What is a Mutual Fund? Process, Types & How to Invest in MF

Newcomers to investing are often advised to start their investment journey with Mutual Funds till they have a better idea of the stock market. There are two principal reasons for this advice.First, Mutual Funds provide individual investors access to professional management of their investments. This is immense support for people who are new to investing and are yet to master the ropes.Second and equally important, Mutual Funds facilitate investments in assets which would otherwise be out of reach due to the large amount of capital typically required for such investments.But what is a Mutual Fund? Let us now check out what a Mutual Fund is and how it works.

A Mutual Fund is a financial instrument combining capital from multiple investors which is then invested in an assortment of securities, including stocks , equities, debt funds , bonds, and other assets.Skilled fund managers oversee these funds and the fund's objectives to guide their investment choices to create dividends for the investorsWhen allocating the pooled corpus towards a diverse range of securities, fund managers try to keep the investments aligned to the objective of the fund, which can be growth, income, stability, or a combination of these.

Mutual Funds issue units to investors. A unit represents an investor's ownership of the fund's portfolio and the dividends that are generated by the scheme.The value of each of these shares is known as the Net Asset Value (NAV) , and it fluctuates based on the performance of the portfolio's underlying securities and the buying and selling of the units.The NAV is calculated and sealed when the market closes for the day as per the following formula: NAV = (Assets minus Liabilities) / Total number of outstanding shares or units.

There are three ways for investors to earn money from a Mutual Fund.

1. Through dividends on stocks and interest on bonds that the fund holds:

The securities that the Mutual Fund invests in yield dividends based on how the market performs, or from pre-determined interest earnings, irrespective of market conditions. Investors collect the dividends or the interest earnings. Asset Management Companies (AMCs) offer investors the option of reinvesting the dividends so that their money can grow further through the power of compounding.

2. Through capital gains:

When investors sell or redeem their units at a price higher than the one the paid when buying the units, they make capital gains. The gains also depend on the time period or holding period of the investment. If the investment is for less than three years, you get short-term capital gains and if the investment is for more than three years, you get long-term capital gains. The tax on capital gains depends on the type of Mutual Fund scheme.

The Mutual Fund process starts with a group of people investing in a particular fund based on their risk tolerance, investment objective, and investment horizon. Once this is done, the fund manager reinvests the pooled money in various assets, while the investors receive units of the fund – which are somewhat like shares of a company. The number of units each investor receives is proportionate to the amount invested.To calculate the number of units allocated to an investor, the invested amount is divided by the fund's NAV for that specific day. Investors opting to exit the fund have the option of selling their units back to the Mutual Fund company. The NAV at the time of selling determines the selling price of the units.Also Read: How Do Fund Managers Manage Your Mutual Fund Investment?

There are various types of Mutual Funds, each serving a specific investment goal. These include:

Class-based asset funds

• Debt Funds: These funds primarily invest in assets such as government securities, corporate bonds, or other fixed-income assets to offer stable returns with lesser risk.
• Equity Funds: These funds invest in stocks of companies and have the objective of capital appreciation, but they carry a higher risk due to their dependency on market movements.
• Hybrid Funds: Hybrid funds offer investors a blend of growth potential and income generation through investments in both equity and debt instruments.

Structure-based funds

• Open-ended Funds: These funds allow investors to invest or redeem units during any time of any business day at the fund's NAV, offering high liquidity. The number of units keeps changing because they keep being sold and bought, causing the NAV to fluctuate.
• Close-ended Funds: These funds have a specific period for investment (usually five-seven years) and are less flexible than open-ended funds. The window for investing is for a limited period when the scheme is launched. This is called the New Fund Offer period or NFO period. Once the NFO period is over, investors cannot buy or redeem units.
• Interval Schemes: These funds combine the features of both open-ended and closed-ended Mutual Funds. The units can be bought or sold only during a pre-determined time, and regular trading cannot be done. New investors cannot buy units once the investment time period is up.

Investment objective-based funds

• Growth Funds: These funds aim for capital appreciation and are typically riskier due to their high equity exposure. They invest money in the equity stocks of the growth sector.
• Income Funds: These funds are designed to provide investors with a dependable income source and are generally regarded as having lower levels of risk. The money is usually invested in debentures, certificates of deposit, and bonds.
• Liquid Funds: These funds provide a quick way of earning income by investing money in short-term and ultra short-term market instruments such as treasury bills, bank certificates of deposit, and commercial papers. The investment is fairly low-risk and brings good returns.
• Tax-saving Funds: These funds provide tax benefits under Section 80C of the Income Tax Act. Also called Equity Linked Saving Scheme (ELSS), this fund invests money into equity. The risk factor is high, but these funds offer very high returns when the market performs well.
• Pension Funds: These offer a long-term investment plan and yield returns regularly after the investor retires from work. The fund's investment corpus is divided between debt and equity instruments. The debt instruments balance out the risk and the equity instruments bring high dividends. Investors can either draw a lump sum of returns, or get a fixed regular pension, or a mix of both.

