what are mutual funds simple definition

what are mutual funds simple definition

There are various avenues of investment available to investors. Mutual funds also offer good investment opportunities to investors. Like all investments, they carry risks. Investors should compare the risk and expected returns after adjusting the tax on various instruments while making investment decisions. Investors can consult experts while making investment decisions.

If you are a new investor, you may be skeptical of buying stocks yourself. At such times mutual funds offer an easy way to build your portfolio, but you should know what they are before investing in them.

What are Mutual Funds

A mutual fund is an investment medium, which accumulates money from investors with common investment objectives. It then invests its money in multiple properties as per the stated objective of the scheme. The investment is made by an asset management company or AMC.

For example, an equity fund will invest in stocks and equity-related instruments, while a debt fund will invest in bonds, debentures, etc.

As an investor, you put your money into financial assets like stocks and bonds. You can do this either by buying directly or by using investment methods such as mutual funds.

In this section, we will understand mutual funds and how to trade in them. 

What is the meaning of mutual fund

A mutual fund is a professionally managed investment scheme, usually run by an asset management company that brings together a group of people and invests their money in stocks, bonds and other securities.

As an investor, you can buy mutual fund ‘units’, which basically represent your stake in a particular scheme. These units can be purchased or redeemed as required at the fund’s existing Net Asset Value (NAV). These NAVs fluctuate according to the fund’s holdings. Therefore, each investor participates proportionally in the profit or loss of the fund.

All mutual funds are registered with SEBI. They function within the provisions of strict regulations designed to protect the interests of the investor.

History of Mutual Funds in India 

A strong financial market with funds coming from retail investors is essential for a developed economy. The first mutual fund was set up in 1963 by the Unit Trust of India (UTI) on the initiative of the Government of India and RBI with a view to promote savings and investment. The share in income, profits and profits earned by UTI from acquisition, holding, management and disposal of securities was made available to retail investors.

Mutual funds in India have come a long way since 1964, when Unit Trust of India was the only player.

Phase I: In 1978, UTI was separated from RBI and IDBI took over the regulatory and administrative control of UTI. US-64 was the first scheme launched by UTI which was the best scheme of UTI for a long time. By the end of 1988, UTI had total assets of Rs 6,700 crore.

Phase II: SBI Mutual Fund was the first non-UTI mutual fund established in June 1987, followed by Can Bank Mutual Fund (December 1987), PNB Mutual Fund (August 1989), Indian Bank (November 1989), Bank of India (June 1990) and Bank of Baroda Mutual Fund (October 1992).

Phase III: The earlier Kothari Pioneer (now merged with Franklin Templeton MF) was the first private sector MF registered in July 1993. 1993 marked the beginning of a new era in the Indian MF industry when private sector mutual funds entered the fray offering Indian investors a diverse choice of MF products.

Phase IV: In February 2003, the UTI Act, 1963 was repealed and UTI was divided into two separate entities. Unit Trust of India (SUUTI) and UTI Mutual Fund which functions under SEBI MF Regulations, 1996.

Phase V since 2012: Keeping in view the lack of penetration of mutual funds, especially in tier II and tier III cities, and keeping in mind the interests of various stakeholders, SEBI initiated several positive measures to revive the sluggish Indian mutual in September 2012. To fund the industry and increase the penetration of mutual funds in the remotest corners of the country.

Today, the Indian mutual fund industry has opened up many exciting investment opportunities for investors. As a result, we have started seeing a phenomenon of savings that is now being handed over to funds rather than banks alone. Mutual funds are now perhaps one of the most sought-after investment options for most investors.

As financial markets become more sophisticated and complex, investors need a financial intermediary who can provide the necessary knowledge and professional expertise when making informed decisions. Mutual funds act as this intermediary.

Why invest in mutual funds

Investing in mutual funds offers a variety of benefits. Let’s see:

Professional Investment Management:

When you invest in mutual funds, your money is managed by professional experts. This is one of the primary benefits of investing in mutual funds. Being a full-time, high-level investment professional, a good investment manager is more resourceful and able to monitor the companies in which mutual funds have invested rather than individual investors.

