Mutual Funds: Introduction

Not everyone has the knowledge and time to pick stocks which can give them exponential returns. Won’t it be nice if we could hire someone else to do this on our behalf. Well, mutual funds are here to the rescue.

This article will give you a brief introduction on mutual funds, why you should invest in them and some of the key concepts you should know before investing in a mutual fund.


What is a mutual fund?

A mutual fund is a financial vehicle which pools money from several investors to invest in different financial instruments like stocks, bonds, money market instruments, gold, and other assets. These funds are managed by professional fund managers who buy or sell these securities on your behalf. The fund manager allocates the fund’s assets in these instruments, seeking capital gains or income for the fund’s investors.


Why should you invest in a mutual fund?

  • Investment handled by experts: Professional fund managers manage your money. They select the securities to invest in and decide when to buy them. They also monitor the performance, and decide when to sell them. So, you don’t need to worry about the ups and downs in the market and you don’t need to make any decision as all such decisions are taken by the fund manager(s).

  • Diversification: Each mutual fund invests in a basket of securities rather than investing in a single security. This helps you to lower the risk, if one company fails. Also, If you invest ₹500 in a mutual fund scheme and that scheme invests in stocks of 30 companies, then it makes your investment of ₹500 diversified over these 30 companies. If you were to have this diversification on your own, then you would need to buy at least 1 stock of each of these companies and hence, would need a larger sum.

  • Affordability: Investing in mutual funds comes at a low cost. You can start investing with as low as ₹500.

  • Easy access: It is relatively easier to buy or sell mutual funds than investing in stocks. Also, in some scenarios, like investing in foreign equities, it is the most feasible way. You don’t need to create a Demat account and a trading account for investing in mutual funds, which is otherwise required in case of investing in stocks.

  • Transparency: Mutual funds are regulated by SEBI (Securities and Exchange Board of India). There are various regulations imposed by SEBI, which makes mutual funds one of the most transparent investment options.


Key concepts


AUM

AUM stands for Asset Under Management. It is the total of all the assets a fund holds. It includes stocks, bonds, and other securities.

What is a mutual fund unit?

Unit represents your holding in a mutual fund scheme. You are issued these units based on the amount you invest in the scheme. As an investor in a mutual fund, you are also known as a unitholder.

What is NAV?

NAV of a mutual fund stands for Net Asset Value. It is the price of a single unit of a fund. It is the price at which you can buy units from the AMC. It is calculated daily after the market hours, by taking into consideration the closing prices of all the securities held in that fund.

Expense ratio

It is the fee charged by the fund houses to manage your investments. As per SEBI regulations, it is always less than 2.5% of the amount invested by you. It varies from fund to fund, but generally it hovers between 0.5-1.0% for the direct plan. (More on direct plan and regular plan in the later part of this article.)

Exit load

It is the penalty charged by the mutual fund, if you are not able to stay invested over a specific time frame. Most funds these days don’t have any exit load but it is a good practice to check for the exit load before investing in a mutual fund.


Types of mutual funds


Debt funds

Debt funds have an objective to provide regular and steady income to the investors. These funds are also known as fixed-income funds. A debt fund invests in fixed income securities such as corporate bonds, government securities, and other debt instruments. A mutual fund is considered a debt fund if it invests a minimum of 65% of its portfolio in debt securities.

As debt funds don’t invest in equities, their performance is not influenced much by market fluctuations. Debt funds tend to be less risky compared to equity funds (that doesn’t mean they’re risk free), but their return potential is also lower. These funds are suitable for conservative or moderate risk profile investors and are ideal for short-term investment goals. (Not sure about your risk profile? Refer to our previous article.)

Based on where these funds invest and what is the average duration of bonds in their portfolio, these funds are further classified as Liquid Fund, Short Duration Fund, Medium Duration Fund, etc.

Equity funds

Equity funds have an investment objective to generate capital appreciation over the long term. This is the largest category of mutual funds. An equity fund invests a major part of its portfolio in equities. A mutual fund is categorised under equity fund if it invests at least 65% of its portfolio in equity instruments.

As the performance of these funds is influenced by the market fluctuations, they have comparatively high risks. Equity funds have the potential to offer the highest returns among all categories of mutual funds but the returns depend on the market volatility. These funds are suitable for moderate or aggressive investors who have the investment horizon of at least 5 years. These funds are ideal for long-term or very long-term goals.

Based on which equities these funds invest in, they can be further classified as large-cap funds, mid-cap funds, small-cap funds, flexi-cap funds, etc.

Hybrid funds

As the name suggests, a hybrid fund invests in a mix of equity and debt instruments. These mutual funds aim to provide investors the best of both worlds – capital appreciation of equity funds and the regular fixed-income of debt funds. The main objective of hybrid funds is to balance the risk-reward ratio by diversifying the portfolio among debt and equity.

As these funds also have some of their part invested in equities, their performance is also influenced by market conditions. But as they are not fully exposed to equities, they have comparatively lower risk than equity funds. The performance of hybrid funds lies between equity and debt funds. These funds are ideal for investors with moderate risk profiles who are ready to take some extra risk compared to debt funds to get more returns.

Depending on their exposure to equity, these funds can be further classified into Conservative Hybrid Funds, Aggressive Hybrid Funds, Balanced Funds, etc.


Bonus: Direct Plan vs Regular Plan

Almost all the mutual funds offer two plans to the investors- Direct Plan and Regular Plan.

A Direct Plan is what you buy directly from the AMC offering the mutual fund (usually from AMC’s own website or from discount brokers like Groww, Zerodha, etc.). Whereas, a Regular Plan is what you buy through an advisor, or a distributor. In the regular plan, the AMC pays a commission to the advisor or the distributor and this commission is taken from your investments through a higher expense ratio. That’s why you will observe the difference in the expense ratio of both these schemes.

For example, the expense ratio of Axis Small cap fund is 0.36% for direct plan and 2.11% for regular plan. So, you should always opt for the direct plan to save the extra fees and hence to earn higher returns.

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