Before investing in Mutual Funds one should know, what are Mutual Funds and How does it work?
A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.
Classifications of Mutual Funds
- Open-Ended Funds: These funds buy and sell units on a continuous basis and, hence, allow investors to enter and exit as per their convenience. The units can be purchased and sold even after the initial offering (NFO) period (in case of new funds). The units are bought and sold at the net asset value (NAV) declared by the fund.
- Closed-Ended Funds: The unit capital of closed-ended funds is fixed and they sell a specific number of units. Unlike in open-ended funds, investors cannot buy the units of a closed-ended fund after its NFO period is over. This means that new investors cannot enter, nor can existing investors exit till the term of the scheme ends. However, to provide a platform for investors to exit before the term, the fund houses list their closed-ended schemes on a stock exchange.
- Interval Funds: These funds are a hybrid of open and close ended funds. While they operate mainly as close ended funds, these funds may trade on stock exchanges and are open for sale or redemption at predetermined intervals at the prevailing NAV.
There are several types of Mutual Fund schemes – Equity, Debt, Money Market, Hybrid, etc. And there are many Mutual Funds in India managing several hundreds of schemes amongst them. You should always remember that you are choosing mutual funds to achieve your financial goals. So, choose a mutual fund scheme based on your goals, time in hand to achieve the goals and your risk profile.
Types of Mutual Funds in India:
Equity Funds
These funds primarily invest a major part of their corpus inequities. Naturally, equity funds have comparatively high risks. Since they tend to reap high returns, they are generally considered to be high risk. These are suitable for high-risk profile investors who have a long-term investment horizon.
Debt Funds/ Income Funds
Debt funds have an investment objective to provide regular and steady income to investors. Such schemes invest in fixed income securities such as bonds, corporate debentures, Government securities, and money market instruments. Though debt funds are less risky compared to equity schemes, the return potential is lower.
Hybrid Funds/ Balanced Funds
These schemes invest in equities and fixed income securities in the proportion indicated in their offer documents. The aim of these schemes is to provide both growth and regular income. This is a great option for investors looking for moderate growth. Typically, the distribution between equity and debt instruments is in a 40:60 ratio. However, these funds are subject to market volatility as equity instruments are part of the investment portfolio.
Money Market Funds
These funds invest in short-term fixed-income securities such as government bonds, treasury bills, bankers’ acceptances, commercial paper, and certificates of deposit. They are generally a safer investment, but with a lower potential return than other types of mutual funds.
Sectoral Funds / Thematic Funds
Sector-specific funds invest in the securities of a specific sector or industry such as FMCG, Pharmaceuticals, IT, etc. The returns on these funds are directed by the performance of the respective sectors/industries. Sector funds allow an investor to diversify funds across multiple companies within an industry. These funds tend to be riskier as the performance is directly linked to that of the overall sector.
Index Funds
Index funds are attached to a particular index such as the BSE SENSEX or the NIFTY. Their performance is linked to the results of that index. Here, the portfolio comprises stocks that represent an index and the weightage assigned to each stock is in line with the identified index. Hence, the returns will be more or less similar to those generated by the Index.
Tax Saving Funds / ELSS Funds
The Income Tax Act offers tax deduction under specific provisions of the Income Tax Act, 1961. Designed to generate capital growth, ELSS (Equity Link Saving Savings Scheme) mutual funds invest primarily in equities and largely suit investors with a higher risk appetite for capital appreciation. Spread over medium to long-term, tax-saving funds come with a lock-in period of 3 years.
Funds of Funds
A scheme that invests primarily in other schemes of the same mutual fund or other mutual funds is known as an FoF scheme. An FoF scheme enables investors to achieve greater diversification through one scheme. It spreads risks across a greater universe.
Why do people invest in mutual funds?
Mutual funds are a popular choice among investors because they generally offer the following features:
- Professional Management. The fund managers do the research for you. They select the securities and monitor the performance.
- Diversification or “Don’t put all your eggs in one basket.” Mutual funds typically invest in a range of companies and industries. This helps to lower your risk if one company fails.
- Affordability. Mutual Funds are a relatively less expensive way to invest compared to directly investing in the capital markets because the benefits of scale in brokerage, custodial and other fees translate into lower costs for investors.
- Liquidity. Mutual fund investors can easily redeem their shares at any time, for the current net asset value (NAV) plus any redemption fees.
- Flexibility. Through features such as Systematic Investment Plans (SIP), Systematic Withdrawal Plans (SWP) and dividend reinvestment plans, you can systematically invest or withdraw funds according to your needs and convenience.
- Regulated. All Mutual Funds are registered with SEBI and they function within the provisions of strict regulations designed to protect the interests of investors. The operations of Mutual Funds are regularly monitored by SEBI.
Based on your risk appetite, the period you want to stay invested, and the type of returns that you expect, you can choose from the different types of mutual funds. It is recommended you choose funds that deliver stability, growth, and income for maximum benefits.
By investing through SIPs in a mechanical way, investors can stay disciplined, which is one of the biggest benefits of investing in mutual funds.