Funds Ka Funda: What Are Mutual Funds? How Do They Work?
Tanya was elated. She had just received her first paycheck, and her first thought was to blow it up on one big party for all her friends and family! Her indulgent father was all for it – after all, it’s not every day that a girl gets her first paycheck!
But then, he counselled her: “From next month onwards Tanya, you should start investing money.” That kind of floored Tanya, because she’d never thought of saving or investing, and hadn’t had the faintest idea of where to begin. She’d vaguely heard of something called mutual funds, but she was clueless about how to get started. So, let’s help Tanya understand what is a mutual fund? And how mutual funds work.
Getting the Basics Right: Mutual Funds Definition
Pool of Investment: Mutual funds are a pool of investments in stocks, bonds, and other securities, or a mix of them. You could think of a mutual fund as a cooperative of investors getting together to invest in something.
Kinds of Mutual Funds: The biggest misconception that Tanya had about mutual funds was that they invested only in stocks and shares. Not true. Mutual funds can invest in a variety of instruments, including equity and fixed income instruments. Even within equity and debt funds, there are many options.
|Fund Objective||Portfolio Composition|
|Growth - primarily equities||Stocks|
|Income - primarily debt||Debt-oriented fixed-income|
|Money Market (including Gilt funds)||Short-term money market instruments (including government securities)|
|Balanced/Hybrid||Combination of debt and equity, to balance risks and rewards|
Growth funds are primarily equity-oriented and tend to be the riskiest. That’s because the underlying securities are sensitive to stock market movements.
Debt funds are not as risky as equity funds. However, they’re not risk free and are susceptible risks like interest-rate risks.
Professional Management: Mutual funds are offered to the public by fund houses, or Asset Management Companies, or AMCs. They hire fund managers, who have the experience and expertise to maximise returns for investors.
Regulation: All AMCs have to be registered with SEBI (Securities and Exchange Board of India). SEBI protects the interests of investors like Tanya and sees that AMCs are transparent and follow the rules.
So, now that you know what are mutual funds, let’s understand some of the investment lingo.
Getting to Know Mutual Funds Lingo
Return on Investment: When you invest, you expect it to grow. Returns on investment (or just returns) show you how much your initial capital has appreciated. At 12% returns a year, an investment of Rs 10,000, would get you profits of Rs 1200 in the first year of investment.
Net Asset Value (NAV): The Net Asset Value is the current price of one unit of a mutual fund. It is calculated at the end of each working day. NAV is the value of all assets under management minus expenses and divided by the number of mutual fund units held by investors. Mutual fund units are bought and sold at the NAV. If the NAV of a fund is Rs 10, then an investment of Rs 10000 would fetch you 1000 units.
Redemption: When you exit from a fund, it means you’re redeeming the units. You can redeem funds at any point. Some funds, like ELSS funds, have a lock-in period of three years during which you cannot redeem. When you apply for redemption, your units are sold at the prevailing NAV, and the money is credited to your account in 48 hours to a week depending on the AMC.
Expense Ratio: This is the fees charged by AMCs to manage your fund. The ratio includes fees charged for buying and selling mutual fund units. It also considers expenses for managing the underlying assets. Expense ratios will affect the returns that you make, so make sure you find out what they are for the fund you want to invest in.
Open-ended Funds: Allows buying and selling of mutual fund units at any time. Most funds are open-ended.
Close-ended Funds: These are offered for a limited period after which they are listed on an exchange, and investors can buy/sell on the exchange. The funds have a fixed period and cannot be redeemed before then.
How Mutual Funds Work
You’ve seen what mutual funds are and the various terms associated with it. The final part of this article is about how mutual funds work. Here’s a summary:
- Mutual funds invest in debt, equities, or both.
- A fund’s value is determined through its NAV, which changes by the day.
- Returns and risk are different for various fund types.
- Debt-oriented funds are considered less risky and are ideal for short term investments but they also offer lower returns.
- Equity funds give higher return in the long term but are riskier.
- Balanced funds invest in both debt and equity and are for those who don’t want to take too much risk but want higher returns than pure debt funds.
- Debt funds are not risk free and are subject to risks like interest rate risk.
- Equity funds are affected by stock market movements.
Before you invest in any scheme, you must understand the risk and rewards of investing in mutual funds. This helps you decide whether to maximise profits by taking a higher risk or protect your investment by going for average returns.
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Read up more on Mutual Funds here
Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing.