one has 10,000 rupees. So finally 10 people together gave one thousand rupees and bought that share. 

Now let’s assume that after some time the value of that share becomes Rs 15,000, then in the same proportion all the money will be divided among those ten i.e. fifteen-fifteen hundred rupees.

Mutual fund was earlier a part of money market i.e. regulated by RBI, later it also became part of capital market where regulation work is done by SEBI. That’s why it has dual regulator RBI and SEBI too.

| Why Mutual Funds?

Mutual funds are considered to be the best means of earning money in the long run because first of all, there is no need for investors to be knowledgeable about investing in it, the reason is that it is managed by such highly professional people who are known in the field of investment.

The second thing is that even a small investor can invest in it with a small amount, you can understand it in such a way that whenever a fund house brings a scheme for the first time, it is sold at the rate of Rs 10 per unit . (What is meant by unit is discussed further here).

The third thing is that the investors’ money is not invested in any one sector but is invested in different sectors, like if all these investors’ money is invested only in the stock market and if the stock market If it does not perform well then all the investors’ money will be lost.

To avoid this, different parts of the money are invested in different sectors like some in bonds, some in shares and some in derivatives. 

The advantage of this is that there will be some area which will perform well. This avoids the risk of losing investors’ money and they always have the hope of good returns.

| How does Mutual Fund work?

Suppose you went to a shop to buy potatoes, there was a bag of 50 kg potatoes which cost Rs 500. All you needed was 20 kg of potatoes. You had 200 rupees with which you could easily buy 20 kg of potatoes, but the shopkeeper said that we sell the whole bag, not open the potatoes. 

Are you wondering what to do now ? Ok, Then you saw some people who had come to buy potatoes but had the same problem.

An idea came to your mind, you and 3 other people together bought a 50 kg bag of potatoes. You had given 200 rupees and the rest gave one hundred rupees each, so in the same ratio you distributed potatoes, that is, you kept 20 kilos of potatoes and gave ten kilos of potatoes to the rest. 

This is the concept of working of mutual funds. Let us understand this a little better with the help of Unit and NAV.

| What is Unit and NAV (Net Asset Value)?

As we have just read above that in mutual funds, investors’ money is not invested in any one sector but is invested in many sectors. 

Suppose the company that manages the mutual fund wants to invest 40 thousand rupees in shares, 30 thousand rupees in bonds and 30 thousand rupees in options, then the total becomes 1 lakh rupees, i.e. It became a fund of Rs.1 lakh. This 1 lakh is divided into several pieces so that small investors can also buy it.

Suppose it is divided into 10,000 pieces, that is, 10,000 units of it are made. Now if that 1 lakh is divided by these 10,000 units, then the price of 1 unit will come out which will be Rs 10. 

This price of 1 unit is called NAV. Now that 10,000 units are ready to be sold in the market, let’s say I have bought 1 unit i.e. I have paid Rs.10 which is the current NAV. 

If you try to understand this 10 rupees, then you will know that out of that 10 rupees, 4 rupees will be invested in shares, 3 rupees in bonds and 3 rupees in options.

Now let’s say that after 1 month that 1 lakh rupees has become 1.5 lakhs. This means that the earlier NAV was Rs 10, now it has become Rs 15. If I had bought 1 unit out of it, then obviously my 1 unit will now be Rs 15. 

That is, I got a profit of 5 rupees. Similarly, if someone has taken 100 units, then he will get a profit of 500 rupees. Hope you understand now.

|  When to Invest in Mutual Funds

There is a beautiful Chinese proverb, “The best time to plant a tree was 20 years ago. but if you missed, then The second best time is now.” 

There is no reason why one should delay an investment, except when there is no money to invest. Within this, it is better to do it than to use mutual funds.

⚫ There is no minimum age when one can start investing. 

⚫ The moment a person starts earning and saving, one can start investing in mutual funds. In fact, even kids can open their investment accounts with mutual funds, which they get once as a gift on their birthdays or during festivals. 

⚫ Similarly, there is no upper age for investing in mutual funds.

There are many different schemes in mutual funds suitable for different purposes. Some are suitable for growth over the long term, while some may be for those in need of security with regular income, and some provide liquidity in the short term as well.

