Mutual Funds 2022 Beginners Guide : Meaning, Types & Importance
For several years now, mutual funds have emerged as a mainstream investment option in India. Investors from varied financial backgrounds have put their faith in them. The Mutual Funds Sahi Hai campaign has become a household name and resonated with millions. As of December 2020, the total number of mutual fund accounts in India stood at 9.43 crore
Investors need to cross the bridge between wanting to invest in mutual funds and knowing the how, why, and when. In this post, we dive through all the nitty gritties, and give you a definite guide on investing in mutual funds.
So What is a Mutual Fund? How Does It Work?
A mutual fund is an investment instrument that pools together funds from several investors and invests in various assets (such as listed companies, types of fixed income instruments, precious metals like gold, etc.) for increased profits. Each shareholder of a particular fund participates in the gains or losses of the fund in proportion to their investment amounts.
Mutual funds are managed or supervised by a group of financial experts, also known as an asset management company - or an AMC. Along with ensuring a financially fortified future, mutual funds also provide investors without comprehensive knowledge with the opportunity to diversify their investments in various asset classes such as equity, debt or gold. The diversification can be both within a single mutual fund investment and across multiple funds - depending on the types of mutual fund you pick.
Who Should Invest in Mutual Funds?
Everyone should think about investing in mutual funds if they have a certain financial objective in mind, be it short-term or long-term. A mutual fund investment can be a great way to achieve your financial goals faster. There are mutual fund strategies for every financial goal. An investor should evaluate his or her risk profile, investment horizon, and goals before making a mutual fund investment. For example, if one’s risk appetite is low and they want to buy a car in the next five years, gilt funds may be a good option. They should consider investing in equity funds if they are willing to take a risk and want to buy a property in the next fifteen to twenty years. If one’s investment horizon is less than two years and you want to earn better returns than a standard savings account, they should consider putting extra cash in a liquid fund.
What Are the Different Types of Mutual Fund?
There’s a wide assortment of mutual funds available in the market, with all kinds of investment objectives and risk-absorbing capabilities. Mutual fund schemes are classified into various categories based on quite a few factors - maturity periods, investment objectives, the assets invested, and fund structures.
Based on the Structure, mutual funds can be classified into three categories:
- Open-Ended Funds: Open-ended mutual funds let investors buy units or sell their holdings at any point during their run time; they have no fixed maturity period.
- Close-Ended Funds: Close-ended mutual funds are closed for further purchase by investors after the initial offering period (NFO). Unlike, Open-ended funds, investors cannot buy fresh units of these types of mutual funds after the NFO period, and cannot withdraw their money at any point of time during their run.
- Interval Funds: Interval funds bring together some of both open-ended and close-ended funds’ characteristics. They allow investors to trade units at predetermined intervals during the fund’s run time.
Mutual Fund categories based on investment objectives:
a. Equity Funds:
Equity funds invest in the stocks of companies of different sizes. They are expected to generate better returns than other types of mutual funds. However, the increased profits are associated with risks of time horizon, since their performance depends on the market conditions. So far, equity schemes remain the most popular kind of mutual funds among investors; Indian investor accounts in equity MFs rose to 9.52 crore at the end of January 2021.
The Securities and Exchange Board of India, or SEBI, authorizes 12 classes of equity mutual funds, which are:
- Multi Cap Fund: An equity scheme that invests in large sized, mid-sized, and small sized stocks. The Cap here refers to market capitalization - a metric typically signifying the size of a company. Multi cap funds offer a diverse investment opportunity in the equity markets. If your goal is long-term wealth creation, these schemes are definitely one of your best options. Multi-caps are suitable for investors who want to invest in equities but are not sure of their risk tolerance levels.
