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Mutual Funds, their benefits, and how to start one

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Mutual Funds, their benefits, and how to start one

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People often want to know what the actual benefits of investing in Mutual Funds are. As opposed to stocks or bonds, mutual funds have some benefits that appeal to a different set of investors. With the advent of the internet age, more and more of us are learning how to invest in the markets. Acquiring this skill set is admirable and is indicative of the country’s growing middle-income households who want to be financially independent but without the hassle of learning how to invest.

Having some level of experience, I have compiled a mutual fund investment guide such that you too can understand what exactly it is that these funds do, the kind of advantages that they provide and how exactly you must go about investing in them.

Definition of Mutual Funds 

Mutual funds are trust funds with multiple investors who have common investing aims and pool in money for the fund. This pool is managed by a professional fund manager who invests this money into multiple avenues like equities, bonds, other funds, money management instruments, and more.

Understanding How Mutual Fund Investments Are Carried Out

This financial vehicle consists of a pool of money that has been brought together via several investors, such that the money can be invested in several securities. These securities include money market instruments, bonds and stocks, among others.

Supervisors Responsible for the Functioning of Mutual Funds

The structure and maintenance of a mutual fund are designed to be in line with the investment objectives outlined in the fund’s prospectus. Professional money managers, aka fund managers, are responsible for operating these funds and supervising the fund’s asset allocation. This is done to produce capital gains or income from which the fund’s investors can benefit.

The Viability of Mutual Fund Investments 

Small or individual investors gain access to professionally managed portfolios comprising bonds, equities and additional securities. The performance of these funds is tracked as per the total market cap held by the fund. This is determined by taking into account the overall performance of the fund’s underlying investments. All shareholders participate in a fund’s gains (or losses) proportionally.

Understanding the Value of a Mutual Fund

Since mutual funds make investments with pooled money brought in by investors, the fund’s value is dependent on the performance of the securities that the fund has bought. This means that each time you buy a mutual fund unit, you purchase a portion of the fund’s value. This unit is indicative of the fund’s varied investments rather than a single holding. 

Calculating the Value of a Mutual Fund

The price of a mutual fund unit is called its net asset value (or NAV). This NAV value is calculated by dividing the total net assets by the total number of units issued. The net asset value of a fund is calculated by subtracting the liabilities from the current value of the mutual fund’s asset and dividing that figure by the total number of units outstanding. The figure you arrive at will be the NAV of the mutual fund. The mathematical formula would look something like this :

NAV = (Assets - Debts)/Number of outstanding units

Example: Suppose the market value of the securities of the mutual fund is ₹700 lakh. The mutual fund issues 10 lakh units of ₹10 each; the NAV of each unit will be ₹70.

It is possible to purchase mutual fund units at the prevailing NAV. A deeper look into the expected or calculated returns on mutual funds should be a good step to take your mutual fund journey forward.

Understanding the Finer Details of the NAV

In contrast to stock prices, which fluctuate through market hours, NAV remains consistent throughout a given trading day. It is determined at the end of each trading day. By investing in a mutual fund by purchasing its units via the NAV, you don’t get access to voting rights.

Assessing the Diversification Mutual Funds Provide

Most mutual funds invest in over a hundred different securities, providing their investors access to diversification for an affordable price. To understand the value of diversification, consider an investor who purchases company A’s stock before the company has a bad quarter. This investor stands to lose considerably since all their money is tied to company A. Had this investor instead purchased some units of a mutual fund that owned a certain amount of company A’s stock and the rest in other assets, then even if company A had a bad quarter, the investor would suffer fewer losses. This is because company A only constituted a small portion of the fund’s portfolio. 

Exploring the Mechanisms of Mutual Funds

When an investor purchases some units of a mutual fund, they gain ownership rights to a portion of the mutual fund company as well as its assets. Ordinarily, investors accrue returns from mutual funds in any one of the following three ways.

Capital Gains – If a mutual fund sells securities whose price has risen, the fund experiences a capital gain. These gains can be passed forward to investors via a distribution.

Dividends – Dividends on stocks and interest on bonds under a fund’s portfolio can provide an income. Almost all the income a fund receives over the course of the year is paid to fund owners via a distribution. Investors are often given a choice to either receive their distributions in the form of a cheque or reinvest the income in lieu of additional shares.

Selling Mutual Fund Units – In case fund holdings rise in price but aren’t sold by the fund manager, the fund’s unit price rises. Shareholders are entitled to sell the same for a profit in the market.

Assessing the Employment Hierarchy in a Mutual Fund

Who’s the Top Gun?