You see, at any stage of life or whatever one is needed, mutual funds can have solutions for everyone.

| Difference between Investing in Shares and Mutual Funds

There are many differences between investing in mutual funds and investing in stocks. As investment in shares gives a stake and shareholders can also get voting rights in the company. 

But mutual fund unit holders do not get any voting rights. When investing in shares, you are investing only in that company, whereas units of mutual funds are invested in shares, bonds, etc. of many companies. 

The stock market fluctuates during working days, that is, its price keeps going up and down all the time whereas NAV is simply calculated at the end of each trading day to see how much it increases or decreases.

Overall, this is the basics of mutual funds, hopefully understandable. Now we will discuss different types of mutual funds and see how many types of mutual funds are currently available in the market and what are their features? 

| Types of Mutual Funds

A mutual fund is a fund that is created when a large number of investors invest their money in it and the entire amount is invested by a management company in shares, bonds or other securities. 

The profit made from this is distributed among all the investors in the same ratio in which those people invested money.

There are many types of Mutual Funds based on risk, based on investment or on the basis of structure etc. Let us understand all the important types;

|  Equity scheme

The special feature of this scheme is that at least 65% of the assets of this scheme have to be invested in equity and equity related instruments. In the article on the stock market, we understood that investing in equities is risky. 

That is why these funds are comparatively high risk. The scheme is suited for investors who can digest high risk. Based on the level of risk involved in investing, the following are the types of mutual funds in India:-

| Types of Mutual Funds Based on Risk

⚫ High Risk Funds – As we have just read above, the greater the portion of an investment that is invested in equities, the higher will be the level of risk. If the risk is high, then the return is also highest from this. 

There is also a return of 20 to 25% in this. These funds require active management as they are dependent on market volatility. Such as – ICICI Prudential Technology Fund, Aditya Birla Sun Life India NextGen Fund, SBI Banking and Financial services Fund etc.

⚫ Medium Risk funds – Obviously, in this, less is invested in the equity part and more in the debt fund part. So that even if there is a loss in the equity portion, then it can be compensated from the debt fund. 

Its average return is usually between 9-12%. These are good for investors who do not have a very high risk appetite and want stable returns. Like- SBI Magnum Constant Maturity Fund, SBI Magnum Medium Duration Fund etc.

⚫ Low Risk funds – If there is a crisis in the market and the market becomes volatile, then in such a situation the money is invested through a special safe medium such as an arbitrage fund. 

This is also a type of mutual fund but it works on very low returns without falling into the trap of high returns. For example, if the market stock is bullish, then buy the stock from the cash market and sell a contract for it on the futures market at the same time. It is kept under hybrid scheme.

If the market continues to work normally, then it does not work properly, but as soon as the market fluctuates, this method works in the meantime. 

For example, suppose the value of a share in the stock market is Rs 500 and at the same time in the derivatives market its value becomes Rs 505 for some reason, then at the same time that stock is bought from the stock market and sold in the derivatives market. 

The returns from this are very less but there is no risk in it. Usually it gives 5 to 6% annual return. This type of investment helps in meeting a short term financial goal. Such as – Aditya Birla Sun Life Liquid Fund, SBI Magnum Ultra Short Duration Fund etc.

| Debt scheme

Just as a major part of investment in equity schemes is invested in equities or equities, similarly a large part of investment in debt schemes is invested in fixed income instruments, such as bonds, debt securities and money issued by governments and corporates market Instruments etc. 

Since these funds have a fixed rate of interest, the risk involved is very low. This is a great option for those who do not want to take risks. Such as – SBI Magnum Constant Maturity Fund Regular Growth, ICICI Prudential Constant Maturity Gilt Growth etc.

| Hybrid scheme

It is called a hybrid scheme because the distribution between equity and debt instruments is generally in the ratio of 40:60. However, the ratio can change as per the requirement. 

The objective of these schemes is to provide both growth and regular income. This is a great option for investors looking for moderate growth. Such as – ICICI Prudential Regular Saving Fund, Kotak Debt Hybrid etc.

| Types of Mutual Fund Based on Structure

⚫ Open-ended funds – These types of funds are available for subscription and buyback on an ongoing basis. This means that this type of scheme is not launched with any fixed duration, hence one can invest in it anytime.

Its second feature is that you can come out of it anytime because it does not have any fixed maturity period. Its NAV is fixed on a daily basis and the investor can buy and sell units at the same NAV.