- Large Cap Fund: An equity scheme that mostly invests in large sized stocks. As per SEBI, these stocks are from the top 100 companies listed in the Indian markets based on market capitalization (AMFI ) publishes an updated list of large, mid, and small cap stocks in the Indian markets every six months). If you’re looking for an equity investment opportunity but don’t have a high risk tolerance, you should consider large-cap funds. While these schemes do come with chances of moderate risks, the risks are comparatively lower compared to mid or small-cap funds.
- Large & Mid Cap Fund: An equity scheme that invests in both large cap and mid -sized stocks. Large and mid-cap funds select stocks to invest in from the top 250 stocks within the Indian markets, based on their market cap.
- Mid Cap Fund: An equity scheme that primarily invests in stocks belonging to the mid cap category – stocks ranked between 100 and 250 by market cap. Although large-cap funds are less risky, mid cap funds have higher potential to grow and offer better returns. They have a considerable longer time horizon i.e. greater than 10 years.
- Small Cap Fund: An equity scheme that mostly invests in small sized stocks. Stocks in the small cap category are essentially all stocks besides the top 250. Small cap funds can provide very high returns, but they are also one of the mutual fund schemes with the highest risks.
- Flexi Cap Fund: A flexi-cap fund is not restricted to making investments in companies with a fixed market capitalization; so unlike large, mid, or small cap funds, the size of a company is not a constraint for flexi-cap funds. A flexi-cap fund, due to broader investment choices, comes with an amplified scope of diversification.
- Dividend Yield Fund: An equity scheme that primarily invests in dividend yielding stocks. A dividend is a portion of earnings that a company passes on to eachindividual shareholder. Typically, established and mature companies pay out dividends. The risks associated with dividend yield funds range from moderate to high, even when the market as a whole is performing well. If you have a high risk tolerance and possess some knowledge of macroeconomic trends, you can go for dividend yield funds.
- Value Fund: An equity scheme that follows a value investment strategy and invests in stocks that the fund manager deems to be undervalued - as in the market value of the stocks is deemed to below their intrinsic value. The ‘true value’ of the stock is determined by a combination of research into the company’s business fundamentals, governance, future potential, and several other factors. An undervalued stock pick can provide increased returns when the value is unlocked in future. A Value investing strategy offers returns when the value is unlocked and underlying security is re-rated. It is to be noted that value funds are primarily suitable for investors with high risk tolerance.
- Contra Fund: An equity scheme that follows a contrarian investment strategy identifying and investing in securities that are under-performing and depressed at the moment but are projected to perform well in the long run, but are available now at cheap valuations. So with a contra fund, much like a Value fund, the fund manager invests in securities it expects to provide above-average returns in future. Contra funds, just like value funds, are better suited for investors with high risk tolerance.
- Focused Fund: An equity scheme that’s allowed to invest in a maximum of 30 stocks. There are no restrictions on the market cap or sectors, these schemes can invest in. The risks are fairly high with these funds.
- Sectoral/ Thematic Fund: An equity scheme that invests in businesses operating in a particular area or industry of the economy, known as a ‘sector’; for instance, mutual funds focusing on pharmaceutical or tech-related companies are sectoral funds. As these schemes invest only in specific sectors with few stocks, the risk factor can be quite high. So if you intend to invest in sector funds, you should be aware of sector-specific trends. For instance, sector funds investing in IT and Pharma companies have shown significant growth. This is because recent years have seen high demand for Indian software and Pharma products in the Western markets. Investors who believe they can time the market and sector cycle well can invest their capital here.
- ELSS/ Equity Linked Savings Scheme: An equity scheme that invests in equity or equity-related instruments. ELSS funds have a lock-in period of 3 years and come with tax benefits. Indeed, one of the foremost reasons for you to invest in an ELSS is to save up on tax. These schemes allow the reduction of up to INR 1, 50, 000 from an investor’s annual taxable income under Section 80C of the Income Tax Act.