Actively managed and passively managed funds

• Within an actively managed fund, the fund manager oversees portfolios with the support of thorough analytical research, to determine the appropriate actions of buying, selling, or retaining specific stocks. The aim is to generate maximum returns and outperform the scheme's benchmark.
• Conversely, a passively managed fund replicates the benchmark index of the scheme proportionately. The fund manager's task is not to outperform the benchmark index but to replicate its returns. Examples of passively managed funds are Index Funds and Exchange Traded Funds.

Investing in Mutual Funds comes with numerous advantages. Here are some significant ones:

Access to professional expertise

Investing can be time-consuming and requires considerable dedication. However, if you lack the time or expertise to navigate the financial markets, Mutual Funds offer a viable alternative, with a professional fund manager handling your investments to generate satisfactory returns – for you. This service comes with certain fees, much like paying a driver for his services.

Potential for higher returns

Another big advantage of Mutual Funds is the potential to earn higher returns compared to traditional investment options. The performance of the market determines the returns of Mutual Funds: in a bullish market, the value of your funds can significantly increase though a bearish market can have the opposite effect. Because of this, comprehensive research and smart investment strategies are crucial for success with Mutual Fund investments.

Diversification

Choosing to invest in Mutual Funds means diversifying one’s portfolio, as a single fund can include a variety of stocks from various sectors. This investing in different asset classes spreads one’s risk exposure; if one investment performs poorly, chances are that another will do well. New investors are frequently advised, "Don't put all your eggs in one basket", and how it is wise to spread one’s resources across multiple options instead of relying on just one. Mutual Funds facilitate this, providing instant diversification.

Tax benefits

Investors can benefit from tax deductions of up to ₹ 1.5 lakh through investing in Equity Linked Savings Schemes (ELSS) as per Section 80C of the Income Tax Act. Furthermore, indexation benefits on debt funds can help investors earn higher post-tax returns.

Different types of Mutual Funds cater to various financial or investment goals. Investment goals can be broadly categorized into short-term (one to three years), medium-term (three to five years), and long-term (five years and more). Different types of funds are better suited for different time frames. For example, liquid funds are better for short-term goals, hybrid funds for medium-term goals, and equity funds for long-term purposes.

There are two ways in which you can invest in a Mutual Fund: invest lump sum or take the SIP route.

1. Going all in with lump sum

If you have a sum of money you want to invest, you can put the lump sum in one go into a Mutual Fund scheme. This means you do not have to invest smaller amounts regularly. For lump sums, the minimum investment required is ₹ 100. However, this number varies depending on the investment company.

2. Going with SIP

SIPs, or Systematic Investment Plans, involve making fixed investments regularly in a Mutual Fund, eradicating the need to time the market and facilitating gradual wealth creation.You can invest in Mutual Fund plans directly without the services of intermediaries (this is called a Direct Plan) or you can invest with the help of intermediaries, such as banks or private distributors or stockbrokers (Regular Plan). If you opt for the first, you need to familiarise yourself with the market.

To invest in Mutual Funds, here are the steps you need to follow:1. Pick an Asset Management Company with a track record of delivering high dividends.2. Decide whether you want to invest a lump sum or take the SIP route. Lump sum investments offer excellent returns if the investment is made when the market is low. With SIPs, you can invest at any phase of the market's cycle.3. Visit the nearest office of your chosen AMC and find out about the different Mutual Fund schemes. You will have to decide on a scheme that is based on your financial growth goals. Alternatively, in this digital era, AMCs operate online as well, and you can sign up for a Mutual Fund scheme online.4. Submit the documentation needed. If you opt for the SIP method and do not have an account, you will have to open one. If you already have an account, you may be asked to submit your KYC and you can start the SIP immediately.5. The fund manager will handle the rest. Try to keep your money invested for long stretches and reinvest your dividends. This will help your money grow more.Also Read: Asset Manager or Fund Manager Which One Should You Pick?

Mutual Funds provide a straightforward means to achieving your financial goals. However, it is advisable to analyse the various fund options available and invest keeping your financial goals in mind. It is always better to consult a financial advisor to guide you.