What is a Mutual Fund and how does it work?

Mutual Fund

A Mutual Fund is a financial medium or channel to invest in securities like stocks, bonds, and other assets. It collects money from a large group of investors and purchases securities. The fund managers operate mutual funds and manage the fund’s assets. Their main aspiration is to produce capital gains or income for the investors. Typically, fund managers are experienced financial advisers with wide knowledge in the securities investments.

Every mutual fund portfolio has its own objectives and investment principles. Small investors or individuals who do not possess any knowledge or experience of direct stock market investments invest in mutual funds. Mutual funds are the most sought after investment vehicles among salaried people in India. There are over 13.65 Crore investor folios related to mutual fund investments as on 31st August 2022.

Mutual fund schemes are a part of the larger financial institutions, Asset Managing Companies (AMCs) or Fund Houses. SBI Mutual Fund, HDFC Mutual Fund, ICICI Prudential Mutual Fund, Reliance Mutual Fund, Aditya Birla Sun Life Mutual Fund, etc. are some of the top mutual fund houses in India.

In India, mutual funds were first introduced in 1963. As 31st August, the total assets under management of all AMCs in India are over ₹39.34 Lakh Crore; it has risen by 200% in the last 5 years. Assets under Management (AUM) is the total market value of all assets managed under a fund house.

Types of Mutual Funds:

Mutual funds are classified based on their principal investments. Equity Funds, ELSS Funds, Fixed income or Debt Funds, Hybrid Funds, Index Funds are the most common categories in the mutual funds.

Equity Funds:

The fund manager of the equity funds invests the money in buying the shares of companies in stock markets. Depending on the size of the companies, the equity funds are further divided into Large-Cap, Mid-Cap, and Small-Cap funds. If you do not know these concepts, refer to my article on Market Capitalization; the lower the market cap, the higher the risk. These Funds are categorized as high risk investments.

ICICI Prudential Blue chip Fund, HDFC Flexi Cap Fund, Nippon India Large Cap Fund, etc. are some of the notable Equity Funds.

ELSS FUNDS:

An ELSS or Equity Linked Savings Scheme is similar to An Equity Fund but with benefits of tax deductions under Section 80C of the Income Tax Act, 1961. The exposure is not limited only to stock investments but also fixed income securities as bonds as well. Nevertheless, majority share of the investments are in Equity or Stocks. There is lock-in period of three years and no provisions for early or premature exit.

Well-known ELSS Funds are SBI Long Term Equity Fund, HDFC Taxsaver Fund, Axis Long Term Equity Fund, etc.

Fixed Income or Debt Funds:

These funds invest the collected money in purchasing the debentures or bonds belonging to the government and corporate entities and other money market instruments. Comparatively, debt funds provide lower returns than equity funds. These Funds are also less volatile compared to Equity Funds and considered as Low Risk Investments.

UTI Bond Fund, Aditya Birla Sun Life Low Duration Fund, Tata Money Market Fund, etc. are reputable Debt Funds in India.

BALANCED OR HYBRID FUNDS:

Well, we can get it from the title hybrid. The investors’ money is invested in different types of securities like equity shares, bonds, and money market instruments. It is like diversifying the investments into various classes, reducing the risks associated. These Funds are in between Equity and Debt Funds in both risk (medium risk) and return.

Quant Absolute Fund, ICICI Prudential Equity & Debt Fund, Edelweiss Aggressive Hydrid Fund, etc. are some examples of Hybrid Funds.

Index Funds:

Index fund manager puts the investors’ money in purchasing the stocks belonging to major stock market indices like Sensex, Nifty 50, Nifty Bank, etc. Since expense ratio is less than 0.5%, these are cost effective and most suited for Novice Investors.

Nippon India Index Nifty 50, Tata S&P BSE Sensex Index Fund, SBI Nifty Fund, etc. are some of the well-known Index Funds.

Pros

1. Investing in mutual funds offers diversification, which means, your money is invested in a number of companies. This approach reduces the risk of losing the returns if one or two companies report losses for a specific time.

2. There are heaps of mutual fund versions available; you can choose according to your interest.

3. The fund manager does the work of choosing the companies and stocks for investing. It saves both our effort and time.

4. You can start investing in small amounts every month; most mutual fund schemes have a minimum systematic installment plan (SIP) of 500/- in India.

Cons

1. Even though you find the previous returns of 12%, 15%, etc. per annum, there is no guarantee of the same returns in the future.

2. Fund houses do not provide their service for free; they levy charges and fees. The salaries of employees, transitions charges, and other maintenance charges are passed on to investors. In India, the expense ratio ranges between 1.5% and 3% for most of the mutual fund schemes.

3. The liquidity of mutual funds is lower than that of regular stocks. We can buy or sell stocks at any time of the day, whereas, the mutual fund redemptions take place at the end of the day.

4. You do not have any right over the selection of securities in the mutual funds. Only, the fund manager has all the right to choosing the right securities for investments.

Summary:

Mutual funds schemes are financial investment vehicles, which means, they collect money from us (investors), and purchase the securities in the capital markets. Equity, Debt, Hybrid, and Index funds are the most common classification of mutual funds. There are both advantages and disadvantages associated with mutual funds. Mutual funds are appropriate for new and inexperienced investors.

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Disclaimer
I provide the information and my views on the website only to educate new investors, stock market enthusiasts, and the common public on equity or stock market investments. Please consult your financial adviser before making any investments in the stock market. In case of any queries, you can contact me via email ID or Contact Form.