Mutual Funds: Meaning, Types and Benefits

“Mutual funds sahi hai”

You may have come across this slogan frequently over the years.

But what are mutual funds, and why are they sahi?

Well! Let’s learn more about this asset class in this chapter.

What Is a Mutual Fund?

Imagine you get invited by a friend to a potluck. You are to bring in one food item. Likewise, all the invitees take one item each and everyone feasts upon the collective spread. What are the benefits here:

1. You don’t have to put in all the hard work in cooking a banquet (no to minimum effort, especially when you just buy something instead of cooking)
2. You get to enjoy a scrumptious and filling meal in exchange for bringing in just one item
3. Your friend manages the event, so you don’t have to stress. Literally, just enjoy the meal, network, and have fun!

Let's now understand mutual funds based on this analogy.

A group of investors pool money, which is invested in various assets like stocks, debt, and other asset classes based on the fund type. A professional called a portfolio manager makes investment decisions. They are responsible for the tactical investing of the pooled capital in various securities such as bonds, stocks, or gold prices, among other things, with an aim to get the best possible returns. In short, the manager monitors how the fund performs and, accordingly, buys and sells assets. The returns generated from the fund are then distributed among the investors proportionate to their contribution.

Understanding How Mutual Funds Work With an Example

Suppose MoneyMagnet Mavericks is a well-known mutual fund house (AMC). It offers various schemes across asset classes. Strategic Horizon Equity Growth Fund is a popular scheme offered by the AMC; it has a track record of generating attractive returns. Investors across the country invest in this scheme by buying units of the fund, managed by Mr Fundmaster, a professional fund manager.

Mr Fundmaster is a CFA with a decade of experience working with several reputed fund houses. He has been managing Strategic Horizon Equity Growth Fund for 3 years now and has managed to generate a CAGR of 12% p.a. Even during market downturns, the NAV did not decline drastically. He balances the portfolio promptly by selling underperforming stocks and buying those with the potential to grow. What he’s doing is spreading funds across stocks of various sectors. As a result, he is diversifying risks so they are not concentrated in a single sector. If one sector performs better than the others, the portfolio benefits collectively, and vice versa.

Suppose you evaluated the fund and want to buy a few units today. The scheme is available for purchase at an NAV of ₹50 per unit. NAV stands for Net Asset Value - it represents the market value per share of a particular mutual fund scheme. It is calculated by deducting the liabilities from the total asset value divided by the number of shares. Therefore, NAV changes as and how the underlying securities change in value.

We can safely conclude that NAV is not only the price at which you can buy 1 unit of the scheme but also reflects the fund's performance.

Let’s talk about returns now. The difference between the buying and selling price of the mutual fund units is the profit/return. It is called a capital gain. In case the underlying assets declare dividends, the fund can also distribute it to you. Well, it depends on the plan; some schemes reinvest the dividends to amplify them, and some distribute them among investors proportionate to their holdings. So, if you hold 10 units, you will get returns and dividends, if any, proportionate to 10 units.

All in all, mutual funds allow you to benefit from professional management, risk diversification, and the potential for capital appreciation.

What are the Types of Mutual Funds?

Mutual funds are of various types. They are classified based on several parameters:

1. Ability to buy or sell units when you wish:

• Open-ended mutual funds:

These funds do not have restrictions on buying or selling units. You can buy or sell units anytime, and the fund continuously issues new units or redeems existing ones based on investor demand. 

• Close-ended mutual funds:

These funds have a predetermined maturity period. You can only buy units during the initial offer period, and after this, the fund is closed for new investors. Meaning new investments are not accepted.

• Interval mutual funds:

These are a combination of both open-ended and close-ended funds. These funds allow investors to buy or sell units only during specific intervals.

2. The underlying asset:

• Equity mutual funds:

These invest predominantly in stocks. They carry higher risk but offer the potential for substantial capital appreciation.

• Debt funds:

These predominantly invest in fixed-income securities such as bonds and debentures. They are considered lower-risk investments compared to equity funds.

