What Are Mutual Funds? Definition & Types

Mutual funds have become hugely popular in the last few years. They are investment products that pool funds from multiple investors to invest in a diversified portfolio of securities. This article is for anyone seeking to expand their knowledge of mutual fund investing. Besides answering the question: ‘What is a mutual fund?’, it also elaborates on how to invest in mutual funds and the advantages and disadvantages of mutual fund investing. 

What Are Mutual Funds?

Mutual funds pool funds from several investors and invest in a diversified portfolio of securities. These professionally managed funds offer a way for individuals to invest in a variety of assets, including stocks, bonds, and money market instruments. 

Mutual fund investing offers instant diversification, and the fund's holdings help mitigate risks. In India, mutual funds are regulated, which makes them transparent and highly popular with new and experienced investors.

How Does Mutual Fund Work?

In mutual funds, investors are allocated units based on the fund's NAV.

NAV or Net Asset Value in a mutual fund is the per-share value of the fund. Investors are allocated units based on their total investment and the NAV of the fund. Calculating NAV involves dividing the total asset value of the fund by the number of outstanding shares. For instance, if the total asset value of the fund is Rs. 1 crore and the fund has 1 lakh outstanding shares, the NAV is the total asset value (Rs. 1 crore) divided by outstanding shares (1 lakh), which is equal to Rs. 100. Meaning, the NAV of the fund is Rs. 100. 

The NAV is calculated daily. Hence, it keeps changing and might go up or down depending on the performance of the securities in the portfolio. 

NAV is affected by the volatility of the market. If the NAV value increases at the time the investor redeems the units, the gain is called a capital gain. Similarly, if the NAV value goes down, you may also incur losses. 

How is Mutual Fund Returns Calculated?

When calculating mutual fund returns, you have several ways to assess how well your investment is performing. Each method provides a unique perspective:

1. Absolute Returns: This is the simplest way to measure the change in value of your mutual fund over a specific period, without considering the impact of time or compounding. The formula is straightforward:

Absolute Return = (Present NAV−Initial NAV / Initial NAV) x 100

For example, if your mutual fund’s initial NAV was ₹30 and now it’s ₹45 after nine months, the absolute return would be 50%.

2. Annualised Returns: To understand your returns on an annual basis, you can calculate the Simple Annualised Return (SAR). This takes the absolute return and adjusts it for the number of days in the period:

SAR = [(1 + Absolute Rate of Return) ^ (365 / Number of days)] −1

Using the earlier example with a 50% absolute return over 270 days, the annualised return would be around 73%.

3. Compounded Annual Growth Rate (CAGR): CAGR provides the average annual growth rate of your investment over several years, offering a clear picture of growth. The formula is:

CAGR = {[(Present NAV / Initial NAV) ^ (1 - Number of years)] −1} x 100

For instance, if you invested ₹10 lakh in 2016 when the NAV was ₹200, and by 2021 the NAV increased to ₹700, the CAGR would be approximately 28.47%.
You can also calculate this using Excel’s RRI function, which simplifies the process by using the number of periods, present value, and initial value.

4. Extended Internal Rate of Return (XIRR): XIRR is a more sophisticated way to calculate returns, particularly when dealing with investments that have irregular cash flows, such as SIPs. This method considers both the timing and the amount of each cash flow. In Excel, you can use the XIRR function to calculate this by setting up a table with all your SIP payments, any redemptions, and then applying the XIRR function to get your rate of return.

Types of Mutual Funds

A. Based on the Fund Structure:

1. Open-Ended Mutual Funds: These funds allow investors to buy or sell units at any time directly from the fund house. They do not have a fixed maturity date and continually issue and redeem units based on investor demand. Open-ended funds provide high liquidity and flexibility for investors.
2. Closed-Ended Mutual Funds: Closed-ended funds have a fixed lock-in period, and their units are typically bought and sold on stock exchanges like shares. These funds have a limited number of units issued during their initial offering, and after that, investors can only buy or sell units through secondary market transactions. Closed-ended funds may trade at a premium or discount to their Net Asset Value (NAV).

