Mutual funds are created when several people who wish to earn wealth (investors) combine their resources to create a huge investable amount (corpus). This large corpus is then invested into various companies across industries, operating in different sectors of the economy - depending on the type of fund chosen. All the investors of a mutual fund share in its profits, losses, incomes, and expenses in direct proportion to their level of investment.
Companies that create mutual fund schemes are called Fund Houses or Asset Management Companies (AMCs). The professionals who study the markets and pick companies to invest in are called Fund Managers. Fund managers spend a great deal of time analysing markets and studying different sectors of the economy to figure out which companies are most likely to turn a profit - in different time frames - and choose the best option.
There are thousands of mutual funds in India, under different categories, offered by hundreds of AMCs and Fund Houses. For fairness and transparency, global agencies exist that analyse and rate the performance of funds over time and make sure that investors are well informed before investing. It is mandatory for AMCs to declare a standard against which the performance of any given fund can be measured - this is called a benchmark. There are also regulatory bodies like AMFI and SEBI that ensure no investor ever gets scammed.
Mutual funds allow individuals to make their money work for them - meaning that they do not need to actively perform tasks for monetary gain. Any amount invested in mutual funds will either grow or shrink depending on market performance and the skill of the fund manager.
There are many different types of mutual funds available today, and can be categorised based on investment objective, structure and asset class. Apart from this, there are also
specialised mutual funds.
1. Types of mutual funds based on asset class:
a. Equity Funds: The primary focus of equity funds is to invest at least 65% of the total corpus into equity (stocks) and equity related instruments of different companies. Stock market fluctuations affect the performance of these holdings and determine whether they make a profit or not - as such, equity funds are slightly riskier than other types of funds. Diversification of the corpus between companies operating in different sectors of the economy and hands-on expert management serve to mitigate most of the risks involved.
Equity funds are further sub-categorised based on the investment strategy (Value, dividend yield, focussed), whether the fund is managed actively or passively (Active/Index), the level of market capitalisation (small-cap, mid-cap, large-cap), or whether it’s a Sector or a Thematic Fund (that only invests in a particular sector like pharmaceuticals or petroleum or a theme such as services, healthcare, etc.).
Equity funds are recommended to those willing to wait at least 5 years to see substantial returns, and who don’t mind the inherent risk involved with equity investments. These funds operate at a higher risk, with the possibility of a greater reward.
b. Debt Funds: The primary focus of debt mutual funds is to invest a majority of its corpus into fixed-income investments, such as treasury bills, money market instruments, corporate bonds and debentures, commercial papers, gilt,, government securities, and other debt securities.
Debt funds are further sub-categorised based on how long their holdings will take to reach maturity (for example short-term debt funds, ultra-short-term debt funds, liquid funds, dynamic bond funds), instruments where they can invest (corporate bond funds, gilt funds, credit risk funds, banking and PSU funds, money market funds)
Debt funds are recommended for those who don’t want to risk their capital for a chance to earn returns higher than bank deposits, but who’d rather invest their capital in order to earn a smaller, relatively stable returns with greater liquidity.
c. Hybrid Funds The primary focus of hybrid funds is to invest in a portfolio as balanced as it is diverse, by channeling investments proportionally into equity and debt instruments. This is done in order to create long-term capital appreciation at lower risk/ with lower volatility.
Hybrid funds can be of two major types - aggressive hybrid funds and conservative hybrid funds. An aggressive hybrid fund is an equity-oriented mutual fund will have 65%-80% of its corpus invested in stocks, shares, etc. and the remaining invested in debt instruments or money market instruments. A conservative hybrid fund is a debt-oriented mutual fund which will have 75%-90% of its corpus invested in debt instruments and the remainder in stocks, shares and other equity instruments. Hybrid funds also allow for a degree of liquidity, and divert part of the corpus into cash and cash-equivalent investments.
Hybrid funds bridge the gap between long-term capital appreciation and short-term income requirements of investors. As such, they are popular among new investors and experienced conservative investors alike.