As per the SEBI’s restrictions, an AMC can offer equity funds belonging to a maximum of 10 of the aforementioned categories; they must choose between value and contra funds.
b. Debt, or Fixed Income Funds:
Debt mutual funds provide interest income by investing in fixed income instruments such as government bonds, corporate bonds, money market instruments like commercial papers, treasury bills, and federal funds, etc. These funds earn through capital gains, interest/coupon payments and the reinvestment of interest earned but are subjected to duration, inflation, liquidity and credit risks.
The SEBI categorizes debt funds into 16 types, which are:
- Overnight Fund: A debt scheme that invests in overnight securities, this is a mutual fund where the underlying instruments mature in just one day. Aside from the really short investment horizon, investing in overnight funds involves very low risks and very high liquidity.
- Liquid Fund: A debt scheme that mainly invests in financial instruments (like treasury bills, commercial papers, and FDs) for a maturity period of up to 3 months (91 days). The objective of a liquid fund is to pass on capital protection and liquidity to the investors, and these funds have the one of the lowest interest-rate risk among all the debt fund schemes.
- Ultra Short Duration Fund: The duration of a debt fund refers to the extent to which the value of a fund can fluctuate when there are changes in market interest rates. So, in simple words, duration stands for interest rate risk. The higher the duration of a fund, the more volatile the fund value, and greater the interest rate risk associated with it. An ultra-short duration fund is a debt scheme that invests in instruments with a maturity period between 3 months and 6 months. Interest rate risk is fairly low with these schemes as well.
- Low Duration Fund: A debt scheme that invests in debt and money market instruments with a maturity period between 6 months and 12 months. For investors with low risk tolerance, these funds are a good option for investing the money you have lying around in a savings account for enhanced returns.
- Money Market Fund: A debt scheme that invests in high-quality liquid instruments such as treasury bills (T-Bills), repurchase agreements (Repos), commercial papers, and certificates of deposit. Among short-term investors, money market funds are one of the more popular investment options.
- Short Duration Fund: A debt scheme that invests in instruments with a maturity period between 1 year and 3 years. Short duration funds can provide better returns to liquid and overnight funds. They are also less susceptible to risks associated with interest rate changes.
- Medium Duration Fund: A debt scheme that invests in instruments with a maturity period between 3 years and 4 years.
- Medium to Long Duration Fund: A debt scheme that invests in instruments with a maturity period between 4 years and 7 years. It’s important to keep in mind that while funds with longer durations may provide higher returns, the associated risks are also higher due to uncertainty of interest rate changes over the long-term, and credit risk.
- Long Duration Fund: A debt scheme that invests in instruments with a maturity period greater than 7 years.
- Dynamic Bond: A debt scheme that switches between long term and short term bond investments depending on changes in interest rates. Investors with enough knowledge of the market to monitor interest rate movements and a moderate risk tolerance might find dynamic funds a fitting investment option.
- Corporate Bond Fund: A debt scheme that only invests in the highest rated corporate bonds- corporate bonds that offer relatively higher rates of interest, equivalent to their higher risks of default.
- Credit Risk Fund: A debt scheme that invests at least 65% of the accumulated funds to below highest rated instruments. In this case, the investor invests in funds where it lends money to risky borrowers who pay higher interest charges to compensate for their comparatively lower credit rating.
- Banking and PSU Fund: A debt scheme that mostly invests in debt instruments of banks, public sector undertakings, and public financial institutions. These funds have comparatively high credit ratings, and since the PSU and Banking sectors are generally backed by the government of India, these funds are one of the safest investment options.
- Gilt Fund: A debt scheme that invests in government securities across maturity periods. These funds have negligible risk of non-payment of interest or principal amount but get affected by interest rate movements as the Government borrowing typically happens to be for a longer duration.
- Gilt Fund with 10 year constant duration: A debt scheme that invests in government securities with a fixed maturity period of 10 years. These schemes are a well suited option for long term investors with low risk tolerance, since they strike a good balance between reasonable returns and minimal risks.
