What is a mutual fund?
A mutual fund is a professionally managed entity that pools the savings of a large number of investors (known as unit holders) and invests the funds in a variety of securities like stocks, bonds, government securities and other money market instruments. The fund house issues units (against the funds received) to each investor. Mutual funds are managed by professionals known as fund managers who try to achieve substantial income and capital gains for the investors.
A fund’s portfolio is structured and managed so as to achieve the investment objectives mentioned in the prospectus. Thus a small time retail investor gets an opportunity to invest in a diversified, professionally managed portfolio at a relatively low cost, something he may not have been able to afford if he directly invested in the stock market.
Mutual funds are one of the best investments available to retail consumers as they are easy to understand and invest in, are cost-effective, don’t require huge capital, are professionally managed and enable the unit holder to enjoy the benefits of diversification.
Why invest in Mutual Funds?
Economies of Scale: Fund houses buy stocks in large quantities and therefore enjoy lower transaction costs, which can be passed onto the retail consumers in the form of a lower average cost. This may not be possible if a retail investor directly purchases shares from the market.
Diversification: The cliché “don’t put all your eggs in one basket” holds true even for mutual funds. Mutual funds invest large sums of money in a variety of stocks across a number of sectors. It is highly unlikely that in a given financial year all stocks belonging to all sectors will decline in the same proportion. A mutual fund holder enjoys the benefit of diversification at a much lower cost compared to the transaction charges he would have to bear if he selectively purchased stocks across different sectors.
However, there are certain sector/thematic funds which invest only in one industry/sector. These tend to be less diversified, riskier and more volatile.
Wide range of products: Mutual fund houses have developed a variety of schemes to cater to different needs and requirements. These include Equity, Liquid, Debt and ETF Gold schemes. Equity schemes may be further classified into Large cap, Mid cap, Small cap, Micro cap, Balanced, Thematic, Arbitrage and Fund of Funds. Debt schemes may be further classified into Gilt funds. MIPs, Hybrid funds and Income funds. A customer is free to decide which scheme he wishes to invest in depending on his financial goal, time horizon and risk appetite.
Regular Investment: Mutual funds are ideal for salaried people who can invest through the SIP mode on a regular basis in order to achieve their financial goals. A retail investor can start an SIP with just Rs 500 a month. He can therefore select a couple of schemes and invest as per his requirement.
Professional Management: Mutual funds are ideal for people who have no time to track the financial markets or do not have the expertise. Qualified fund managers backed by an able research team continuously track the performance of companies and sectors. On the basis of their research they determine which stocks to purchase or sell and at what price so as to achieve the fund’s objectives. Thus a small retail investor can enjoy the benefits of professional management at a fraction of the cost and enjoy higher returns.
Liquidity: Open ended schemes can be redeemed partially or fully at any time and the customer will receive the current price (NAV) of the units. They are more liquid than other forms of investment like real estate or bonds. The redemption procedure is standardised, easy and time bound and hence a customer gets his money within the stipulated time frame.
Tax Benefits: Currently if an investor remains invested in an equity scheme for more than 12 months the capital gains are tax free. In addition, an investor can avail of tax benefits under Section 80C if he invests in ELSS (Equity Linked Saving Schemes) for three years.
Transparency: The performance of various schemes is regularly reviewed by various publications and rating agencies also rate the schemes depending on the returns they have earned. This information is available in the public domain. Investors can use this data to compare the performance of various schemes before deciding the most appropriate one. All unit holders have access to fund data like the current NAV and AUM, Fund’s portfolio and Fund Manager’s strategy.
Rupee Cost Averaging: If an investor adopts the SIP route he can enjoy the advantages of rupee cost averaging. He will be allotted more units when the NAV declines and fewer units when the NAV increases. The investor will also enjoy the benefit of compounding as when you stay invested over a long period of time it enables your money to earn money over time.
Regulations: All mutual funds are registered as well as monitored by SEBI. They must follow all the rules and regulations laid down by SEBI.
Types of Mutual Funds
Equity Funds: These mutual funds invest in shares of companies. They are high risk-return funds as their profits are linked to the stock market. The dividends earned can either be ploughed back into the fund by the fund manager or distributed to investors in the form of dividend. They are ideally suited for investors who have a long term perspective and can stay invested for at least five years. There are various types of equity funds such as Large Cap/Diversified, Flexi Cap, Mid Cap, Small/Micro Cap, Arbitrage, Thematic, Balanced and Fund of Funds.
Debt/Income Funds: These funds invest mainly in securities such as corporate bonds, government securities, debentures, commercial papers and other money market instruments. Their main aim is to provide regular income and is ideal for medium to long term investors who have a low risk appetite and would like to earn regular income. Capital appreciation is significantly lower as compared to equity funds. Debt funds are less risky as compared to equity funds.
Liquid Funds: These funds invest in highly liquid instruments and are a suitable alternative to bank deposits as they provide liquidity, better interest rates compared to banks and capital preservation. They are ideal for institutional investors, corporates and HNIs who want to invest for a short period (even as short as a day). Returns will be significantly lower as compared to equity funds as the fund manager invests funds in liquid assets like T Bills, Commercial Papers, GILTS and CDs.