2. Types of mutual funds based on investment objectives:
a. Growth Funds: These funds invest primarily in equities. Diversified investments in stocks and shares of various companies usually make up a good Growth Mutual Fund. The primary goal of these funds is to provide as much capital appreciation as possible during the tenure of the fund.
Most mutual funds offer growth or dividend/income as options under the same fund, meaning that an investor can choose whether to receive regular payments (dividend/income) or reinvest the money that would otherwise have been paid to him as a dividend back into the fund itself (growth).
Investors who aren’t planning to retire or pull out of their investments anytime soon, and possess the ability to take risks, are the ideal investors for this type of fund.
b. Income Funds: These funds aim to provide investors with regular income, generated through investments in government securities, stocks with high dividend potential, bonds, debentures, etc. While it’s true that no mutual fund scheme can outright guarantee results, these funds are actively managed and hence are more likely to successfully generate regular income.
Investors with a low risk appetite who are looking for a place to park surplus funds for a short to medium term can consider these funds, as they provide a regular income. Generally, pensioners, super safe investors, and beginners in the world of mutual fund investments chose these funds.
c. Liquid Funds
The primary goal of these funds is to provide capital safety and near-instant liquidity to its investors. These funds primarily invest in debt instruments of a high credit quality and design the portfolio to mature in around three months’ time. Thus, interest rate fluctuations in the economy do not affect this fund as much as they do for other funds as the maturity of invested instruments is lined up with the maturity of the scheme itself. Even so, no mutual fund scheme can guarantee results.
These funds have a huge potential in generating income more than regular savings bank accounts which provide around 4% - 5% on average.
d. Tax-Saving Funds or ELSS:ELSS or Equity Linked Savings Schemes are mutual fund schemes whose primary aim is to generate long-term capital growth through investments in equities, stocks and shares. Investments made in ELSS are also eligible for deductions under Section 80C of the Income Tax Act, 1961.
Most Indians invest in tax saving fixed deposits, which provide earnings at a predetermined rate of interest and also serve to save a portion of income from taxes. However, tax saving fixed deposits have a lock-in period of 5 years, while tax saving ELSS have a lock-in period of only 3 years, and, historically have provided better returns.
e. Capital Protection Funds The primary aim of capital protection funds is to protect investors’ capital in the event of economic instability, while also providing the possibility of capital appreciation and growth. These funds invest primarily in bonds and zero coupon debt although there is a small portion invested in equity as well.The Unstable movements of interest rates is countered by aligning the maturity of the debt portfolio and the maturity of the fund itself.
These funds are close-ended, and cannot be interfered with during their term - which can be 1 year, 3 years, or 5 years. It should be noted that there is no institutional coverage or guarantee that these funds will perform as advertised, but historical performance of these funds suggests that they’re mostly successful.
f. Fixed Maturity Funds: Usually compared with fixed deposits, fixed maturity funds are close-ended funds that invest primarily in debt instruments which have a predetermined maturity date. The maturity date of the debt investments are made to coincide with the maturity of the fund itself. Unlike most other debt funds, there is no constant purchase and sale of debt securities. Instead, these funds adopt a buy-and-hold strategy which helps them reduce the overall expense ratio.
These funds are very similar to fixed deposits in that they are debt instruments that lock in funds for a predetermined tenure and provide tax benefits.Unlike fixed deposits that provide assured returns, fixed maturity funds provide indicative returns at the time of buying in. This means that the real returns could fluctuate and eventually be higher or lower than what was initially indicated. As far as taxation goes, fixed maturity plans offer a dividend or growth option, and are either taxed for dividend distribution tax or capital gains tax, as the case may be.
