Basics of Mutual Funds

Back to the basics? Yes, back to the basics. It is important for every reader to understand the ‘What’ and ‘How’ of any financial instrument before making a decision on putting that hard earned money in investments which will make a difference in your financial goals. So, here’s an attempt to provide a crisp write up on the basics of Mutual Funds.

What is a Mutual Fund?

Mutual fund is a pool of money contributed by individuals to invest in a predetermined security like Stocks, bonds, money markets, etc. The mutual fund is managed by a fund manager who is responsible for investing the money into various securities.

Mutual funds are very lucrative investment instruments because of their low cost, ease of handling, liquidity and most of important of all, diversification. This makes them low risk instruments.

How to Invest and How Much can I invest?

One can invest in mutual funds either online or through intermediaries like banks or brokers, also called as agents. One needs to fill a simple and provide the necessary documentation. Units of the fund are bought at Net Asset Value or NAV.

Eg. Sanjay wants to invest Rs 1 lakh in HDFC Capital builder fund. If the current NAV of the fund is at 10, then Sanjay will receive 10,000 units of the fund.

The minimum initial investment required is Rs 500 if a SIP (Systematic Investment Option) is chosen and additionally in the multiples of Rs 500 or Rs 100 depending on the fund.

Additionally read How to Choose a Mutual Fund

Types of Mutual Funds

Mutual Funds can be majorly classified by: Structure and Nature.

1. By Structure: There are two types – Open Ended and Close Ended

a) Open ended funds are open throughout the year for subscription with no fixed maturity. Units can be bought and sold at Net Asset Value or NAV making these funds highly liquid.

b) Close ended funds are can be subscribed only during the offer. Once listed on exchange, this can be bought and sold in secondary market at Net Asset value which depends on demand –supply situation, expectations of unit holder and other market factors. Repurchase schemes are also available on a periodic basis.

There are also interval schemes available which is a combination of the above 2 types. These can be traded on stock exchange or may be open for sale or redemption during pre-determined intervals at NAV.

2. By Nature: They can be classified as follows:

a) Equity Funds- invests primarily into stocks. Based on the stocks they can be further sub classified into Diversified Equity, Mid Cap, Sectoral Funds and ELSS.

• Diversified Equity Fund– is a fund which invests in stocks across various sectors like auto, pharma, infrastructure, etc.
• Sectoral Fund– invest in specific sectors E.g. Pharma fund, Bank Fund, etc
• Cap Fund– These funds invest in large cap stocks, mid cap or small cap stocks.
• ELSS– Equity Linked Savings Schemes are diversified equity funds with tax savings benefit.

b) Debt Funds– invest in government or corporate bonds, money markets, Commercial papers, etc. These provide steady income and are low on risk.

c) Balanced Funds- As the name suggests, these invest in stocks and debt instruments.

Returns from Mutual Funds

Mutual Fund investment provides good returns. Returns in funds can be 2 types-

a) Capital Appreciation– which is due to increase in NAV and one can avail the benefits upon sale.

b) Dividends– Mutual Funds pay dividends on a yearly basis based on the performance of the fund. And this can be part of the returns.

Glossary

As you read about mutual funds, there are a few terms you will come across more than often. So, here’s sneak peak at a few terms associated with mutual Funds-

1. Net Asset Value= (Total Assets-Total Liabilities) / total number of units.

This is calculated on daily basis by the Asset Management Company. Keep in mind that higher lower NAV does not necessarily mean a cheaper fund and a higher NAV does not mean an expensive fund. Research well before investing in mutual funds. More on that in a follow up blog.

2. Expense Ratio– Running a mutual fund has administrative costs such as brokerage fee, advertising expenses, salaries cost, etc associated with it. These form a part of the expense ratio and are recovered from the investors in the form of a fee. Based on the mutual fund, expense ratio can range from 1-3%.

3. Loads– Some funds have entry and exit load. Simply put, this is the cost one needs to pay to enter or exit a mutual fund and can range from 2-5%.

Conclusion

Mutual Fund is the buzz word in the financial world. Maintaining a well-diversified portfolio with low risk is not something that comes with ease to retail investors due to constraints of time and money.

Thus, mutual funds managed by professional fund managers are indeed a very alluring option. Add to that the benefits of low risk due to diversification, liquidity, tax benefits like in ELSS, and the ease of handling due to the ever evolving effort of AMCs for simplification of processes; Mutual funds are but the “best” option available.