What types of mutual funds are suitable for new investors?

Posted On: 27 August 2024

Mutual funds can be an easy and affordable way to invest in the financial market, especially for beginners. Directly investing in stocks requires knowledge of what to buy and when to sell it. On the other hand, traditional saving schemes do not usually offer inflation-beating returns over long term.

Mutual funds offer a balance, as they are professionally managed, allowing you to participate in the growth potential of stocks and debt securities even if you don’t have market knowledge. This article will tell you more about mutual funds and the categories that may be suitable for first-time investors.

Table of contents

What are mutual funds?
Types of mutual funds
What mutual funds are suitable for new investors?
How to choose a suitable mutual fund

What are mutual funds?

Mutual funds are investment avenues that collect money from multiple investors, pool it together, and invest it in a diversified portfolio comprising stocks, bonds, or other securities. This diversification helps spread risk. A professional fund manager handles the portfolio, deciding how to allocate the money and what trades to make to optimise return potential while mitigating risks. Here are some of the other benefits of mutual funds:

1. Liquidity: Investments in most mutual funds (except closed-ended funds or those that have a lock-in period) are highly liquid, meaning they can be easily accessed whenever needed. This flexibility contrasts with other investments like real estate or fixed deposits (FDs), where premature withdrawals might lead to penalties or reduced interest rates.

2. Options: Mutual funds offer a wide range of schemes tailored to different investment goals, timeframes, and risk appetites.

3. Low barrier to entry: With investments commencing at a nominal amount and the option to contribute periodically through systematic investment plans (SIPs), mutual funds accommodate a range of financial capabilities, making them accessible even for those with modest starting capital.

4. Financial discipline: SIPs in mutual funds – where you invest a fixed amount at fixed intervals – help you cultivate disciplined investing habits. Plus, you can start with a small instalment (such as Rs. 500 or Rs. 1,000 a month) and increase it over time.

Types of mutual funds

There are multiple mutual fund categories in India, each investing in different types of assets. Broadly, they can be classified as:

1. Equity funds: These primarily invest in company stocks, offering the potential for high returns in the long term but also entail high risk. Equity fund sub-categories include:

Large-cap funds: Invest in established companies
Mid-cap funds: Focus on medium-sized companies
Small-cap funds: Target small companies
Multi and flexi cap funds: Invest across market capitalisations

The risk and return potential of these sub-categories varies, with large-cap investment being the least volatile. As a thumb rule in investing, higher return potential usually means higher risks.

2. Debt funds: These invest in fixed-income securities like bonds and government securities. They are generally less risky than equity funds but with lower growth potential. Debt funds are suitable for investors seeking modest growth potential with relative stability in the short, medium, or long term. Sub-categories include:

Liquid funds: Invest in highly liquid short-term securities
Short-term funds: Invest in securities with macaulay duration of 1 to 3 years
Gilt funds: Invest in government securities
Corporate bond funds: Invest in bonds issued by companies.

Here, too, the risk and return potential varies, with very short-term securities entailing the least risk. However, no investment is risk-free.

3. Hybrid funds: These invest in a mix of equity and debt securities, seeking to balance growth potential with relative stability. Sub-categories include:

Conservative hybrid funds: Higher allocation to debt
Balanced hybrid funds: Equal allocation to equity and debt
Aggressive hybrid funds: Higher allocation to equity

4. Solution-oriented schemes: These include retirement funds (which have a lock-in period of five years or until retirement age, whichever is earlier) and children’s funds (lock-in period of five years or until the child reaches maturity, whichever is earlier.

5. Other: This comprises funds that don't fit into the above categories, including:

Passive funds: These track a specific market index, aiming to match the returns of that index, subject to tracking error.
Fund of funds: Invest in other mutual funds

By understanding these categories, investors can make informed decisions based on their risk tolerance, investment horizon, and financial goals.

What mutual funds are suitable for new investors?

Since mutual funds are professionally managed, beginners can invest in any, depending on their risk tolerance and investment objectives. However, some fund categories may be better suited for new investors, especially if they do not yet want to take on too much risk.

