A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds.
To many people, Mutual Funds can seem complicated or intimidating. We are going to try and simplify it for you at its very basic level. Essentially, the money pooled in by a large number of people (or investors) is what makes up a Mutual Fund. This fund is managed by a professional fund manager.
It is a trust that collects money from a number of investors who share a common investment objective. Then, it invests the money in equities, bonds, money market instruments and/or other securities. Each investor owns units, which represent a portion of the holdings of the fund. The income/gains generated from this collective investment is distributed proportionately amongst the investors after deducting certain expenses, by calculating a scheme’s “Net Asset Value or NAV. Simply put, a Mutual Fund is one of the most viable investment options for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.
What are the various types of mutual funds?
Various types of Mutual Fund schemes exist to cater to different needs of different people. Largely there are three types of mutual funds.
1. Equity or Growth Funds
- These invest predominantly in equities i.e. shares of companies
- The primary objective is wealth creation or capital appreciation.
- They have the potential to generate a higher return and are best for long-term investments.
- Examples would be
- “Large Cap” funds invest predominantly in companies that run large established business
- “Mid Cap funds” invest in mid-sized companies. funds that invest in mid-sized companies.
- “Small-Cap” funds that invest in small-sized companies
- “Multi Cap” funds that invest in a mix of large, mid, and small-sized companies.
- “Sector” funds invest in companies that are related to one type of business. E.g. Technology funds that invest only in technology companies
- “Thematic” funds that invest in a common theme. E.g. Infrastructure funds that invest in companies that will benefit from the growth in the infrastructure segment
- Tax-Saving Funds
2. Income or Bond or Fixed Income Funds
- These invest in Fixed Income Securities, like Government Securities or Bonds, Commercial Papers and Debentures, Bank Certificates of Deposits, and Money Market instruments like Treasury Bills, Commercial Paper, etc.
- These are relatively safer investments and are suitable for Income Generation.
- Examples would be Liquid Funds, Short Term, Floating Rates, Corporate Debt, Dynamic Bond, Gilt Funds, etc.
3. Hybrid Funds
- These invest in both Equities and Fixed Income, thus offering the best of both, Growth Potential as well as Income Generation.
- Examples would be Aggressive Balanced Funds, Conservative Balanced Funds, Pension Plans, Child Plans, Monthly Income Plans, etc.
Types of Funds
- An Equity Fund is a Mutual Fund Scheme that invests predominantly in shares/stocks of companies. They are also known as Growth Funds.
- Equity Funds are either Active or Passive. In an Active Fund, a fund manager scans the market, researches companies, examines performance, and looks for the best stocks to invest in. In a Passive Fund, the fund manager builds a portfolio that mirrors a popular market index, say Sensex or Nifty Fifty.
- Furthermore, Equity Funds can also be divided as per Market Capitalisation, i.e. how much the capital market values an entire company’s equity. There can be Large Cap, Mid Cap, Small, or Micro Cap Funds.
- Also, there can be a further classification as Diversified or Sectoral / Thematic. In the former, the scheme invests in stocks across the entire market spectrum, while in the latter it is restricted to only a particular sector or theme, say, Infotech or Infrastructure.
- Thus, an equity fund essentially invests in company shares and aims to provide the benefit of professional management and diversification to ordinary investors.
- A debt fund is a Mutual Fund scheme that invests in fixed income instruments, such as Corporate and Government Bonds, corporate debt securities, money market instruments, etc. that offer capital appreciation. Debt funds are also referred to as Fixed Income Funds or Bond Funds.
- A few major advantages of investing in debt funds are a low-cost structure, relatively stable returns, relatively high liquidity, and reasonable safety.
- Debt funds are ideal for investors who aim for regular income but are risk-averse. Debt funds are less volatile and, hence, are less risky than equity funds. If you have been saving in traditional fixed income products like Bank Deposits and looking for steady returns with low volatility, debt Mutual Funds could be a better option, as they help you achieve your financial goals in a more tax-efficient manner and therefore earn better returns.
- In terms of operation, debt funds are not entirely different from other Mutual Fund schemes. However, in terms of safety of capital, they score higher than equity Mutual Funds.
ELSS Fund – Tax Saving Mutual Fund
- An ELSS is an Equity Linked Savings Scheme, that allows an individual or HUF a deduction from the total income of up to Rs. 1.5 lacs under Sec 80C of Income Tax Act 1961.