Another great feature of this is that its past performance can be tracked which helps the investor to take the right decision. SIP i.e. Systematic Investment Plan, STP i.e. Systematic Transfer Plan, SWP i.e. Systematic Withdrawal Plan etc. come under this.

⚫ Close-ended funds – This type of scheme is launched with a fixed duration such as 3, 5 or 7 years. Therefore, it cannot be exited until that period is over. Since it can never be exited, its NAV is also not fixed on daily basis.

It can also be invested in this only as long as the investment period is left in it. That is, it cannot be invested when it feels like it.

Under certain circumstances, its units are traded on the stock exchange. It does not have the facility to track past performance, hence the investor may find it difficult to make a decision.

Its specialty is that it provides stability to the scheme and it allows portfolio managers to build a stable asset base and devise the right investment strategy.

⚫ Interval Funds – This is a hybrid fund that has the characteristics of both open ended and closed ended funds. These funds can be bought or sold only at specific intervals as per the discretion of the fund house. The rest of the time the fund is closed.

| Types of Mutual Fund Based on Investment

Following are the types of mutual funds in India based on investment strategy:

⚫ Growth Fund: This is a high risk equity fund in which a major part of the investment money is invested in stocks. This is a good one for those investors who have extra money and are able to invest this money for 5 – 10 years.

⚫ Income funds: It is a type of debt fund that invests money in government bonds, certificates of deposits and securities etc. That’s why the risk is less in it.

⚫ Liquid Funds: This is also a type of debt fund. It invests in short-term fixed-interest generating money market instruments and debt instruments with a tenure of up to 91 days.

The investor can invest only up to Rs 10 lakh and returns are not guaranteed as the fund’s performance depends on how the market performs unlike Fixed Deposits which are not market dependent.

⚫ Tax Saving Fund: Equity Linked Saving Scheme (ELSS) is one of the most popular tax saving schemes. The lock-in period of these funds is 3 years. It also offers a good rate of return and is free from tax.

⚫ Aggressive growth funds: These funds are invested in companies that have high growth potential, especially in new companies. As a result, these funds manage to generate above-average returns when the markets are rising. But if the company does not grow as expected, the loss is certain.

⚫ Fixed Maturity Fund: As the name suggests, this scheme invests for the maturity period. Investment is mainly in bonds, securities, money market etc. The maturity period ranges between 1 month to 5 years.

⚫ Pension Funds: These funds allow one to create a corpus for retirement. Some common pension plans in India are unit-linked which invest in both equity and debt instruments. The government also runs many types of pension fund schemes.

| Special Types of Mutual Fund in India

⚫ Gilt Funds – These funds exclusively invest in government securities. There is no risk of default from these investments.

⚫ Index fund – This is a passively managed fund. That is, it is not actively managed like other funds. That’s why he saves that cost. These funds mimic the portfolio of a particular index like Sensex, Nifty, etc. and invest in securities in the same weightage.

For example, if we talk about the Sensex, there are 30 companies out of which Reliance has 12.78%, HDFC has 12.25% and in the same way the weightage of other 28 companies is divided. 

So 12.78% of the amount invested under Index Fund will be invested in Reliance, 12.25% in HDFC and so on in other 28 companies. As much as the return that the index gives, the same return will be distributed among the investors through the index fund.

⚫ Fund of funds – Its concept is that instead of investing the money of mutual fund directly in equity or debt, it is first invested again in some other mutual fund and then from there this equity or debt is invested in. This makes it more diversified, this is called the Fund of Funds (FoF) scheme.

⚫ International funds – In this type of Equity Mutual Fund, investors invest their investments in shares of companies listed outside India. This means that even when the Indian stock market does not perform well, there is no possibility of much loss.

An investor can also use a hybrid strategy (eg, 60% in national equities and the balance in foreign funds) if he so desires.

⚫ Commodity-focused stock fund – This is one of the types of mutual funds that is a great option for investors trying to diversify their portfolio and who can take substantial risk. 

As the name suggests, it invests in commodities. However, returns are not regular and are based on the performance of the stock company or the commodity itself. 

• Gold is the only commodity where mutual funds can invest directly.

Overall, this is the type of mutual fund, hopefully you will understand. For better understanding, must read other related articles, the link is given below.

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| Share Concept Series (BCS)