B. Based on Asset Allocation:

1. Equity Mutual Funds: These funds primarily invest in stocks or equities, offering the potential for higher returns but also higher risk. They are suitable for long-term investors aiming for capital appreciation.
2. Debt Mutual Funds: Debt funds invest primarily in fixed-income securities like government and corporate bonds. They are considered lower risk compared to equity funds and are suitable for investors looking for a stable income with lower volatility.
3. Hybrid or Balanced Mutual Funds: These funds invest in a mix of both equities and debt instruments. They aim to provide a balance between capital appreciation and income generation, making them suitable for investors with a moderate risk appetite.
4. Money Market or Liquid Mutual Funds: Money market funds invest in highly liquid, short-term debt instruments like Treasury Bills and commercial paper. They offer high liquidity and stability, making them suitable for parking surplus funds or short-term goals.
5. Sectoral and Thematic Mutual Funds: These funds focus on specific sectors or themes, such as technology, healthcare, or infrastructure. They are more specialised and carry sector-specific risks.
6. Index Mutual Funds (Exchange-Traded Funds): These funds aim to replicate the performance of a specific stock market index, providing investors with diversified exposure to the market. They are passively managed and typically have lower expense ratios.
7. Solution-Oriented Mutual Funds: These funds are designed to meet specific financial goals like retirement or children's education. They have a predefined investment horizon and asset allocation strategy to align with the goal.

Modes of Mutual Fund Investment

Investors can invest in mutual funds following two popular ways.

Lumpsum

When you make a single large payment to the mutual fund, the units get allocated to you based on the day’s NAV value. For instance, if the fund’s NAV on the day is Rs. 50 you’ll be allotted 200 units for a lump sum investment of Rs. 10,000.

SIP

In SIP, you make regular investments in the fund. These are small fixed instalments paid every month, and the units are allocated based on that day's NAV value. A systematic Investment Plan encourages regular investment practices and eliminates any need to time the market. 

How To Invest in Mutual Funds?

There are 3 common ways to invest in mutual funds.

• Through the mutual fund company’s website: In that case, you will have to register on their website and create an account. However, if you want to invest in multiple funds from different companies this method can be inefficient. 
• Through banks: Sometimes your bank allows you to invest in funds available in their net banking or mobile banking platforms. But it might restrict your ability to discover potential schemes as the bank may only promote a limited number of funds.
• Through Angel One: Angel One is a renowned brokerage house. We offer advanced screeners and reports to help you find mutual funds according to your requirements.     

Documents Required to Invest in Mutual Funds:

To invest in mutual funds, you typically need the following documents:

• KYC (Know Your Customer) Documents: These include identity proof (e.g., Aadhaar card, passport, voter ID), address proof (e.g., utility bills, rental agreement), and a recent passport-size photograph.
• PAN (Permanent Account Number) Card: This is mandatory for all mutual fund investments in India.
• Bank Account Details: You need a bank account for transactions like SIP (Systematic Investment Plan) registrations and receiving payouts.
• Filled Application Form: You must complete and submit the mutual fund application form, which is available from the fund house or authorised distributors.
• Payment Instrument: A cheque or demand draft for the initial investment amount.
• Nomination Form (Optional): You can nominate a person to receive the mutual fund units in case of your unfortunate demise.
• Declaration of Status (For NRIs): Non-resident Indian investors may need additional documentation like overseas address proof, passport copy, and foreign bank account details.

Terms used in Mutual Funds

As a beginner, it is difficult to understand the terminology of mutual funds. Here are the 10 most commonly used terms in mutual funds:

Mutual Fund Functions

To comprehend the inner workings of mutual funds, it is crucial to delve into their operational mechanisms:

• New Fund Offer (NFO) Launch: Asset Management Companies (AMCs) initiate mutual fund schemes through NFOs. They disclose the scheme's strategy before its launch, allowing potential investors to assess their investment decisions. NFO units are typically offered at an affordable price, such as ₹10.

Also, Read More About What is NFO Mutual Fund?

• Pooling of Funds: Following the NFO launch, fund houses collect capital from interested investors. This pooled money is used to purchase various assets like stocks and bonds. Even individuals who missed the NFO can invest in the fund once it becomes operational.
• Investment in Securities: The fund's strategy guides the fund manager in allocating the pooled funds. It provides an expert purview with in-depth research about the securities and the investment avenue that aims to yield optimal returns for unit holders.