Debt mutual funds: Their relative stability makes them suitable for investors who are on the more conservative end of the risk spectrum. The return potential, while lower than that of equities, can be higher than that of traditional savings avenues.
Index funds: These are passive funds, meaning that the goal is to try to match the performance of a stock market index (subject to a tracking error, i.e., the difference between the fund’s performance and that of the index.) The investment portfolio of passive funds mirrors that of the benchmark index. Examples include Nifty50 index funds, whose portfolio comprises the same 50 stocks and in the same proportion as the Nifty50 index.

In comparison, actively managed mutual funds try to beat the index. Fund managers identify and invest in securities that they believe can potentially outperform the market in the long run.

Index funds typically entail slightly lower risk than actively managed funds, as their performance is tied to the market segment they invest in. The portfolio construction process and investment strategy are also easier to understand, as they seek to match the stock market index.
Large cap funds: Such funds invest chiefly in the country’s largest companies in terms of market capitalisation. Such companies tend to have a track record of strong performance and healthy balance sheets, making them less volatile than smaller companies. This can make large cap funds suitable for new investors who want to invest in equities but seek a more optimised risk-reward balance.
Hybrid funds: Hybrid funds offer a middle ground for investors seeking a blend of growth and relative stability. These funds invest in a mix of equity and debt securities, allowing for potential capital appreciation while mitigating some of the inherent risks associated with pure equity investments. This can make them suitable for new investors who want a more balanced approach.

How to choose a suitable mutual fund

A mutual fund that is suitable for you depends on individual circumstances, goals, and preferences. Here are some of the factors to bear in mind when selecting a fund:

Risk tolerance: Different mutual funds cater to varying risk appetites and investment horizons. Equity funds require a high risk tolerance. Conversely, if you prioritise relative stability, debt funds may be a better fit.
Investment horizon: Your time frame significantly influences your fund choices. Equity funds and equity-oriented hybrid funds are more suitable for a long investment horizon, as they offer growth potential over time but can be very volatile in the short term. Short-term needs require relative stability of capital invested, making debt mutual funds more suitable.
Investment goals: Long-term goals such as buying a home or building a retirement corpus may require significant capital appreciation potential, making equity-oriented funds suitable. The long investment horizon can also mitigate the risk of short-term volatilities.
Expense ratio: The expense ratio represents the fee charged by the fund. Lower expense ratios can translate into higher net returns over time.
Fund manager's experience: The fund manager's track record and investment philosophy play a significant role in the fund's performance.

Conclusion

Mutual funds offer a balanced mix of professional management, diversification, and potential for growth, making them a suitable investment avenue for new investors or those who do not have the time or inclination to track the market. They can also be less risky than investing directly in stocks. By carefully analysing your financial goals, risk tolerance, and investment horizon, you can select mutual funds that align with your needs. Whether you're seeking the potential for long-term wealth creation or relative stability with modest growth, mutual funds can help you work towards your objectives and tap into the potential of financial markets.

FAQs

How do I choose a mutual fund to invest in?

Choosing the right mutual fund involves a careful evaluation of various factors. These include your investment goals, risk tolerance, investment horizon, expense ratio of the fund, and the fund manager's expertise.

Which is the most stable mutual fund?

No mutual fund is entirely risk-free. However, debt funds, particularly those investing in government securities or low-duration securities are usually relatively stable.

Which is the best mutual fund for beginners?

For beginners, debt funds, index funds, large-cap funds, and hybrid funds can be good starting points.
Large-cap equity funds invest in well-established companies with a proven track record, offering relatively lower volatility compared to mid-cap or small-cap funds.
Hybrid funds provide a mix of equity and debt exposure, aiming to strike a balance between growth potential and stability.
Index funds, which passively track a specific market index, can also be a suitable option for beginners due to their low expense ratios, broad market exposure, and simple investment strategy.

Which mutual funds give the highest return?

Historically, small-cap and mid-cap equity funds have the potential to generate the highest returns over the long term. However, they also come with higher volatility and risk. Sectoral funds, focusing on specific industries, can also offer significant returns if the chosen sector performs well. High returns are often accompanied by higher risks, and investments should align with your risk tolerance and investment goals.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.