3. Types of mutual funds based on risk factor:
a. Ultra low-risk mutual funds: Mutual funds like ultra-short-term funds and liquid funds, etc. do not present a lot of risk but generate returns above bank fixed deposits/ savings bank account.
b. Low-risk mutual funds: Funds like arbitrage funds and low duration funds favour investors with a low risk appetite.
c. Medium-risk mutual funds: Funds in this category generally have balanced investment portfolios, meaning that they divide the corpus between equity and debt instruments. Thus, the fund can provide long term capital gains, as well as stability. Medium-risk funds cannot make the most of equity, as the risk is offset by investments in debt instruments as well.
d. High-risk funds: These are funds that offer the highest potential rewards and as such carry the highest amount of risk. The primary focus of these funds is to maximise potential returns through investments in equities, which are volatile by nature.
4. Specialized Mutual Funds:
Index Funds:These funds invest their corpus into the stocks that comprise a particular index. Index funds aren’t actively managed, which means they simply replicate the index. As such, are less exposed to the negative effects of equity-related volatility. This does away with the need for active investment management. The fund returns are generally close to index returns. But, in the case of a market downturn, the index fund will also lose its market value.
The benefit these funds reap by not being actively managed is that the expense ratio comes down.
a. Fund of Funds: As the name suggests, these funds invest in other mutual funds instead of directly investing in equity and debt instruments. This kind of investment management is often referred to as multi-manager investment management. These allow investors to diversify risk across various funds the fund of funds invests inInternational fund of funds (or foreign fund of funds) as the name says comprise of investments in foreign funds holding stocks/bonds of international companies or international mutual funds.
b. International Funds or Foreign Funds: The primary aim of these funds is to maximise returns and minimise losses caused by domestic market fluctuations. With a foreign fund, investors can take advantage of the burgeoning markets in other countries, even if the market in the home country is experiencing setbacks. Funds can fully invest in foreign companies, or partly invest in foreign companies and partly in domestic companies or partly or wholly in international mutual funds.
c. Global Funds: These funds aim to generate maximum returns through investments in funds all over the world. These global funds invest in the best funds, worldwide, and in the investor’s home country as well. These are the widest and most diversified funds in the sense that currency variations, national policies, and market fluctuations of many countries need to be considered and tracked. Despite the obvious managerial challenges, these funds have provided historically high returns as they invest in the top stocks and funds, worldwide.
d. Emerging Market Funds: These funds aim to take advantage of the higher growth rate displayed by emerging and developing economies of smaller nations in order to generate higher returns. While these investments are on the riskier side, it is clear that investments through the next decade will be dependant on these emerging markets to generate returns, as their economic growth rate is far greater than that of established economies like the US and UK.
e. Sector Funds: The primary aim of these equity-based funds is to generate returns from investments in one specific sector ((for example pharmaceuticals or financial services). These funds are basically the opposite of diversified equity funds, as they focus on one specific sector rather than many. Logically, putting all of one’s eggs in one basket is a recipe for disaster, but many investment experts have an in-depth understanding of various sectors, and have historically proven that sector funds can provide massive returns, even higher than some diversified portfolios, provided market entries and exits are timed well. These funds are suitable for investors with a very high risk appetite.
f. Thematic Funds or Theme-Based Funds: Similar to sector funds, these funds focus their investments into companies that revolve around a particular theme. Unlike sector funds which invest only in companies within a particular sector, these funds invest in companies across sectors, which are united by a common theme. For example, a pharmaceutical sector fund would invest only in pharmaceutical companies, but a thematic fund in the same pharmaceutical space would invest in chemical processing companies, research laboratories, healthcare providers, etc. as well as pharmaceutical companies.
g. Asset Allocation Funds: The primary aim of these funds is to maximise returns through the perfect allocation of investments in various asset classes - like equity, debt, fixed assets, bonds, real estate, gold, etc.
These funds are basically hybrid funds tailored to the investors profiletaking into consideration everything about the investor like age, risk appetite, current net worth, investment goals and financial goals, etc. and also the current trends and condition of the market itself. Some Asset Allocation Funds are funds of funds, and as such carry a greater expense ratio.