Managers have real-time access to important market information and are able to execute trades on the largest and most cost-effective scale. Simply put, they have the information to trade in markets that retail investors cannot have.

Low investment limit:

A mutual fund enables you to participate in a diversified portfolio for as little as Rs 5000, and sometimes even less. And with no-load funds, you pay little or no sales fees to own them.

For example, the minimum investment amount in some bonds and fixed deposits is Rs 25,000. Instead, you can give your money to mutual funds, which in turn will invest in bonds and fixed deposits. This can be done for as little as Rs 1000.

Convenience:

Mutual funds have their own facility of investing. The additional paperwork that comes with each transaction, the amount of energy you invest in researching for stocks, as well as actual market-monitoring and transaction operations. With mutual funds, you don’t have to do anything like that.

Simply go online or place an order with your broker to buy mutual funds. Another major advantage is that you can easily transfer your funds from one fund to another within a mutual fund family. This allows you to easily rebalance your portfolio to respond to significant fund management or economic changes.

Liquidity:

In open-ended schemes, you can get your money back at any time on the prevailing NAV (Net Asset Value) from the mutual fund itself.

This makes mutual fund investments highly liquid. Compare this with fixed deposits or bonds, which can have a fixed period of investment.

Variety:

When investing in mutual funds, you have many options to choose from. You have many mutual fund schemes to choose from, which can invest in a whole range of industries and sectors, different types of assets, etc. You can find a mutual fund that matches any investment strategy you choose.

There are funds that focus on blue-chip stocks, technology stocks, bonds or a mix of stocks and bonds. In fact, the biggest challenge may be sorting out the variety and choosing the best one for you.

Transparency:

Sebi’s rules for mutual funds have made the industry very transparent. You can track the investments made on your behalf to know the sectors and stocks being invested.

In addition, you get regular information about the value of your investment. It is mandatory for mutual funds to publish the details of their portfolio regularly.

How to choose a mutual fund

Money is precious. Earned through hard work. You can’t put your money in any investment vehicle or mutual fund without doing some research.

Here are a few things to keep in mind while choosing a fund:

Previous performance:

History is important. Before investing, check the historical performance of the mutual fund scheme, investment decisions of the asset manager, fund returns, etc. While past performance is not an indicator of the future, it can help you figure out what to expect in the future.

You can understand the investment philosophy of the fund and what kind of returns are offered to investors over time. It would also be prudent to check two-year and one-year returns for consistency.

Statistics like how the fund performed in the bull and bear market in the past will help you understand the strength of the fund. Tracking the fund’s performance in the bear market is especially important because a true test of a portfolio often shows how little it falls during a recession.

Match the scheme’s risk with your profile:

Even though a mutual fund diversifies its portfolio to reduce risk, they can eventually invest in the same type of asset. The risk of the fund depends on the kind of assets invested in it. For this reason, check if the mutual fund is suited to your risk profile and investment horizon.

For example, some sector-specific schemes come with high-risk, high-return tags. If industries or sectors lose their choice of market, such schemes are prone to crash. If the investor is away from risk, he can opt for a low-risk debt scheme instead.

However, if you are a long-term investor who doesn’t mind the risk, you can go ahead with a sector-specific mutual fund scheme. For this reason, most investors prefer balanced schemes, which invest in a combination of equity and debt. They are less risky than pure equity or growth funds, which are likely to yield higher returns, but are more risky than pure debt schemes.

Diversification:

While choosing a mutual fund, one should always consider factors such as the extent of diversification that a mutual fund offers to your portfolio. A mutual fund can offer diversification either by investing in multiple assets or by balancing your overall portfolio.

For example, suppose you have 70% investment in stocks from different industries in your portfolio, then it is prudent to invest 30% in debt funds to balance the portfolio.

Similarly, if your portfolio has a lot of investment in a particular sector like IT, avoid investing in a mutual fund that also invests in IT. This way, you can balance your risk towards the same kind of risk.

