What is a mutual fund? How does it work?
Off-late mutual funds have gained significant traction for investment purpose. In this article, we will cover what are mutual funds and how an investor can put mutual fund to use while avoiding the risks and hassles associated with picking individual assets. If you have never invested in mutual funds before, this article will cover the basics of mutual funds that every investor should know.
What are mutual funds?
A mutual fund is a professionally managed fund that pools the savings from many investors (individuals, companies, trusts, etc.). This fund is then invested in securities such as stocks, bonds, money market instruments, commodities etc. While some mutual funds invest in a single asset class, others may have a combination of asset classes. One of the basic and common objectives of any mutual fund is to beat the benchmark returns and provide an alpha for it.
Types of Mutual Funds
There are five types of mutual funds category as determined by capital market regulator Securities and Exchange Board of India (SEBI):
- Equity Schemes – These mutual funds invest in equities and equity-related securities and offer comparatively highest returns but brings along a high degree of risk. The category is further divided based on portfolio composition such as multi-cap fund, large-cap fund, mid-cap fund etc.
- Debt Schemes – This type of mutual fund invests in debt instruments of varying maturity and varied yield and risk level.
- Hybrid Schemes – invest in a mix of stocks, bonds, and other securities.
- Solution Oriented Schemes – These are schemes where there is a specific goal that is aimed at. For example Retirement fund, Children’s fund. In such schemes investment can be made in any asset class.
- Other Schemes – This includes all funds which are not covered above. For example Exchange Traded Fund that seeks to replicate an index, hybrid funds that also invest in a group of other mutual funds and are popularly known as funds of funds etc.
Active vs. Passive
Irrespective of fees, category, an investment instrument, performance, each mutual fund is also classified into two categories namely – Active Funds and Passive Funds
- Passive Funds – These funds invest as per pre-defined strategy and seek to match the performance of a specific market index. Thus these types of funds require little investment skill, little management, and low fees when compared to their counterparts actively managed funds.
- Active Funds – These funds seek to outperform the market indices and have the potential to outperform the passively managed funds with high margins. These funds, however, comes with a cost i.e., management fees and is managed professionally by a team of analysts.
How does an investor earn by investing in mutual funds?
When an investor invests in a mutual fund, he/she can generate income that will be contributed by the following three sources:
- Divided payments – Fund house typically distributes dividend or interest when they receive dividend or interest on underlying securities. A proportionate amount is distributed to investors by way of dividend and/or interest.
- Capital gain – Whenever a fund manager sells securities, he/she books capital gain/capital loss depending on the type. Generally, some funds also distribute net capital gain to investors at regular intervals (typically annually).
- Net Asset Value – When the net asset value ((NAV) of the fund increases, the investor gets the benefit while redemption. When purchasing shares in a mutual fund, you can choose to receive your distributions directly or have them reinvested in the fund.
How does it work?
While in the stock market, investor purchase shares of companies through exchanges from another seller mediated by a broker, in case of mutual funds, an investor purchase shares of a mutual fund directly from the fund house. Fund house create new shares to be sold to new or existing investors when they invest additional amount, unlike stock market where the number of shares is limited. Given the direct transaction with the fund house, an investor can redeem/sell their units to the fund house directly at any point in time.
To elaborate, fund house collects money from multiple investors that are then invested in different securities such as equities, bonds, etc. This pooled investment is managed by professionals who understand the market well and seek to achieve growth by making strategic investments. Investors’ get units of the mutual fund as per the amount they have invested.
Pictorially the entire process can be elucidated as under:
How is the cost of each share determined?
Cost of each share is determined based on fund’s per-share Net Asset Value (NAV). A fund may charge additional purchase cost at the time of entry. Thus it is advisable to confirm on the entry-load, as it may be applicable while investing in any mutual fund. Similarly, at the time of redemption, the fund may charge an exit-load that is reduced from the current NAV.
Mutual funds have gained prominence in the Indian market over the last decade and more so after demonetization last year. It is considered to be one of the most sought-after investment instruments currently and has the potential to outperform any other instrument over a business cycle. In addition to return potential, mutual funds also provide the benefits of a diversified portfolio without the time needed to manage the same. With the advent of technology, a lot of companies came up with a methodology to identify best-suited mutual fund schemes, in an ocean of schemes, for investors with varied risk-reward appetite, and goals. Should you wish to invest with one of the fastest growing fintech company in India, offering the most secured, simplified yet robust investment platform, then feel free to reach us at email@example.com and we shall be glad to help you start!