- Floater Fund: A debt scheme that mostly invests in debt securities that come up with a varied range of coupons depending on market conditions or benchmark indexes - called floating rate bonds. The returns generated by a floater fund are largely affected by fluctuations (or changes) in interest rates. So, with floater funds, you can benefit from these fluctuations of your country’s economic cycle, which influences the returns of these instruments.
c. Hybrid Mutual Funds:
Hybrid mutual funds invest in a combination of both debt and equity assets, as well as other relevant instruments.
The SEBI sanctions 7 kinds of hybrid mutual funds in India, which are:
- Conservative Hybrid Fund: A hybrid scheme that invests primarily in FD-like instruments, with some dispensation to stocks. There’s a higher focus on bonds as 75-90% of investments are put behind them, and the rest is invested in stocks. Conservative funds, additionally, are low risk in nature.
- Balanced Hybrid Fund: A hybrid scheme that invests in a mix of both equity and debt instruments in specific ratios. Balanced schemes invest about 40% to 60% of the fund in equities, and the rest in debt instruments. If you have a low risk tolerance, balanced funds might be a good investment option for you.
- Aggressive Hybrid Fund: A hybrid scheme that invests mainly in stocks, with some allocation to FD-like options. As opposed to conservative funds, aggressive funds invest about 65-80% of the portfolio in stocks, and the rest in bonds. Aggressive hybrid funds come with comparatively high risks, however.
- Dynamic Asset Allocation or Balanced Advantage Fund: A hybrid scheme that invests across different sectors (including stocks and FD like instruments) and is meant for consumers with all kinds of risk horizons.
- Multi Asset Allocation Fund: A hybrid scheme that invests in at least three different asset classes (for example, equity, debt and commodities) with at least 10% of the total fund invested in each asset class. Multi asset allocation funds may be classified into two categories.
- Risk tolerance funds: In this case, the asset allocation depends on an investor’s risk tolerance; while those with a higher risk absorbance capability can have more allocated in equity instruments, those with lower risk tolerance can invest majorly in fixed income instruments.
- Target date funds: The asset allocation depends on an individual investor’s intended time horizon.
- Arbitrage Fund: A hybrid scheme for investors who want to profit from volatile markets without taking on high risk. When there’s a price difference for a particular share in the spot and derivatives market, arbitrage funds use that difference to their profit. For instance, an arbitrage scheme would choose to buy a share from the spot market for a lower price and sell it in the derivatives market for a higher price for profitable returns. Let’s take a look at an example to see how arbitrage schemes generate profit. Suppose the equity share of the company X is trading in the spot market at INR 2,000 and in the derivatives market at INR 2,050. Now, if with an arbitrage scheme the fund manager chooses to buy these shares from the spot market at INR 2,000 and gets into a derivatives contract to sell the shares at INR 2,050, when the prices match later on in both markets, the fund manager can sell the shares in the derivatives market and generate a profit of Rs 50/share (notwithstanding the transaction costs).
- Equity Savings Fund: A hybrid scheme that invests in equity, arbitrage, and debt instruments. With an ESS, minimum 65% of the total funds is invested in equity instruments, while the rest is invested in debt instruments and arbitrages. An ESS maintains a good balance of risks and rewards; those looking to earn capital to fulfil any short term goals should consider investing in an ESS.
As per the SEBI’s regulations, MF corporations can offer either an Aggressive Hybrid fund or a Balanced fund, but not both.
Solution Oriented Schemes:
- Retirement Fund: A retirement solution oriented scheme with a lock-in period of 5 years or till the investor’s retirement age - whichever is reached first.
- Children’s Fund: A fund for investment for kids with a lock- in period of at least 5 years or till the kid in question reaches the age of maturity - whichever comes earlier.
Other Types of Mutual Funds
- Index Funds - attempt to track an index’s performance, such as SENSEX or NIFTY. Since these indices are themselves a fairly diversified pick of a market’s top stocks, index funds are fairly safe, with much lower costs. An index fund is typically a passively managed fund since it simply involves investing in securities that accurately track the benchmark’s performance.
