What are Mutual Funds? How it Works, Meaning, Benefits & Types

“Mutual Funds Sahi Hai” ” Mutual Fund investments are subject to market risks. Read all the scheme related documents carefully. “ We all regularly come across advertisements like these while traveling, watching tv or working. But we never really stop to think, what investing in Mutual Funds could be like. In fact, many of us are even somewhat invested in mutual funds but have no idea as to what these funds are doing for us. So, let’s look at the ‘whats?’ and ‘hows?’  of Mutual Funds in the following article.

Simply put, a Mutual Fund is a pool of money managed by a professional that invests in various assets like equity, debt, gold, and other assets primarily with an objective to generate returns on the investments. Let us now understand the concept of Mutual Funds with a simple analogy.

Carpooling - An Analogy

Let’s assume that there are 3 people who commute regularly from their homes to their respective offices. Initially, each of them used to travel separately on their two-wheeler. But the distance of their daily journey was so long that driving the two-wheeler by themselves was too tiring for them. Travelling by car all by themselves was not a choice as none of them could afford the increased cost of the commute.A cab-hailing company recently started carpooling service in their city and hence they decided to give it a try. Now, as it is a pooling service, the cost of it would definitely be lower than the regular cost of travel in a cab. Plus, none of them has to drive the car as the driver would be driving it. Also, each of them must pay only for the distance they travel I.e., the person with a shorter distance has to pay a low fare compared to the person with a longer distance. Hence the cost gets proportionately divided based on the distance of their commute.Now just take a step back and understand the same example from the perspective of an investor who wants to invest in an asset that he can’t afford to invest in them single-handedly. A Mutual Fund can be compared with the cab-hailing company here as they pool the money of such investors who want to invest in such assets but with a low ticket. The driver in the example can be compared with the fund manager of the . He is the professional who takes the responsibility to invest the investor’s money at a place where the objectives of the investors and the mutual fund can be achieved. And just like the distance of their commute decides their cost, here in mutual funds, the amount of their investment decides their share in the profits/ income of the scheme.To summarise, a Mutual Fund is an investment vehicle that pools the investor's money and invests it in different assets under the supervision of a fund manager. The fund manager is the one who oversees the fund and is responsible to invest the pool in such a way that the objectives of the investors and the fund are achieved.

Now we already know what Mutual Fund is but one important thing you should know is that not anyone can start a mutual fund scheme. Companies that want to start a mutual fund need to qualify based on certain criteria of SEBI and AMFI (Association of Mutual Funds of India) and then they can form an AMCs (Asset Management Companies). These AMCs, in turn, create a Mutual Fund scheme in the form of a trust and appoint a fund manager with the necessary expertise in managing investments. This trust then collects the investor’s money with similar objectives and pools them to make investments on their behalf based on the risk and objective of the fund.The investors are given units based on the amount of their investment and the NAV of the fund. NAV or Net Asset Value is the market value of the total assets of the fund less the expenses and the liabilities of the fund divided by the total units in the fund. So, for example if the net assets (total assets less the expenses and the liabilities) of the fund are valued at Rs. 1000 Crore and the total outstanding unit of the fund is 10 Crore then the NAV of the fund is Rs.100. NAV is the price at which an investor invests or redeems their investment in the mutual fund.For example, if a person invested Rs. 1,00,000/- in a mutual fund scheme with a NAV of Rs. 100, then the person will get 1000 units of the mutual fund scheme. And as the fund NAV grows, the investment of the person will also grow. You can read about NAV in detail here.Mutual Funds are one of the best solutions for those investors who don’t have large sums to invest but want to invest in multiple assets, or for those who don’t have the time or the required expertise to analyse, and research the ideal investment options for their wealth.Mutual Funds fits right into this need and offer low ticket investments with the oversight of a professional fund manager who will do all the needful analysis and research and invest the investor’s money according to the objectives of the fund. The AMC charges a fixed fee for the services offered and the expenses made towards managing the fund. This fee is a fixed percentage charged over the fund’s total assets called as Total Expense Ratio (TER).You might also wonder that not all the investors have the same objective. An Investor can have various objectives to invest like investing for wealth creation, children’s education, retirement planning, vacation expenses, etc. So, with different objectives, investment style, horizon as well as risk also differs. And for that, there are various types of Mutual Funds categorised into different types of schemes to allow the investor to choose mutual fund schemes as per their needs and risk profile. Let’s take a look at the broad types of Mutual Funds.Also Read: How Mutual Funds Work?

Categories based on the structure

1. Open-Ended Mutual Fund

Open-ended mutual funds are mutual funds that allow investors to invest and redeem from the scheme at any given point of time. Such funds are perpetual in nature and hence an investor can invest in it any time. They are also liquid and allow investors to exit the fund anytime. However, some exit loads may apply based on the duration of investment.