Know your fund manager:

The success of a fund largely depends on the fund manager. Some of the most successful funds are run by the same managers. It would always be prudent to know about the fund manager before investing as well as about the change in the strategy of the fund manager or any other important development of the AMC.

For example, if the portfolio manager, who has generated the successful performance of the fund, is no longer managing that particular fund, you would do well to wait and analyze the advantages and disadvantages of investing in that fund.

Read the fine print:

The prospectus says a lot about the fund. Reading the fund’s prospectus is essential to know about its investment strategy and its risk. Funds with a high rate of return may have a high element of risk. Therefore, it is extremely important that an investor always chooses a particular scheme after considering his financial goals and weighs them against the risk of mutual funds.

Remember that all funds carry some level of risk. Just because a fund invests in government or corporate bonds doesn’t mean there is no risk involved.

Cost:

High-cost funds should outperform low-cost funds to generate returns for you. Even a small difference in fees can translate into a large difference in returns over time.

Therefore, make sure to match costs and returns. There is no point in spending extra if it is giving the same returns as a low-cost fund.

Patience:

Finally, an investor should not enter and exit mutual funds when the market reverses. Market cycles are natural. Have patience. Like stocks, mutual funds also pay only if you have the patience to wait. This applies to both buying and selling. Do not choose a fund just because it has shown a jump in value in the current boom.

Make sure its returns are consistent. Similarly, do not sell a mutual fund just because it is not performing well due to poor market conditions. However, there is no point in staying in a fund that lags behind the market year after year.

Basic Terms and Concepts of Mutual Funds 

As you learn and understand everything about mutual funds, you will learn about the terms and concepts of mutual funds that are specific to it. Here’s a jargon de-buster for you:

Net Asset Value:

This is probably the most important word to know about mutual funds. Net Asset Value (NAV) is important to understand the performance of a particular scheme of a mutual fund. As an investor, when you invest in mutual funds, units will be issued to you. Then you will become the unit holder. It’s like buying shareholding shares.

Mutual funds invest the money collected from investors in the securities market. In simple terms, net asset value is the market value of all securities held by the scheme. It is measured on a per unit basis. Since the market value of securities changes every day, the NAV of a scheme also changes on a day-to-day basis.

NAV is calculated by dividing the net asset by the total number of units issued. Total net assets subtract liabilities from the market value of all assets of a mutual fund, as on a given date.

For example, if the market value of securities of a mutual fund scheme is Rs 200 crore and it has issued 10 crore units to investors, the NAV of the fund is Rs 20 per unit. Mutual funds are required to disclose NAV regularly – either daily or weekly depending on the type of scheme.

Assets Under Management (AUM):

A mutual fund collects money from investors and uses this money to buy assets such as stocks, bonds and other securities. The total value of assets purchased by a fund is called Assets Under Management (AUM).

Capital Gains Distribution:

In addition to dividends, mutual funds also distribute the profits from selling certain underlying assets at higher prices. This is called capital gains distribution. It can also be used to buy more MF units (reinvestment).

Diversification:

Diversification is one of the major benefits as well as the characteristic of mutual funds. It is the practice of investing in different types of securities or asset classes. This is done to reduce the risk.

The underlying principle is that not every property moves simultaneously. Some get up, some fall together. So when you own both stocks in your portfolio, any loss from one will be zero from the profit in the other, thus reducing your overall risk.

Compounding:

When you invest in a financial asset, you earn on the amount invested. Over time, you can either reinvest this amount or put it into a bank account. Either way, you earn some amount on your current profits – either through investment returns or from bank interest. Thus, your total returns increase over time. This is called compounding. Over time, compounding can significantly increase the value of the investment.

For example, you invest Rs 1000 today and make a profit of Rs 100 from now on – a return of 10%. You decide to reinvest this amount as well. Next year, a return of 10% gives you Rs 110, not Rs 100. The higher the frequency of investment or interest payments, the greater the impact of the compound.