If a mutual fund exists in the form of a virtual company, its fund manager is the CEO and may occasionally be called the fund’s investment adviser. This fund manager is hired by a board of directors and is legally obliged to carry out work that favours mutual fund shareholders the most. It isn’t unusual for fund managers to be the owners of a mutual fund.

Limited Employees Hired

The fund manager is responsible for hiring a few analysts who select investments or conduct market research. The fund accountant calculates the fund’s NAV. Finally, a compliance officer and an attorney are hired by mutual funds to ensure government regulations are followed.

Where Do Mutual Funds Fit in the Bigger Picture?

A large number of mutual funds fall under larger investment companies. In fact, some of these companies have several hundred mutual funds under their helm. To understand this better, consider some of the popular fund companies, including SBI and Kotak.

Understanding the Forms that Mutual Funds Take 

Today, there exist mutual funds that serve almost every kind of investor. It is possible to invest in a wide variety of mutual funds today. Each of these is representative of the varied securities they target and the kinds of returns they hope for. I have outlined below the varied forms mutual funds in India based on their investment objective.

1. Capital Protection Funds

 Here, money is invested among fixed income instruments as well as in the equity markets. This split investment style helps protect the principal amount that was originally invested by the fund.

2. Fixed Maturity Funds

These funds choose assets invested in debt and money market instruments. The maturity date applicable either matches that of the fund or occurs prior to that of the fund.

3. Growth Funds

These funds primarily direct money towards equity stocks in hopes of transpiring capital appreciation. Investors that have long-term investment horizons may find these to be risky investments. The risk factor involved with these funds makes them appropriate for those seeking more significant investment returns.

4. Income Funds

This form of mutual fund directs its money primarily toward fixed income instruments. These could be in the form of debentures or bonds. Here the goal is capital protection and providing investors with a regular income stream.

5. Liquid Funds

These funds primarily focus on investing in short-term and very short-term instruments such as treasury bills. They help provide liquidity. As far as risks are concerned, they are low-risk investments that provide moderate returns. Investors that have short-term timelines should go for this kind of mutual fund.

6. Pension Funds

This form of mutual fund makes investments keeping in mind a long-term goal. Ordinarily, these funds provide investors with regular returns by the time they are expected to retire. Investments of this kind of fund can be split across equity and debt markets. Here, equities constitute more risks that provide greater returns while debt markets help even out this risk, and although they provide lower returns, they are steadier. It is possible for investors to avail of their returns in the form of lump sums, as a pension or as a combined form of the two. 

7. Tax-Saving Funds (Equity-Linked Savings Schemes)

The primary focus of such mutual funds is equity shares. These funds are tethered to high risks. However, they provide high returns if the fund performs well. You qualify for deductions as stated under the Income Tax Act if you invest in these funds. ELSS funds can be a great way to cut down those taxes if you're starting out, read more about them here.

Apart from the aforementioned forms in which mutual funds exist, they are also categorised according to their asset class (equity, debt, money market and hybrid). Mutual funds are also categorised according to their risk, i.e., low risk, medium risk and high risk. Speciality funds also exist and take several forms, for instance, index funds, sector funds, international funds, real estate funds and gilt funds among others.

Merits Synonymous with Mutual Funds

The points below have touched upon some of the many advantages of mutual funds. 

Funds Managed by Professionals

Not all investors have the skill set, knowledge, or time to conduct adequate research and make wise individual stock or bond purchases. Mutual funds provide a solution here as they are managed round the clock by professional money managers. 

These fund managers monitor investments 24/7 and make portfolio adjustments wherever necessary to fulfil the scheme objectives. They are experts in their arena and have experience and the resources to actively buy, sell and monitor holdings making mutual fund investments worth investing in. Their presence alone cements one of the most important advantages of a mutual fund.

Risks are Diversified 

Purchasing mutual fund units provide an easy avenue to diversify your holdings across several securities and asset categories. This, in turn, helps spread the risk you’re exposed to, thereby reducing its impact. This is particularly helpful in case the underlying security of a mutual fund experiences volatility. 

Diversification helps counter the risks associated with a given asset class with others. This means that even if a single investment in a portfolio dips in value, other investments may not experience this day and may even experience a hike. 

Permit Small Investment Amounts

Many investors may find mutual funds far more affordable in comparison to purchasing individual securities that a given mutual fund holds. Further, the minimum initial investments stipulated by most mutual funds are fairly reasonable. 

Given the vast economies of scale, a low expense ratio exists for mutual funds. This expense ratio is indicative of the yearly operating expenses associated with a fund that is made clear in the form of a percentage of the fund’s daily net assets.

Liquidity

Investors of open-ended mutual funds can redeem (or liquidate) their holdings to fulfil their financial needs whenever the stock markets are open. Once these units are redeemed, the redemption amount is credited to your account within 3 to 4 working days. 