There are two primary types of asset allocation funds - Dynamic and Static.Dynamic Asset Allocation Funds are able to adjust the number of assets that comprise the portfolio, depending on prevailing market conditions. Static Asset Allocation Funds, on the other hand, decide their investment strategy and level of investments to be made in different asset classes well in advance.
h. Exchange Traded Funds (ETFs): These funds are slightly different than other mutual funds. ETFs own stocks, bonds, commodities, etc. and ownership of the fund is held in the form of shares by shareholders. This is because ETFs are traded just like stocks in stock exchanges. Shareholders cannot directly own the underlying assets in which the fund is invested, but rather indirectly own these assets through owning shares of the fund itself. ETFs provide greater liquidity as they can be bought and sold on the stock exchange and have lower costs.
ETFs can only be bought or sold directly from or to authorized participants (APs), after an agreement has been entered into. APs are usually massive investment houses, who use creation units to conduct trades of their ETF holdings. Creation units are massive chunks of thousands of ETF shares.
The primary advantage of these ETFs is that units in the funds themselves can be traded on the stock market quickly to make the most of market fluctuations. ETF units are freely tradeable for the assets that make up the ETF, thus, the value of the ETF’s units does not vary much from the value of its owned assets. Most retail or individual investors buy ETF units from the exchange once it is listed and not creation units.
5. Mutual Funds based on structure:
a. Open-Ended Mutual Funds: As the name suggests, open-ended mutual funds allow investors to buy and sell units of the fund as per their convenience and feelings about the market. Investors in open-ended funds can also exit the fund at any time, at the fund’s current Net Asset Value (NAV). While these funds offer great flexibility, it also means that the unit capital of the fund undergoes constant changes with investors buying into - and selling out of - the fund with little to no prior warning.
b. Closed-Ended Mutual Funds: With closed-ended funds, the total unit capital, fund tenure, investment avenues, etc. are all decided in advance of the fund units being offered for purchase. Once the purchase window has closed, investors remain invested until the completion of the fund’s tenure. Units cannot be bought or sold during this time.
c. Interval Funds: These funds allow investors to enter or exit the fund at predetermined intervals, decided by the fund house. While these funds have a certain amount of liquidity, they should not be considered a liquid investment, as they cannot be redeemed at any time, only during specific intervals. Even so, they combine the benefits of open and closed ended funds, and have some added benefits like the fact that they can also invest in private assets and assets that aren’t listed on any exchange.
What is a mutual fund?
There are thousands of mutual funds in India handling thousands of crores of Rupees.
Mutual funds are an investment tool that pools money from several investors and invests it in company stocks, bonds, government instruments, etc. in order to generate a profit for investors. This profit may be paid out as dividends to investors (dividend plans) or reinvested by the fund for capital appreciation (growth plan), There are many different types of mutual funds based on various characteristic differences. Most mutual funds try to diversify their investments into as many different companies and industries as possible, and some invest in only specific industries and sectors of the economy. Some funds aim for high-risk-high-reward strategies, while some opt for low-risk-regular-income strategies. There’s a huge variety of funds to choose from, and a large number of Asset Management Companies (AMCs)/fund houses. that offer excellent schemes for all types of investors. Some banks and financial distributors also sell mutual funds.
How do mutual funds work?
Different types of mutual funds operate slightly differently from one another, but they all have some basic principles on which they operate that define them as mutual funds.
The most basic way in which mutual funds operate is explained below:
1. An asset management company (AMC)/fund house identifies a potential earning possibility in the market and calculates the risk and potential reward involved in this particular investment.
2. The AMC studies other related investment opportunities that could boost the value of - or ensure the success of - the main opportunity.
3. The fund manager working for the AMC picks and chooses different investments in order to balance out the risk and total earning potential - balancing the right high risk-high reward equities with high safety-relatively consistent income securities.
4. All the details about the fund including risk factors are well documented and presented to the industry body SEBI for regulatory approval and to the public for consideration.
5. The fund scheme is made available to the public, who then buy into the fund by purchasing fund units. The more fund units are purchased, the larger the investment, and thus the greater the proportion of potential income.