- Thus if an investor was to invest Rs. 50,000 in an ELSS, then this amount would be deducted from the total taxable income, thus reducing her tax burden.
- These schemes have a lock-in period of three years from the date of unit allotment. After the lock-in period is over, the units are free to be redeemed or switched. ELSS offers both growth and dividend options. Investors can also invest through Systematic Investment Plans (SIP), and investments up to ₹ 1.5 lakhs, made in a financial year are eligible for a tax deduction
- Index Funds are passive mutual funds that mimic popular market indices. The Fund Manager doesn’t play an active role in selecting industries and stocks to build the fund’s portfolio but simply invests in all the stocks that make up the index to be followed. The weightage of the stocks in the fund closely matches the weightage of each of the stocks in the index. This is passive investment i.e the fund manager simply copies the Index while building the fund’s portfolio and tries to maintain the portfolio in sync with its index at all times.
- If the weight of stock within the index changes, the fund manager must buy or sell units of the stock to have its weight in the portfolio aligned to that of the index. While passive management is easier to follow, the fund doesn’t always produce the same returns as that of the index due to tracking errors.
- Tracking error occurs because it is always not easy to hold the securities of the index in the same proportion and transaction costs are incurred by the fund in doing so. Despite tracking errors, index funds are ideal for those who don’t want to take the risk of investing in mutual funds or individual stocks but would like to gain exposure to the broader market.
Money market funds
A money market fund is a kind of mutual fund that invests in highly liquid, near-term instruments. These instruments include cash, cash equivalent securities, and high-credit-rating, debt-based securities with a short-term maturity (such as U.S. Treasuries).
Balanced funds, also known as hybrid funds, are a class of mutual funds that contain a bond (debt) component and a stock (equity) component in a specific ratio in a single portfolio. These mutual funds help investors diversify their portfolios by investing in asset classes such as equity and debt.
Income funds are mutual funds or ETFs that prioritize current income, often in the form of interest or dividend-paying investments. Income funds may invest in bonds or other fixed-income securities as well as preferred shares and dividend stocks.
Fund of funds
A fund of funds (FOF)—also known as a multi-manager investment—is a pooled investment fund that invests in other types of funds. In other words, its portfolio contains different underlying portfolios of other funds. These holdings replace any investing directly in bonds, stocks, and other types of securities.
Specialty funds are a type of mutual fund that focuses their equity investing within a specific industry or sector of the economy. Some specialty funds cover broad sectors and others direct their investments on an industry group within a sector.
What are the different ways of investing in Mutual Funds?
- There are several ways to start investing in a Mutual Fund scheme.
- One can invest in Mutual Funds by submitting a duly completed application form along with a cheque or bank draft at the branch office or designated Investor Service Centres (ISC) of Mutual Funds or Registrar & Transfer Agents of the respective the Mutual Funds.
- One may also choose to invest online through the websites of the respective Mutual Funds.
- Further, one may invest with the help of / through a financial intermediary i.e., a Mutual Fund Distributor registered with AMFI OR choose to invest directlye., without involving or routing the investment through any distributor.
- A Mutual Fund Distributor may be an individual or a non-individual entity, such as bank, brokering house or on-line distribution channel provider.
- One can choose to invest online, as platforms these days have all necessary safeguards to ensure secure investing. It is really more a matter of comfort and convenience.
How do I get my returns in Mutual Funds?
Like other asset classes, Mutual Funds returns are calculated by computing appreciation in the value of your investment over a period as compared to the initial investment made. Net Asset Value of Mutual Fund indicates its price and is used in calculating returns from your Mutual Fund investments. Return over a period is calculated as the difference in sale date NAV and purchase date NAV upon purchase date NAV and converted to percentage by multiplying the result by 100 . Any net dividend* or other income distribution by the fund during the holding period is also added to the capital appreciation while computing total returns.
Capital appreciation in Mutual Funds is reflected by increase in NAV over time. This happens because NAV of a fund is derived from stock prices of companies included in the portfolio of the fund, and the prices fluctuate every day. Change in NAV of a fund over time contributes to the capital appreciation or loss in your holding. View the return performance of your investments in the account statement provided to you by the fund house. This statement captures both your transactions and the return on your investments.
Note: *NAV of a Fund falls to the extent of dividend payout and statutory levy, if any.