This does not apply to close-ended mutual funds and equity-linked saving schemes wherein redemption can only occur at maturity and post the 3-year lock-in period respectively. However, if they want to redeem before the end of the lock-in period, investors can take a loan against these funds.

Highly Regulated

The Securities and Exchange Board of India (or SEBI) is responsible for regulating mutual funds as per the SEBI Regulations of 1996. This entity has put forward stringent rules and regulations that do the following.

  • Protect investors
  • Provide them with transparency of the risks associated with their investments
  • Ensure fair valuation principles prevail

Enjoy Tax Benefits 

Certain mutual fund investments provide their investors with tax benefits, such as ELSS schemes that are eligible for tax benefits for up to INR 1.5 lakhs as per section 80C of the Income Tax Act. Further, mutual funds that are held for long time frames are tax-efficient.

Selecting the Right Kind of Mutual Fund to Invest In

Given that the market is currently flooded with several different mutual funds, selecting a fund that is most appropriate to your needs may be tricky. Follow the three simple steps listed below to make a wise mutual fund investment decision.

Step 1. The best way to pick a mutual fund relates to first understanding your own needs. 

Step 2. Discern what your investment goals are.

Step 3. Consider the amount of risk that you are willing to take. The most significant returns ordinarily involve the highest stakes.

Always read a given investment’s policy documents before investing in it. This document will also help shed light on precisely what you’ve invested in and the possibilities available to you by virtue of this investment.

Final Thoughts

Mutual funds provide investors with several investment opportunities and have several advantages. That said, investors must consider their own threshold for risk, the time frame they are willing to commit to a given fund investment and their end goals. With Fi, you can choose among an array of mutual funds in the simplest ways that are most suitable for your goals.

Frequently Asked Questions:

Q1. Are mutual fund investments safe?

 A1. Mutual fund investments are safe, provided you’re aware of all they entail. Although these funds can never be separated from the risks associated with investing in them, the returns they offer often outweigh the risks they are linked with.

Q2. What is the best way to invest in mutual funds?

 A2. By investing in mutual funds online, you can compare different schemes and assess their pros and cons with greater wase making this the ideal platform via which to invest in them. 

Q3. Which mutual fund is the best for beginners?

A3. Some of the best mutual funds beginners can invest in, keeping in mind their past 5-year returns include the following.

  • ICICI Prudential Equity and Debt Fund
  • Mirae Asset Tax Saver Fund
  • Canara Robeco Equity Tax Saver Fund
  • DSP Tax Saver 
  • Kotak Tax Saver Fund

Q4. Can I withdraw my money from a mutual fund at any time? 

A4. Most mutual funds are open-ended and liquid investments, so it is possible to withdraw money from them at any point in time. That said, there do exist certain closed-ended funds that have a lock-in period. Here, you must wait for this lock-in (or maturity) period to close before withdrawing your money. 

Q5. Do mutual funds only invest in stocks?

A5. Mutual funds invest in several assets, including but not limited to stocks. Bonds, commodities contracts and real estate investment trusts are just some of the many securities mutual funds may choose to invest in.

Q6. Are fund managers necessary?

A6. A mutual fund manager’s value cannot be sufficiently stressed. Their experience, knowledge and understanding of the markets go a long way in helping mutual funds accrue returns on the principal originally invested. That said, there do exist certain mutual funds that are passively managed. Here, the management fees paid by investors are lower.

Q7. What is an exit load?

A7. An exit load refers to the fee applicable to investors should they choose to exit a scheme either partially or wholly within a certain period from the time they first invested in the fund. 

Q8. What is net asset value (NAV)?

A8. The price of a mutual fund unit is called its net asset value (or NAV). 

Q9. What is an expense ratio?

A9. An expense ratio helps indicate the yearly operating expenses associated with a fund that is made clear in the form of a percentage of the fund’s daily net assets. 

Q10. How do you calculate the return on mutual funds?

A10. Return on mutual funds is calculated by using the current NAV as well as the initial NAV of the mutual fund i.e.,

Absolute return = (Current NAV – initial NAV)/ initial NAV x 100

Q11. How do beginners invest in mutual funds?

A11. Beginners can start investing in mutual funds with a modest amount of money. They can diversify their holdings across several stocks and other instruments like gold and debt. Next, they can consider investing in automated monthly investments. Learn more about KYC for Mutual Funds here.

Still Curious? Check out related blogs on mutual funds:
Is Equity Better than Mutual Funds?

Mutual Funds vs. Stocks

The Power of Compounding in Mutual Funds

What are Equity Based Mutual Funds? 

Returns on Mutual Funds

Best Mutual Funds in 2022

Mutual Funds for Assured Returns or Dividends

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