Introduction to Mutual Funds

A Beginner’s Guide – Part I

The term mutual funds is one that most of us have heard of but how many of us actually know what they are? This article is part I of our series on mutual funds that will breakdown what mutual funds are, types of funds, and how you can go about investing in them to help grow your wealth.

What are Mutual Funds

Essentially a mutual fund is a pool of money managed by a fund manager and is used to purchase securities i.e., company stocks, bonds, or shares. 

Fund houses or asset management companies pool investments from multiple people and/or institutions with similar investment goals. If you invest in mutual funds, you own certain units which represent a proportion of the fund that you hold and are dependent on the amount invested. 

How Mutual Funds work

Investment amount is collected by investors and units are allotted. The price of each mutual fund unit is referred to as NAV or Net Asset Value. This is then invested in a set of bonds or stocks and forms the fund portfolio. Based on the investment goal of the mutual fund scheme, the fund manager will decide the portfolio allocation.

Let us understand the same with a simple example. A mutual fund company called ABC starts a new scheme  and collects Rs. 1 crore from 1000 investors who each invest Rs. 10 lakh. The fund house provides units at an NAV of Rs. 100, and will allot 10,000 units (Investment/NAV) to each investor. Therefore, the total number of units that is allocated by the fund house is 10 lakh.

Suppose the fund house has an objective of investing in 10 stocks and the fund manager decides to invest equally in each stock, the corpus  of Rs. 1 crore will be divided equally to Rs. 10 lakh in each stock. However, in reality a higher amount is invested in stocks that are known to deliver higher returns over a long term.

Assuming the number of investors don’t change and the value of the stocks in the portfolio has increased to 1.5 crore, the NAV of each unit is now Rs. 150 and the investment of each investor would have increased to Rs. 15 lakh.

Benefits of Mutual Funds

The sheer number of benefits offered by mutual funds makes this one of the most sought after investment options available in the market today.

• Diversification

‘Don’t put all your eggs into one basket’ is a saying that we’re all familiar with and in the financial world this essentially means to reduce risk by diversifying your investments so that even if one fails, there are others to fall back on.

Mutual funds by nature are diverse i.e., investments are divided into various portfolios so the risk is automatically lower making this one of the safer investment options available today.

• Professional Advice

With mutual funds you are outsourcing the task of investing to an expert whose primary task is to ensure profits. This way you are not just mitigating the risk associated with your investments but you can also sit back, relax, and let the experts handle your investments for you. 

• Liquidity

Most investment options such as Recurring Deposits and Fixed Deposits come with a lock-in period and do not allow you to withdraw your investment amount as and when you need it. With mutual funds on the other hand, unless it is a close-ended mutual fund, it is easier to purchase or exit a fund scheme anytime. However it must be noted that mutual fund transactions happen just once a day after the fund house releases that particular day’s NAV.

• Custom Financial Goals

Imagine having an investment option that is tailored to suit your risk appetite as well as investment goals. Well, mutual funds fall into this category purely because there are multiple funds available. Choose a fund that suits your income, expenditure, risk tolerance, and investment goals and invest as much as you wish to. 

• Tax Efficiency

One of the primary reasons individuals invest in mutual funds today is due to tax-efficiency. You can invest an amount up to Rs. 1.5 lakh in tax-saving mutual funds under Sec 80 C of the Income Tax Act of 1961. The returns are also generally much higher than traditional instruments such as FD.

Additionally, many are under the false impression that one can invest in mutual funds only if they have a large amount to invest. The reality is that you can start investing  with amounts as low as Rs. 500. 

There are many more advantages of investing in mutual funds such as hassle-free and cost-efficient investment processes and much more.

In Conclusion

Many believe that mutual funds come with a lot of risk or are unsafe. This is far from the truth as fund houses are strictly under the purview of statutory bodies such as SEBI. There are a plethora of funds available for investment therefore as a customer, it is important for you to assess your needs and requirements such as income, long term and short term goals, as well as your risk appetite before investing. 

Interested in investing in mutual funds? In next week’s blog, we talk about how you can start investing in mutual funds.