6. The investments are made and, depending on the fund’s structure, the fund will either be passively or actively managed by a fund manager.
7. Under the dividend option, declared dividends are proportionally distributed amongst investors. Under the growth option, dividends are reinvested for capital appreciation.
8. At the end of the fund’s tenure, capital gains are paid out to the investors.
Now let’s understand basic mutual fund operation with an example:
Let’s say that there’s a huge national demand for 50 lakh units of bottled water per month, but the water bottling plant can only produce 1 lakh units per month. Suppose that the bottling plant can meet this demand if it has a new bottling machine - it can earn a massive profit from supplying the demand. Unfortunately, the bottling plant does not have the funds to purchase this new machine - so it seeks investment. This is an opportunity for a win-win situation for any investor who has enough wealth to help the bottling plant purchase the machine. In most cases, individual investors won’t have the requisite funds to purchase large machinery, so, a few investors get together and pool their funds to buy the machine, and will split all profits equally amongst themselves, or in proportion of the amount they’ve invested.
Once the machine has been purchased, the investors must wait for the bottling plant to integrate the new technology and start producing enough units to meet the demand.
Now that the bottling plant has met the demand of 50 lakh bottles per month - which is a 50x increase in supply - it will obviously be earning a lot more income for the sale of its product. Since the expansion of this bottling plant was enabled by the purchase of a machine, which was enabled by the foresight of certain investors - the investors will get to claim a share of the new profits enjoyed by the bottling company.
This basically explains how an investment helps a company grow, but mutual funds take it a step further. Mutual funds don’t just invest in one or two companies, but in hundreds of companies across different sectors of the economy. In addition to the bottling plant, the same mutual fund scheme may have invested in a transportation company, enabling quicker movement of bottled water from the factory to the distribution centres. In addition to the transportation company, the same mutual fund scheme could also have invested in an advertising agency that promotes the sale of this particular brand of bottled water - ensuring smooth sales from distribution centre to end customer. In this way, a mutual fund takes care of most aspects of its investment and tries to ensure its success.
Now since it’s a mutual fund, it can have two options by which investors can enjoy their profits - growth or dividend. Under the growth option, all earnings made by the fund are reinvested in the fund itself, and the capital invested is allowed to grow until the tenure of the investment is completed or the investor chooses to redeem the investment. Under the dividend option, the bottling plant will declare income, and dividends will be distributed amongst the investors.
Now, suppose that the demand for water suddenly dropped from 50 lakh units to 10 lakh units, but the machine had already been purchased and is now running on lower capacity, or the machine purchased was faulty, or there’s a labour strike preventing water from being bottled - the profits generated will not be as high as expected, and returns for investors will be low, and investors could also lose money. This is called a risk factor, and is one of the major defining characteristics of any mutual fund scheme. Risk must be thoroughly studied in order to mitigate it, and even then, great care must be taken to invest the right amount at the right time in the right place.
This is basically how a mutual fund works - large amounts of money are pooled together to invest in companies/ government instruments that can generate a profit as a result of increased capacity, capability, etc. enabled by investments.
Should I invest in mutual funds?
Mutual fund investments are for anyone who wishes to be richer than they currently are - through smart investments.
Investors can begin with as little as Rs.1,000 to invest in really good mutual fund schemes, depending on their goals. Funds selected could vary in terms of time available to reach goals (short, medium, or long term), amount of funds ready to invest, amount expected at the end of the investment tenure, amount of risk the investor is prepared to undertake, type of industry diversification required, type of asset class desired. There are also funds called Equity Linked Savings Schemes or ELSS that allow investors to claim tax deductions under Section 80C of the Income Tax Act, 1961.
Mutual fund investments allow for wealth creation while offering several benefits of diversification, professional management, low cost, etc.
There are many different types of investors, some who like to take risks for the possibility of earning high returns, some who don’t like taking too many risks but wouldn’t mind mid-sized returns, and some who prefer little or no risk and only wish to earn relatively stable, but higher than bank interest from their investments. Whatever the type of investor, there are thousands of mutual funds out there to choose from.