Depreciation:

This is a decline in the value of your investment in mutual funds. This means that you will have a capital loss when you sell a mutual fund unit. This is the exact opposite of appreciation.

 Average Portfolio Maturity:

The average maturity of all securities in a portfolio of bonds or money market funds.

Portfolio:

It is a collection of mutual funds or even assets you own as an individual. It includes all financial instruments invested such as stocks, bonds and other securities.

An expert in mutual funds handles all these assets. He also decides which property to buy and sell. This specialist is called a portfolio manager. The frequency of trading activity in a fund’s portfolio – how often assets are bought and sold – is called portfolio turnover.

Load:

This is the amount that mutual funds charge from investors for various reasons. There are different types of loads – management fee, entry or front-end load, exit load.

The amount paid to your fund manager for their expertise and portfolio management skills is called management fees.

Entry/front-end load is the amount that mutual funds charge when investors buy units. This is usually rare.

Exit load is the amount that a mutual fund charges you to sell or redeem your shares.

All these stocks usually vary from one fund to another. There are funds that do not charge any fees or loads. These are called no-load funds. MFs that charge investors are called load funds.

To compare one fund to another by how much they charge investors, expense ratios are used. It is calculated by dividing the total expenses of the fund by its total assets, which are expressed in percentage format. In addition, investors may also have to pay their brokers or sales agents a small fee called a commission.

Exchange-Traded Funds (ETF):

An exchange traded fund is an investment vehicle like a mutual fund, but is traded on stock exchanges. It typically tracks an index, a basket of assets or a commodity. Due to demand-supply forces, the value of the fund fluctuates like a stock.

Since most ETFs track a certain benchmark asset, it does not require active portfolio management services. Because of this, its charges are usually low.

Funds of Funds:

Mutual funds invest in a variety of assets such as stocks and bonds. They can also invest in mutual funds. These are called funds of funds.

New Fund Offering (NFO):

When one is listed on a stock exchange, it comes with an IPO or an initial public offering. Similarly, when a mutual fund launches a new scheme and invites investors to put in money in exchange for units, it is called new fund offering or NFO.

Redeem:

There are two ways to exit a mutual fund – sell it to another investor or return the fund. The latter is called ‘redeeming’. Once an investor redeems a lot of their MF units, the NAV of the fund changes. This is because the total number of units issued to investors varies.

Many mutual funds charge investors to exit within a certain period. This fee is deducted from the Net Asset Value (NAV) and the rest is paid to the investor. This price is called the redemption price.

Frequently Asked Questions on Mutual Funds

How many types of mutual funds are there?

There are four broad types of mutual funds: equity (stocks), fixed-income (bonds), money market funds (short-term debt), or both stocks and bonds (balloped or hybrid funds).

Are mutual funds safe?

All investments carry some risk, but mutual funds are generally considered a safer investment than buying individual stocks. Since they hold multiple company stocks within one investment, they offer more diversification than owning one or two individual shares.

Which is the safest type of mutual fund?

Bond funds are generally considered safer than equities, which also means that they often have lower returns. But they often earn higher returns than money market funds, which also invest in debt securities.

Can I ever withdraw mutual funds?

Most mutual funds are liquid investments, which means they can be withdrawn at any time. On the other hand, some funds have a lock-in period. Equity Linked Savings Scheme (ELSS), which has a maturity period of 3 years, is one such scheme.

Can I invest in cash?

Yes, mutual funds can be invested in cash up to Rs 50,000 per investor, per mutual fund, per financial year. However, any repayment (redemption/dividend) is made only through the bank channel.

How to know the performance of mutual fund schemes?

The performance of a plan is reflected in its NAV which is disclosed on a daily basis. The NAV of mutual funds is required to be published on the websites of mutual funds. All mutual funds have to put their NAV on the website of the Association of Mutual Funds in India (AMFI) www.amfiindia.com and thus investors can access the NAV of all mutual funds in one place. Also, every MF is required to have a dashboard on their website that provides performance and key disclosures related to each scheme managed by the AMC.

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