What are mutual funds?

Two heads are better than one! Who hasn’t heard of this famous saying? You get smarter and better performance with a variety of thought and efforts. This is the same principle which makes Mutual Funds such a sweet deal! You get the best of the lot with just one investment. Wondering what we are talking about? Then read on to join the club.

What are mutual funds?

Mutual funds investment schemes work on the concepts of pooling and asset allocation. Different investors, with the same risk profile, pool their investments in a collective fund. The fund is managed by experienced fund managers. They allocate the pooled investments into different stocks and securities of the equity and debt market. This allocation is determined by the mutual funds investment objective of the fund and the securities bought using the fund are called the underlying assets of the fund.

Returns under mutual funds correspond to the movement of the financial markets. If the value of the underlying assets increases, the overall value of the mutual fund portfolio increases and you earn a return.

How do mutual funds work?

To understand the working of a mutual fund, let’s take a simple example –

Suppose 100 individuals pool Rs.1000 each in a fund to start a fruit business. The corpus accumulated is Rs.100, 000. Now, an experienced fruit vendor uses this fund to buy different fruits whose value, he believes, would increase giving his profits. His purchase list is as follows –

The per-unit cost of the fruit is Rs.13.33 approximately

Now, if the value of apples and mangoes rise by Rs.10 and Rs.5 per unit respectively, the total value of the fund would become – Rs.132, 500. Now, the per-unit cost of the fruit would become – Rs.17.67. Thus, the owners would incur a profit of Rs.4.34 per unit of the fruit.

This is the same concept of how mutual funds work. Investors put in their mutual funds investments in a pool and accumulate a corpus. The corpus is used by the fund manager to invest in different types of stocks, deposits, bonds, gold and other assets. Different units of different types of assets are invested into. Thereafter, the total value of the portfolio divided by the total number of securities purchased gives per unit cost of the fund which is called the Net Asset Value (NAV). In the above example, the NAV was Rs.13.33 when the fund was invested.

Thereafter, as the market performs the value of the underlying securities (fruits in the above example) changes. When there is an increase in the value of the underlying assets, the NAV rises and the investors earn a return on their investments.

The mutual funds investment strategy and the risk appetite of different investors are different. That is why they need different schemes to suit their investment objectives. Mutual funds also resonate with this sentiment and offer different types of schemes for different investors. 

Broadly, mutual fund schemes can be divided into three main categories–

1. Equity mutual funds
   
   
2. Debt mutual funds
   
   
3. Hybrid mutual funds
   
   
   

Equity mutual funds are those which invest at least 65% of their portfolio in equity stocks and securities. These funds, therefore, have a high-risk profile since equity is highly volatile. Returns are also commensurate with the risk profile and equity mutual funds have the potential to offer exponential returns.

Debt mutual funds, on the other hand, are on an opposite footing. Under these funds, the majority of the portfolio is invested in debt and money market instruments which have a fixed rate of interest. Since debt investments have guaranteed returns, these funds do not experience market volatility. Returns are also low but stable even in a bearish market.

Hybrid mutual funds are those which lie between equity and debt. They aim to provide the best of equity and debt mutual funds by investing in both equity and debt instruments. The portfolio of hybrid mutual funds is invested partly in equity and partly in debt depending on the investment objective. This reduces the risk of pure equity funds and offers better returns than pure debt funds – the best of both worlds! Hybrid mutual funds have a moderate risk-return profile. 

All the above-mentioned funds are further sub-divided into different categories based on their portfolios. Equity mutual funds can be of the following types –

• Large cap funds which invest primarily in stocks of large cap companies
  
  
• Small cap funds which invest primarily in stocks of small cap companies
  
  
• Mid-cap funds which invest in stocks of mid-cap companies
  
  
• Multi cap funds which invest in stocks of large, mid and small cap companies
  
  
• Sectoral funds which invest in stocks of companies of a particular sector (banking, IT, pharma, etc.)
  
  
• ELSS funds which have a lock-in period of 3 years and allow tax benefits on the amount invested
  
  
  

Similarly, debt funds can be offered in the following variants –

• Short term debt funds which invest in debt instruments having a maturity of 1-3 years
  
  
• Liquid funds which invest in instruments having a maturity period of up to 91 days
  
  
• Gilt funds which invest in Government securities
  
  
• Dynamic bond funds which invest in bonds depending on their interest rates
  
  
• Income funds which invest in securities having a maturity period of 5 years and above
  
  
  

Hybrid funds, on the other hand, can be equity-oriented or debt-oriented. The variants of balanced funds include the following –

• Aggressive hybrid funds which invest at least 65% of the portfolio in equity
  
  
• Balanced hybrid funds which invest in equity and debt in the ratio of 60:40 which is interchangeable 
  
  
• Monthly income plans which invest primarily in debt instruments and aim to provide incomes in the form of dividends
  
  
  

The benefit of mutual fund investing

Mutual funds have found popularity among investors, even in this pandemic stricken world, given the following reasons –

1. They diversify the risk through asset allocation and expert fund management
2. They have the potential to offer attractive returns which are also inflation-proof
3. Investing in ELSS schemes offers tax benefits
4. Returns from equity mutual funds up to Rs.1 lakh are tax-free
5. The different types of mutual fund schemes make them suitable for every investment need
6. You can invest in small amounts through SIPs and gradually build up a considerable portfolio
7. You can invest through an online mutual fund app like Niyo so as to reap the most benefits. It is a mutual fund investment app

So, understand the fundamentals of mutual fund investments and then choose a scheme depending on your financial goals, investment horizon and risk appetite. Stay invested for a long term and see your mutual fund investments work their magic and maximize your wealth.

Final Words

Two heads are definitely better than one. But also remember that three cooks can spoil the broth. Hence, it is important to select a Mutual Fund scheme which has the perfect amount of diversification.

The right scheme (basis your financial goals, investment horizon and risk appetite) will be able to keep you on the fast-track route to wealth creation!