What is a mutual fund: Meaning, types, and benefits

Posted On: 19 August 2024

Beginning your journey into investing might seem overwhelming due to the many options available. However, mutual funds have become a popular choice for both newcomers and seasoned investors alike. Understanding what mutual funds are, how they operate, and the benefits they offer can empower you to make informed decisions and potentially increase your wealth.

Table of contents

What are mutual funds?
How do mutual funds work?
Features of mutual funds
Different types of mutual funds
Modes of investing in mutual funds
Pros of mutual fund investing
Cons of mutual fund investing
How to calculate mutual fund returns
Terms used in mutual funds

What are mutual funds?

Mutual funds are an investment vehicle that pool money from multiple investors to buy various assets like stocks, bonds, and money market instruments. Managed by investment professionals and regulated by the Securities and Exchange Board of India (SEBI), mutual funds offer diversification, which helps spread risk across different investments for potential returns. By pooling funds, they aim to provide investors with growth and reduce individual investment risk.

How do mutual funds work?

Pooling of funds: Mutual funds pool money from many investors. This pooled money forms a larger fund, allowing investors to access a diversified portfolio of investments that they might not be able to afford individually.

Professional management: Mutual funds are managed by professional fund managers or investment teams. These managers have expertise in analysing markets, selecting investments, and managing the fund's portfolio. Their goal is to achieve the fund's objectives, such as growth, income, or a balanced approach.

Diversification: Mutual funds invest in a variety of securities, such as stocks, bonds, and other assets. By spreading investments across different sectors, industries, and geographic regions, mutual funds reduce the risk of significant losses from any single investment. Diversification helps balance potential gains and losses, aiming to provide relatively stable returns over time.

Investor units: When you invest in a mutual fund, you buy units of the fund. The value of these units is based on the fund's net assets divided by the number of units outstanding. Investors can buy or sell units at the current Net Asset Value (NAV) price, which is typically calculated at the end of each trading day.

Net Asset Value (NAV): NAV represents the per-unit value of the mutual fund. It is calculated by subtracting the fund's liabilities from its assets and dividing the result by the number of outstanding units. NAV changes daily based on the performance of the fund's investments.

Liquidity: Mutual funds offer liquidity, allowing investors to buy or sell their units at any time (subject to market conditions). The ease of liquidity provides flexibility for investors who may need to access their money quickly.

Returns and distributions: Mutual funds generate returns through dividends received, interest income, or capital gains from the securities held in the portfolio. These returns are distributed to investors in the form of Income Distribution cum Capital Withdrawal (IDCW) or reinvested to buy more units. Investors may receive regular income from IDCW or benefit from capital appreciation when the fund's investments increase in value.

In summary, mutual funds simplify investing by pooling funds from multiple investors, employing professional management to diversify investments, offering liquidity for easy access to funds, and distributing returns to investors based on the fund's performance.

Features of mutual funds

Diversification: First of all, mutual funds spread your investment across various assets, reducing the risk compared to investing in individual stocks.
Professional management: Secondly, mutual funds are managed by experienced fund managers who optimize returns while managing risks.
Transparency: Investors can access detailed Scheme Information Documents and daily NAVs, ensuring clear insight into their investments' performance.
Liquidity: Mutual funds, especially open-ended ones, offer high liquidity, allowing you to redeem investments quickly, typically within 1-3 business days.
Well-regulated industry: Finally, mutual funds operate under strict regulations set by SEBI, ensuring investor protection, risk mitigation, liquidity, and fair valuation.

Different types of mutual funds
Some of the types of mutual funds are mentioned below:

Equity funds: These funds invest in stocks, including large-cap, mid-cap, and small-cap categories, to achieve long-term capital growth.
Debt funds: These funds focus on fixed-income securities like government and corporate bonds, offering regular income with relatively lower risk.
Hybrid funds: These funds invest in both equity and debt instruments, balancing growth potential with relative stability.
Index funds: These funds seek to replicate the performance of a specific stock market index, subject to tracking error, offering low-cost broad market exposure with minimal fees.
Sector funds: These funds focus on specific economic sectors, such as technology or healthcare, and provide targeted exposure to industries with growth potential.
Tax-saving funds (ELSS): Tax-saving funds, or ELSS, provide tax benefits under Section 80C of the Income Tax Act, 1961, and have a mandatory lock-in period of three years.
Retirement funds: Designed to help save for retirement, these funds often offer tax benefits and align with long-term retirement goals.
Dividend yield funds: These funds invest in stocks that offer high dividend payouts, aiming for regular income and potential capital growth.