• Hybrid or balanced funds:

These maintain a mix of debt and equity instruments to balance return and risk. They cater to investors seeking a diversified portfolio.

• Money market funds:

These invest in short-term, low-risk instruments like treasury bills and commercial paper. They aim to provide stability and liquidity.

• Multi-asset funds:

These diversify across different asset classes, such as stocks, bonds, and commodities, offering investors a balanced investment strategy.

3. Based on portfolio management

• Actively managed funds:

These funds are managed by a professional fund manager who makes investment decisions to outperform the market. The manager continuously monitors the portfolio and adjusts holdings based on market conditions.

• Passively managed funds:

These are like index funds or Exchange-Traded Funds (ETFs). The fund manager is not actively involved in managing the fund as it aims to replicate the performance of a specific market index.

4. Based on the investment objective

• Growth-oriented mutual funds:

These focus on capital appreciation over the long term. These funds invest in stocks with high growth potential.

• Income funds:

These prioritise generating a regular income stream for investors. They invest in fixed-income securities like bonds and may distribute periodic dividends.

• Liquidity funds:

These aim to provide easy access to cash. They invest in short-term money market instruments, ensuring high liquidity and capital preservation.

5. Specialised Funds

• Thematic or solution-oriented funds:

Thematic funds focus on specific themes or sectors, such as technology or healthcare. Solution-oriented funds cater to specific financial goals, like tax-saving or retirement planning.

• Exchange Traded Funds (ETFs):

Unlike other mutual funds, ETFs are traded on stock exchanges. They often track an index or a commodity and offer diversification with intraday trading flexibility.

• Overseas funds:

These funds are a type of mutual fund that invests in international markets, providing Indian investors exposure to global opportunities and diversification beyond domestic markets.

• Fund of Funds (FOFs):

Fund of Funds invests in other mutual funds rather than individual securities. They provide diversification across different fund schemes and asset classes.

By now, you may have understood how mutual funds can benefit you. Here’s a list:

Benefits of Mutual Funds

• Managed professionally:

Mutual funds are managed by a professional fund manager who has knowledge and experience of the stock market. They constantly monitor the investment and rebalance the portfolio based on the market condition in order to ensure that the investment objective is being met. So you don’t have to put in time and effort.

• Diversification:

Investing in mutual funds is an easy way to diversify your funds as they invest in various asset classes like stocks, bonds, etc. If one asset class is volatile, the other can balance the risk. 

• Liquidity:

In the case of open-ended mutual funds, you can redeem them easily on any business day. So you can easily meet your liquidity requirements.

• Affordable:

Mutual funds offer a cost-effective way for small investors to access professionally managed portfolios that may be challenging to build on their own.

• Transparency:

The details regarding a fund, i.e., performance, holdings, and objectives, are disclosed regularly. This means you can have clear insights into the fund's operations and can make informed decisions.

Although there are many ways in which a mutual fund investment can benefit you, as with any investment, mutual funds also come with risks. Let’s look at some.

Risks Involved in Mutual Funds

• Market risk:

• Since the underlying assets are stock market instruments that are subject to volatility and risks, mutual funds carry market risks. Changes in stock prices or economic conditions can impact a mutual fund.

• Liquidity risk:

• The ease with which you can buy or sell shares depends on market liquidity. Selling assets in illiquid markets can be challenging, affecting redemptions.

• Credit risk:

• Mutual funds that invest in bonds face credit risk. Insolvency of bond issuers adversely affects the performance of the bank, affecting investment returns.

• Interest rate risk:

• Interest rate fluctuations affect bond prices and the funds holding these securities. Depending on the direction of the fluctuation in the interest rate, the fund may incur significant losses or gains.

• Fund manager risk:

• The performance of the fund is influenced by the manager's decisions. For instance, poor asset allocation can lead to investor inefficiency and dissatisfaction.

• Political and legal risks:

• Changes in government policies or laws may affect mutual fund investments. Political and regulatory uncertainty can cause market volatility and affect investment returns.