Understanding Mutual Funds: A Beginner’s Guide
What are mutual funds?
A mutual fund is a collective investment vehicle that collects & pools money from a number of investors and invests the same in equities, bonds, government securities, money market instruments.
The money collected in mutual fund scheme is invested by professional fund managers in stocks and bonds etc. in line with a scheme’s investment objective. The income / gains generated from this collective investment scheme are distributed proportionately amongst the investors, after deducting applicable expenses and levies, by calculating a scheme’s “Net Asset Value” or NAV. In return, mutual fund charges a small fee.
Mutual Fund is a vehicle in the for of trust) to mobilize oney from investors, to invest in different markets and securities, in line with the common investment objectives agreed upon, between the mutual fund and the investors. In other word, through investment in a mutual fund, an investor can get access to equities, bonds, money market instruments or other securities, that may otherwise be unavailable to them and avail of the professional fund management services offered by an Asset management Company
In short, mutual fund is a collective pool of money contributed by several investors and managed by a professional Fund Manager.
Mutual Funds in India are established in the form of a Trust under Indian Trust Act, 1882, in accordance with SEBI (Mutual Funds) Regulations, 1996.
The fees and expenses charged by the mutual funds to manage a scheme are regulated and are subject to the limits specified by SEBI.
How a mutual fund works?
One should avoid the temptation to review the fund’s performance each time the market falls or jumps up significantly. For an actively-managed equity scheme, one must have patience and allow reasonable time – between 18 and 24 months – for the fund to generate returns in the portfolio.
When you invest in a mutual fund, you are pooling your money with many other investors. Mutual fund issues “Units” against the amount invested at the prevailing NAV. Returns from a mutual fund may include income distributions to investors out of dividends, interest, capital gains or other income earned by the mutual fund. You can also have capital gains (or losses) if you sell the mutual fund units for more (or less) than the amount you invested.
Mutual funds are ideal for investors who –
- lack the knowledge or skill / experience of investing in stock markets directly.
- want to grow their wealth, but do not have the inclination or time to research the stock market.
- wish to invest only small amounts.
Why invest in Mutual Funds?
As investment goals vary from person to person – post-retirement expenses, money for children’s education or marriage, house purchase, etc. – the investment products required to achieve these goals too vary. Mutual funds provide certain distinct advantages over investing in individual securities. Mutual funds offer multiple choices for investment across equity shares, corporate bonds, government securities, and money market instruments, providing an excellent avenue for retail investors to participate and benefit from the uptrends in capital markets. The main advantages are that you can invest in a variety of securities for a relatively low cost and leave the investment decisions to a professional manager.
Beginners can start investing in mutual funds either online or offline. Investing in mutual funds online is very simple and can be done in two ways. You can create an account on an official AMC website or mobile application of respective AMC.
Here are the five simple steps to follow for investing in mutual funds-
- To understand your risk tolerance and capacity before investing in mutual funds.
- Asset allocation, i.e., dividing your money between various asset classes. To balance out the risk factors, asset allocation should include a mix of equity and debt instruments.
- To identify funds that invest in each asset class and to make a comparison based on past performance or the investment objective.
- Select the mutual fund scheme in which you will be investing. Diversification of your portfolio and regular follow-ups are essential.
Advantages of investing in Mutual Funds:
- Professional Management: Investors may not have the time or the required knowledge and resources to conduct their research and purchase individual stocks or bonds. A mutual fund is managed by full-time, professional money managers who have the expertise, experience and resources to actively buy, sell, and monitor investments. A fund manager continuously monitors investments and rebalances the portfolio accordingly to meet the scheme’s objectives. Portfolio management by professional fund managers is one of the most important advantages of a mutual fund.
- Risk Diversification: Buying shares in a mutual fund is an easy way to diversify your investments across many securities and asset categories such as equity, debt and gold, which helps in spreading the risk – so you won’t have all your eggs in one basket. This proves to be beneficial when an underlying security of a given mutual fund scheme experiences market headwinds. With diversification, the risk associated with one asset class is countered by the others. Even if one investment in the portfolio decreases in value, other investments may not be impacted and may even increase in value. In other words, you don’t lose out on the entire value of your investment if a particular component of your portfolio goes through a turbulent period. Thus, risk diversification is one of the most prominent advantages of investing in mutual funds.
- Affordability & Convenience (Invest Small Amounts): For many investors, it could be more costly to directly purchase all of the individual securities held by a single mutual fund. By contrast, the minimum initial investments for most mutual funds are more affordable.
- Liquidity: You can easily redeem (liquidate) units of open ended mutual fund schemes to meet your financial needs on any business day (when the stock markets and/or banks are open), so you have easy access to your money. Upon redemption, the redemption amount is credited in your bank account within one day to 3-4 days, depending upon the type of scheme e.g., in respect of Liquid Funds and Overnight Funds, the redemption amount is paid out the next business day. However, please note that units of close-ended mutual fund schemes can be redeemed only on maturity. Likewise, units of ELSS have a 3-year lock-in period and can be liquidated only thereafter.
- Low Cost: An important advantage of mutual funds is their low cost. Due to huge economies of scale, mutual funds schemes have a low expense ratio. Expense ratio represents the annual fund operating expenses of a scheme, expressed as a percentage of the fund’s daily net assets. Operating expenses of a scheme are administration, management, advertising related expenses, etc. The limits of expense ratio for various types of schemes has been specified under Regulation 52 of SEBI Mutual Fund Regulations, 1996.
- Well-Regulated: Mutual Funds are regulated by the capital markets regulator, Securities and Exchange Board of India (SEBI) under SEBI (Mutual Funds) Regulations, 1996. SEBI has laid down stringent rules and regulations keeping investor protection, transparency with appropriate risk mitigation framework and fair valuation principles.
- Tax Benefits: Investment in ELSS upto ₹1,50,000 qualifies for tax benefit under section 80C of the Income Tax Act, 1961. Mutual Fund investments when held for a longer term are tax efficient.
Please note,
The views in the article/blog are personal and that of the author. The idea is to create awareness and for educational purpose and not intended to provide any product recommendations.