Investing in mutual funds is no longer the ‘new’ way to get rich, it’s a tried and tested method with standard practices that have helped millions of people around the world meet their financial goals.
Funds can be held for the short-term, medium-term, or long-term. Investors can stay invested for as long as they like, although data has proved that staying invested for the long-term schemes minimises the chance of losses and can provide the greatest overall earnings thanks to the power of compounding! Small and medium term investments can help you meet short and medium term goals as well.
How to invest in mutual funds?
Once you’ve decided to invest in a mutual fund, you must decide which fund to invest in, and this is the most time-consuming part of the process.
Below is a step by step guide on how to choose the best fund for you:
1. Investment Goals: Fully define your investment and financial goals - “I would like to have earned Rs.x in ‘x’ number of years. I can take ‘x’ degree of risk”
2. Risk Factor: Understand how much risk you’re willing to take in order to reach your financial goals - understanding this is the key to choosing which type of mutual fund you will eventually invest in. High risk investments have the potential to provide the highest returns, but also come with the possibility that the invested capital could be lost. Medium risk investments will try their best not to lose the invested capital, but in doing so will reduce the amount of funds available to invest in growth-generating investments (which are risky by nature). Low risk investments will expose the capital to the lowest amount of risk possible. Understanding one’s risk appetite is vital to being investing correctly, and is called risk profiling.
3. Asset Allocation: After discovering your risk profile and narrowing down your potential investments, you must decide which asset classes you wish to invest in.Stocks and shares of companies are the first and most popular asset class among risk takers - also called equity - investments in this asset class usually carries a greater amount of risk and also the potential for higher earnings. The second asset class is fixed-income securities or bonds, and is the most popular among risk-averse investors who prioritize the safety of their investments. These assets provide regular income and capital safety. The third asset class is money market instruments or cash equivalents which provide liquidity and a certain degree of safety. The fourth main asset class consists of commodities and real estate. A mutual fund will invest in all these asset classes proportionally, in order to provide safety as well as maximise growth potential.
4. Picking the right AMC: Choosing the right asset management company (AMC)/fund house/bank/etc. can be as important as picking the right fund. Make sure that the company through which you’ve chosen to invest has a proven track record and has a roster of qualified and experience fund managers - this will ensure that your money is handled by capable professionals who have faced different market conditions in the past and can actively manage your fund and keep it away from danger. The right AMC will also have a large ‘family of funds’ to choose from, or to shift between, depending on the performance of your invested fund.
5. Picking the right fund: Picking the right fund is a combination of understanding your investment goals, risk profile, asset allocation, and total investable corpus - and matching those to mutual fund schemes (among thousands available) which has the ability to provide returns in line with your goals. This is the most time consuming, but most rewarding part of the process, as you will learn about different funds and the different unique features that some of them offer. Once you’ve narrowed it down, you can also check how it’s performed against its benchmark and how consistently it has performed, before putting your hard earned money in it. will have to match the funds against a benchmark to see how they have performed in the last 5 to 10 years, and take historical performance into account as well.
6. Approaching the AMC/Fund House/Bank: Once you’ve decided the fund you want, all you have to do is approach the AMC/bank,fund house offering the fund and purchase fund units in exchange for money. Alternatively, you could invest online through a paperless, fast, and secure platform like FundsIndia.
Investing in mutual funds online
You can either follow this process, or try the intuitive online investment platform offered by FundsIndia - which assess your requirements and provides the best and top performing funds for you to choose from. The online service is totally free, totally paperless, 100% secured online and lightning fast.
Mutual fund investments done online are also quicker and do not require you to step out of your comfort zone for any document verification or fund transfer. The entire process is handled efficiently online. FundsIndia has an award-winning team of market research analysts, financial gurus and investment experts who will direct your funds into the most rewarding mutual funds.
You can also access all the FundsIndia investment facilities on your smartphone through the FundsIndia Android App.