- Fund of Funds - These funds invest in other mutual funds. They attempt to achieve further diversification and minimize risk.
How to Invest in Mutual Funds:
Two of the most popular methods you can pick for investing in mutual funds are:
- Lump Sum Investment: With a lump sum investment, you can invest the entire amount of investment in one go.
- SIP: With a SIP or a systematic investment plan, you can invest a fixed amount at regular intervals.
If you would like to find out more in detail about these two investment methods, you can give our post on Lump sum vs SIPs a read.
Why You Should Invest in Mutual Funds?
Mutual funds are one of the healthiest investment options for a number of reasons, including but not limited to:
- Mutual Funds Are Professionally Managed: Many of us simply cannot afford to spend considerable time fine tuning our stock portfolio investments due to lack of time or expertise. But Mutual Funds which are managed by experienced professionals, allow the investors to simply put money and sit back patiently, watching their investments grow.
- Mutual Funds Allow for Diversification of Investment: Diversification is one of the golden rules of good investment strategies. Mutual funds, by definition, are diversified. They invest in a diverse range of assets like stocks, bonds, and commodities like gold and other precious metals. Reducing risks associated with investing in mutual funds through diversification is fairly obvious. When the value of one particular investment declines, it can get balanced out by the others; so the portfolio’s overall performance doesn’t suffer from market volatility.
- You Can Start Investing in Mutual Funds with a Small Amount of Money: Mutual funds are pretty flexible when it comes to the amount of investment. If you invest through the SIP route, you can start out with an amount as small as INR 1000. This allows you to carry on with your usual lifestyle and spending habits while also investing simultaneously.
- Most Mutual Funds Are Liquid Investments: Unless there’s a lock-in period in a particular scheme, you can conveniently redeem most of your mutual fund units online whenever you want. In other words, your funds remain accessible to you throughout your investment period.
- The Advantage of Rupee Cost Averaging: Another benefit to invest through a SIP is the concept we call ‘rupee cost averaging’. It allows you to buy more mutual fund units when the market is down and less when the market goes up, so ultimately your total cost of purchase averages out.
Identifying investment objective and the category of funds that align to your objective:
- AUM (Assets under Management): The AUM is the total worth that a mutual fund scheme holds for investments. The total AUM of a fund house can indicate its size and success.
- Total Expense Ratio: Expense Ratio is the AMC's fee for managing the fund. Depending on the MF scheme, the expense ratio is usually anywhere between 1 to 3% of your invested amount. It is lower for Direct mutual funds (where the AMC sells directly to the investor) and higher for Regular mutual funds (where the mutual funds are sold by an intermediary or distributor).
- Net Asset Value (NAV): The NAV is the value of one unit of a particular mutual fund at a certain date and time. A shift in a fund’s NAV suggests a change in its returns.
- Lock-in Period: This is the specific time period when you cannot withdraw your investment. The lock-in period begins on the date of your investment.
- Exit Load: The exit load is a fee the AMC charges if you redeem your holdings before a certain time period.
- Date of Inception: Knowing the specific date when a mutual fund scheme was launched can help you evaluate its performance and returns over specific periods (i.e., 6 months, 1 year, 3 years, 5 years, etc.).
- Returns: Checking the returns of a mutual fund over certain periods (1 year, 3 years, 5 years, or more) can help you decide if your investment would be potentially profitable or not.
- Risk: Fairly self-explanatory term. You should find out the level of risk you might face when you invest in a mutual fund to see if it matches your risk appetite.
Taxability of Mutual Funds
Mutual funds are one of the most popular investment options since they aid you in achieving your financial objectives. Mutual funds are also a tax-advantaged investment. Fixed deposits have a significant disadvantage, especially if you are in the highest income tax bracket because the interest is added to your taxable income and taxed at the rate set by your income tax slab. This is an area where mutual funds excel. You get the benefit of experienced money management and tax-efficient returns when you invest in a mutual fund.