2. Close-Ended Mutual Fund

Close-ended mutual funds on the other hand are funds that are open for investment only for a certain duration. Also, redemption is allowed only on the maturity of the fund and not at any given point of time. The subscription period and the maturity is pre-defined and hence investors can decide whether to invest or not.

3. Active Mutual Funds

Active Mutual Funds are mutual funds that are ‘Actively Managed’ by a fund manager who has the authority to analyse, research and monitor the fund and invest /hold /redeem the fund money in assets based on his outlook. The fund manager must follow the objectives of the fund and invest the money based on his research and analysis. Here, the fund managers work to generate maximum returns and to out-perform the fund’s benchmark.

4. Passive Mutual Funds

Passive Mutual Funds are mutual funds that follow a certain index called a benchmark index and invest in assets with similar proportions of the benchmark. Here the fund manager rather follows a passive approach and tries to replicate the benchmark index. The fund manager doesn’t have the authority to invest, hold, or redeem as per his judgement but to simply do what the benchmark does and generate similar returns to the benchmark index. Even outperforming the benchmark index is looked at as a negative sign.Also Read: Types of Mutual Funds & How to Invest in them?

1. Equity Mutual Funds

Equity Mutual Funds as the name suggests invest in equities. Such funds, as mandated by SEBI must invest at least 65% of their fund assets in listed equity. These funds aim to generate high returns for the investors and hence are highly risky in nature. Investors investing in equity mutual funds typically have a long-term horizon (usually 5+ years) to tackle the risk and volatility.Within the equity mutual funds, there are various types of funds based on the equities that they invest in. Some examples are Large Cap Mutual Funds, Mid Cap Mutual Funds, Small Cap Mutual Funds, Multi-Cap Mutual Funds, Flexi-Cap Mutual Funds, ELSS Mutual Funds (Tax-Saver Mutual Funds), Index Funds, etc.

2. Debt Mutual Funds

Debt Mutual Funds are funds that primarily invest in fixed income and money market instruments like G-Secs, Corporate Bonds and any other debt assets. Such funds invest in these assets to generate stable returns with moderate to low risk. Hence, investors with a short to medium term horizon prefer debt mutual funds over equity mutual funds. Debt Mutual Funds are also further categorised into different types based on the investing style and maturity of the securities they hold. Some common debt mutual fund types are Overnight Funds, Liquid Funds, Short Term Funds, Arbitrage Funds, Gilt Funds, Money Market Funds, Medium Term Funds, Banking and PSU Funds, Long Term Funds, etc.

3. Hybrid Mutual Funds

Such funds invest in equity and in debt based on the objective and risk of the fund. Some funds also invest in other assets like gold to add the benefit of diversification. Investors that want a bit of equity and high returns and a bit of debt and stable returns invest in such funds. Some common type of hybrid mutual funds are Aggressive Hybrid Funds, Conservative Hybrid Funds, Balance Advantage Funds, Multi Asset Funds, etc.

Link Also Read: Debt Funds: Meaning, Types, Benefits, Taxation Explained

Investing in Mutual Funds is really easy. You can also do it by yourself. If you are doing it for the first time, you need to complete your KYC by giving your details like PAN, identity proof and address proof and become KYC compliant. Then you simply need to visit the website of any AMC you want to invest with and follow the steps. Alternatively, you can also visit the office of the AMC or any intermediary and submit all required documents along with the cheque for your investment and you are good to go.

There are basically two ways to invest in a Mutual Fund.

1. Lump Sum Investment

When you invest an amount (significant or small) in a mutual fund at one go, this is called lump sum investment. For example, if you invest Rs. 10,000 in a mutual fund at one go rather than dividing that amount into smaller chunks and investing it periodically, you make a lump sum investment. Lump sum investment is usually made by investors who don’t have a fixed pattern of investment and wants to invest as and when they want to.

2. Systematic Investment Plan (SIP)

When you invest a fixed amount (small or big) in a mutual fund at regular intervals, you invest via SIP. For example, if you invest Rs. 1,000 every month in a mutual fund, it is called a Systematic Investment Plan . This way of investing allows an investor to invest in all cycles of the economy. The NAV that they get also gets averaged out through all the cycles. Such type of investment is made by investors who want to invest small chunks regularly without timing the market cycles. Final word Now that you know what Mutual Funds are and how do they function, it would be much easier for you to learn about them in detail before starting to invest in them. Mutual Funds offer the investors a solution to invest in assets with a ticket they might not be able to invest in them directly.