All That You Need to Know about Mutual Funds

A mutual fund is a trust in which investors pool in money, which is in turn used to buy various instruments like equities, debt funds and bonds.

In this post we will mostly talk about equity mutual funds.

Why a Mutual Fund?

If you are salaried, the chances are that you may retire salaried. You may have dreams of entrepreneurship, but for most it is farfetched. Getting out of a steady income life to venture into an inconsistent and risky option is not everybody’s cup of tea. The second best and probably safer option is to be a passive partner in a business. Equities or Stocks give us this opportunity! You can be a part of a company by owning its shares. But there are thousands of available companies in the stock market. Which one of them is going to do well? Which one is a safe bet? Which company can be huge wealth creator in the future? These are challenging questions that need deep analysis of business model in order to come up with a good portfolio of companies. Most of us don’t have the time to learn and analyse in such deep detail. Therefore we give our money to Banks and Fund houses to manage our hard earned money and invest it wisely.

Fund Managers

Like in any other field, investing has its own Tendulkar’s and Dravid’s. We want to give our money to a Tendulkar and not a Kambli, who probably looks good in the beginning but has trouble being consistent over a long period. Remember you are parking your funds for long term and hence you need a person who is courageous at the same time cautious with the fund. The field of investing has seen a lot of promising talent but they burn out quickly. Research on who manages your fund and their track records. Avoid any new managers without reputation.

Types of Equity Mutual Funds

Mutual Funds can be categorised in two ways as shown in the picture above.

Type Based on Period

Closed ended mutual funds are funds in which you cannot pull out, you have a lock in period. The disadvantage is that your money sits in a pre-defined time period and you get what you get at the end of it. You may think this is risky, but on the contrary if one chooses a long term for the fund it may be beneficial. This is because it negates investor panic during a crash in the market. As you cannot take out the money, you will bear the pain and reap benefits in the long term. Agreed the liquidity suffers, but you give yourself a chance to make a handsome return on investment. You will not fall prey to selling at extremely low prices. The best time to invest in a closed ended fund is after a bear market (lingo for end of bad year for the market).

Open ended fund is that fund where you can pull out as you like. You think the market is going to collapse, pull out. You think the market is going up, you can buy. Simple. You need some cash, sell how much you want. Highly liquid. The Systematic Investment Plan (SIP) fits into this category. An SIP is advised in a bull market as averaging is very important! So if you are investing now in India, go for an open ended fund.

Type based on desired return

Mutual funds are also categorised based on the extent of desired return. Growth funds target investing in equities or stocks that are set for growth. But growth comes at a higher risk and hence the risk-reward ratio is high for such funds and the possible capital appreciation is very high. These funds are sub categorized into small, mid and large cap funds. Not necessary but generally small and mid-sized companies grow faster than very large organisations. Income funds are safer instruments. The fund is a portfolio of bonds and government securities that offer higher than inflation returns over a long term.

Balanced funds are a mixture of Growth and Income funds. If you are below the age of 30, you would like to go for growth funds.

Costs

A lot of people fret about charges. This is unwarranted and should not be the focus of one’s thoughts while choosing the fund. If you there for the long term, the fund manager and the portfolio matters more. So research on the portfolio of companies and take an educated guess if the portfolio manager is a sensible dude!

Conclusion

As the saying goes “Mutual Funds are Subject to Market Risks, please read the Offer Document before Investing”. This is just not a disclaimer. Take each word seriously and invest wisely.

Arjun Balakrishnan is an investment fanatic who loves writing about investment topics. He regularly writes at Investment Gyaan.