How to Save Taxes with Mutual Funds?
What if we say that Investing in Mutual funds can also help save tax? It is interesting to note that under Section 80C of the Income Tax Act of 1961, mutual funds, have a category that is called Equity Linked Savings Schemes (ELSS), are excellent tax-saving vehicles. If you invest your money in specific investments, you can claim deductions from your taxable income under this provision. ELSS is an equity diversified fund that is linked to the equity market. Investments in equity and equity-related securities are made through this type of mutual fund. Since ELSS has a three-year lock-in period, you must keep your money in these funds for at least three years. And the longer you keep your money in these funds, the more likely you are to make money. Tax-saving funds allow you to invest up to Rs 1.5 lakh. Section 80C of the Income Tax Act allows you to claim a tax deduction of up to Rs 1.5 lakh.
Advantages of Mutual Funds
Now after gaining considerable knowledge over Mutual Funds to get started with, we might as well highlight the various advantages of Mutual Funds.
- Investors are not required to have an expert understanding of the markets and how they work because the investments are managed and executed by qualified and experienced Fund Managers.
- A mutual fund investment can be made in lumpsum or in installments.
- Investments in ELSS mutual funds help save tax U/s 80C up to 146000.
- Depending on their risk appetite, investors can choose between low, medium, or high-risk funds.
- Mutual funds provide diversification across sectors and assets thus reducing risk.
- Mutual funds are highly liquid as the units are being bought and sold in real time.
- To begin investing in mutual funds, you do not need a huge sum of money. Investing in Mutual funds can be started with a sum of money as low as Rs. 100.
- Investing can also be done through SIPs (systematic investment plans), which allow you to pay a certain amount to a mutual fund every month.
When Should You Invest in Mutual Funds?
There is absolutely no reason to put off investing unless you don't have any money to invest in the first place. Within that, it is always preferable to invest in Mutual Funds rather than doing it yourself.
There is no set age at which one can begin investing. One should start investing as soon as one starts earning. Investing in Mutual funds is the best option as they are professionally managed, highly liquid, historically given better returns than bank FD, RD, PPF, Savings bank account. Investment can be done on their behalf too. Mutual fund investing does not have a maximum age limit. Mutual funds offer a wide range of investment options to fit a variety of needs. Some are appropriate for long-term growth, while others may be suitable for people seeking security and regular income, and some also give liquidity in the near term
Questions to Ask Yourself Before Investing in Mutual Funds:
It’s okay to be unclear on which mutual fund to invest in. These are often big decisions, and the earlier you are in your investment journey, the more likely they are to crop up. It’s all for the better though - more information is only helpful. Asking yourself these three basic questions might help you make the decision:
1. What is your investment objective?
Before you think of investing, you must be clear on what your purpose of investment is. Is it a short term goal? Is it long-term savings? Invest in mutual funds for specific individual goals.
2. How long can you wait for returns?
You have to determine how long you can afford to wait for your expected returns before choosing a mutual fund for yourself.
3. What kind of risks can you take?
Mutual fund schemes that generate higher returns also come with higher risks. For instance, equity funds are among the riskiest MF schemes, even though they may be a much safer option compared to other investments broadly. So, before deciding on a fund, you must know if you can absorb the associated risks.
How Can You Make a Mutual Fund Investment?
You can make mutual fund investments from the comfort of your home with Glide Invest. All you’d have to do is follow these quick steps:
- Install the App: First, you need to download and install the app on your smartphone.
- Register: Now register on the app with your basic personal details. Don’t forget to link your bank account!
- Invest According to Your Goals: You can pick mutual fund schemes as per your preferences and invest in within moments. Our simple goal planning tool is also there to help you should you require assistance!
And that’s it! After your investment shows up on your account, you can track your mutual fund investment through your account dashboard. Now you can just sit back and relax!