Modes of investing in mutual funds

Lumpsum investment: A lumpsum investment means putting a large amount of money into a mutual fund all at once. For example, if you have ₹20 lakh, you can invest this entire amount in a single transaction. This method is simple and can be beneficial if you have a substantial amount ready and are confident in your investment choice.
Systematic Investment Plan (SIP): A Systematic Investment Plan (SIP) allows for regular, smaller investments over time. For instance, you might invest Rs. 2,000 per month for a year. SIPs encourage consistent investing and utilize rupee cost averaging, which helps mitigate market volatility by spreading your investments.

Pros of mutual fund investing

Liquidity: Mutual funds offer high liquidity, allowing you to buy or sell units easily and access your money whenever you need it.
Affordable: Mutual funds are accessible with small investment amounts, making them practical for both new and seasoned investors.
Transparent: Mutual funds are regulated by SEBI to ensure transparency and promote fair practices.
Flexible investment options: Mutual funds provide various investment options to suit different budgets and preferences, catering to diverse financial goals.
Quick and hassle-free process: Investing in mutual funds is an easy and efficient process. Starting out is quick, and diversifying your investment portfolio is easy.
Suited to financial goals: Mutual funds cater to various financial goals with different types of funds, accommodating both short-term savings and long-term growth objectives.

Cons of mutual fund investing

Fees and commissions: Mutual funds often include management fees, exit loads, and administrative charges, which can impact your returns.
Market risks: Mutual funds are subject to market fluctuations, meaning the value of your investment can rise or fall based on market conditions.
Evaluating funds: Choosing the right mutual fund can be challenging due to the many options available. Investors must research and evaluate funds matching their financial goals and risk tolerance.

How to calculate mutual fund returns

Absolute returns: Absolute returns measure the overall change in investment value over time. The formula is:
```
Absolute return = (Final Investment Value – Initial Investment) / Initial Investment * 100
```
Simple annualized return: Simple annualized returns convert absolute returns into an annual percentage rate, assuming a constant growth rate. Use this formula:
```
Simple annualized return = [(1 + Absolute Rate of Return) ^ (365 / number of days)] – 1
```
This method helps you understand annual growth if the investment was held for less than a year.
Compounded annual growth rate (CAGR): CAGR provides a smooth annual growth rate, accounting for compound interest over time. The formula is:
```
CAGR = [{(Current Net Asset Value / Initial Net Asset Value) ^ (1 / Number of years)} - 1] * 100
```
For a more accurate assessment, you can use Excel's RRI function to calculate CAGR by entering the duration and NAV values.
Extended internal rate of return (XIRR): XIRR is suitable for calculating returns on SIPs because it handles investments made at different times. To use XIRR in Excel, list investment dates and amounts in two columns, add the redemption date and amount in the last row, and then apply the XIRR function to get your returns as a percentage. This method effectively tracks returns for investments made over time with varying amounts.

Terms used in mutual funds

AMC: Asset Management Companies managing all aspects of mutual funds.
NAV: Net Asset Value, the market value of the fund's investment portfolio.
SIP: Systematic Investment Plan, regular periodic investments in mutual funds.
NFO: New Fund Offer, the period when a mutual fund is launched for the first time.
AUM: Assets Under Management, the total value of all investments managed by the fund.
CAGR: Compound Annual Growth Rate, the average annual growth rate of the mutual fund over a specified period.
Exit load: Fee charged for exiting a mutual fund during the lock-in period.
XIRR: Extended Internal Rate of Return, calculates returns on irregular cash flows.

Conclusion

Mutual funds are a flexible and accessible way to reach your financial goals. With diversification, professional management, and potential tax benefits, mutual funds offer a strong investment opportunity for investors.

FAQs

What are the tax implications of mutual funds?

Mutual fund tax implications vary by fund type and investment period: Equity funds face a 10% tax on long-term gains above Rs. 1 lakh, debt funds follow your income tax slab, but ELSS funds offer tax benefits under Section 80C.

Are mutual funds safe?

Mutual funds are regulated by SEBI to ensure safety and transparency. However, they are associated with market risks and may not guarantee returns.

Is investing in mutual funds a good idea?

Yes, investing in mutual funds offers diversification, professional management, and potential tax benefits, making it a strong choice for reaching various financial goals.

Are mutual funds better than stocks?

Mutual funds provide diversification and professional management, which can reduce risk compared to individual stocks, but the ideal choice depends on your risk tolerance and financial objectives.

Is mutual fund SIP safe?

Mutual fund SIPs promote disciplined investing and lower market timing risks, though they are not completely risk-free, they offer a structured and safer investment approach over time.

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.