For example, Short Term Fund focuses on pooled investing in short-term stocks, which provide better returns and have a low-risk profile than other short-term stocks.

• Distribution of Returns: As mutual funds generate returns, the profits can be either distributed among investors or reinvested within the scheme for potential growth. Investors receive payouts if they opt for the Income Distribution Cum Capital Withdrawal (IDCW) option. Alternatively, selecting the growth option allows gains to accumulate within the scheme for future growth.

Features and Benefits of Investing in Mutual Funds

1. Diversification: Mutual funds offer instant diversification, thus spreading the risk across different asset classes and reducing the impact of any single investment's performance on the overall portfolio.
2. Professional management: Fund managers use their expertise and research to invest in promising investment opportunities.
3. Liquidity: Liquidity makes mutual funds suitable for short-term or emergency cash needs. Investors can buy or sell their mutual fund units on any business day. 
4. Affordability: Mutual funds are affordable and allow investors to benefit from economies of scale.
5. Transparency: Mutual funds are required to publish regular performance reports. This level of transparency enables investors to make informed decisions.
6. Regulatory oversight: It ensures compliance with industry standards, offering investors a level of protection and confidence to invest in mutual funds.
7. Flexibility: Mutual funds are available in various types, allowing investors to choose funds that align with their investment goals, risk appetite, and time horizons.
8. Dividend reinvestment: In mutual funds, dividends generated are often reinvested, potentially boosting long-term wealth accumulation.
9. Tax efficiency: Mutual funds can be structured to provide tax benefits. For example, investors can save tax up to Rs. 46,800 a year on investments up to Rs. 1.5 lakh under Section 80C of the Income Tax Act, 1961, by investing in ELSS mutual funds.

Disadvantages of Mutual Funds

By understanding the disadvantages along with the advantages of mutual funds, you’ll be able to make an informed decision.

1. Fluctuating returns: Those who prefer fixed returns on investment may feel disappointed by mutual funds' returns. Mutual funds don't offer fixed returns and may not appeal to risk-averse investors. 
2. Less control: Unlike equity investments, you have less control over your portfolio in a mutual fund. In the case of mutual fund investing, all decisions related to the fund's holdings and investment strategies are taken by the fund managers.
3. Fees and expenses: Mutual fund investments involve charges such as management fees, operating expenses, and sales loads. These costs can reduce the investor's net gains.
4. Diversification: Diversification is always cited as the major plus of mutual funds, but over-diversification can reduce your overall gains. The chance increases because you have less control over your portfolio.
5. Performance fluctuations: Mutual fund returns are subject to market volatility, economic conditions, and the skills of the fund manager. Poor investment decisions or adverse market conditions can result in periods of underperformance, potentially impacting an investor's returns.
6. Fund evaluation: Some investors can find it difficult to compare funds - performance, NAV etc. You may find mutual funds complex if you’re a completely new investor. 
7. Exit load: The fund house will charge a fee when you redeem your units within a specific time frame. These fees are designed to discourage frequent withdrawals from the fund, but ultimately, they will limit your access to the fund. 
8. Past performance: While evaluating the fund's past performance is a common decision-making factor, it is important to keep in mind that robust past performance doesn't guarantee future performance. 
9. CAGR: The performance of the fund in comparison to the CAGR doesn’t tell investors about the risks or the method of investing involved. 
10. Manager’s performance: The return on the fund depends on the experience and judgments of the fund manager. 
11. Capital gain tax: Gains from the investment are subject to tax as per the capital gain tax rules and may result in an increased tax obligation for the investor. 

Objectives of Mutual Fund

Mutual funds achieve the following objectives for the investor:

• Diversification: Mutual funds offer instant diversification, which helps mitigate risk and improve risk-adjusted returns.
• Principal protection: Some mutual funds offer a degree of principal protection. Mutual funds are highly regulated and discourage aggressive investing strategies.
• Capital growth: The primary purpose of mutual fund investing is capital growth. 
• Tax savings: Some mutual funds have the advantage of tax savings, like the ELSS. However, it also comes with an initial three-year lock-in, which makes it less liquid.  

Final words

The beginner's guide to mutual funds aims to provide a solid foundation for understanding these investment vehicles. By explaining mutual funds meaning, types, advantages, and disadvantages, this article provides an in-depth understanding that will help beginners make an informed decision. 

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