Mutual fund is a pool of fund from various investors with a common investment objective and is managed by an investment professional, who invests in different asset classes to meet the investment objectives.
Mutual fund constructs multiple schemes with different investment objectives in order to cater to investors with discrete investment objectives. Thereby, investors should invest in mutual fund schemes which align to their investment objectives.
The primary aim of a mutual fund scheme is to create wealth or earn income by investing in diverse assets.
How Mutual Funds schemes work?
Mutual Funds announce mutual fund schemes with definite investment objectives and seek investment from the investors. Investors invest in the mutual funds schemes which are in line with their investment objectives.
When a mutual fund scheme is made available for the first time to investors for investment, it is called ‘New Fund Offer’ (NFO). In an NFO, investors can buy the units at face value. Thereafter, investors have to buy units at a price called ‘Net Asset Value (NAV).
Net Asset Value (NAV) of FUND
The Net Asset Value is the worth of each unit in mutual fund scheme as of any particular date. It is calculated as:
(Value of all investments and cash less the expenses and fund management fees) ÷ (Number of units issued by the mutual fund)
Advantages of Mutual Fund Investments
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Professional fund managers have good knowledge of the investment domain and have better access to research materials about the market and companies. The fund manager’s objective is to invest according to investment objectives and generate returns exceeding the benchmark.
Risk reduction via diversification
Mutual funds allow an investor to diversify across securities. Since prices of securities move independent of each other, owning to a wide set of securities in a mutual fund lowers investment risk.
Redemption request in equity and debt funds, if received before 3 pm, gets processed the very same day, with funds credited into your account usually in T+3 days.. This shows liquidly won’t be an issue if invested in a Mutual Fund as compared to investing directly. For example, selling a thinly traded stock is difficult, but an investor can exit a MF even if the fund is holding the same scrip.
Mutual Funds are governed by Securities & Exchange Board of India (SEBI). SEBI is legally bound to disclose financial statements and fund performance details. You can check the latest fund related info, portfolio performance and returns chart in the monthly disclosure document, known as factsheet.
An individual investor will incur cost in accessing information and conducting her own research before making an investment decision. A mutual fund spreads its cost over large volume of transactions thus lowering the cost for an individual investor.
An investor with a small sum to invest will not be able to diversify adequately. However, the investor can still enjoy the benefits of low risk via diversification in a mutual fund.
Types of Funds
Open-Ended Funds, Close-Ended Funds and Interval Funds
Open-ended means one can enter and exit the fund anytime, at daily NAV, subject to exit load at the time of withdrawal, if applicable. For example, you can exit from equity funds, which are essentially long-term products, within 6 months.
Certain funds take a long-term approach and restrict withdrawal to avoid volatility caused by huge redemptions. Such funds are close-ended funds, say for 3 or 5 years. This means, on expiry of the term, the portfolio is liquidated and the funds are distributed. Typically, there is liquidity as these funds are listed on the exchanges where one can sell units to another investor only. List price is generally lower than the NAV.
To get the liquidity feature in close-ended funds, there is another category called ‘interval’ funds. Essentially, these are close-ended funds that become open to transactions during preset interval periods, for instance, first 5 days of every quarter.
Active Funds and Passive Funds
The fund manager in an actively managed fund picks stocks based on his expert view on the market, sector and company. As fund managers tend to buy and sell securities actively, the expense ratio of the scheme is also higher. Investors expect actively managed funds to outperform the broader market.
passively managed fund also known as an index fund, mirrors market indices such as the S&P BSE Sensex (an index of the 30 largest companies in India) or the CNX Nifty (an index of the 50 largest companies in India). Since passive funds don’t need research for stock selection, the expenses in such funds are lower than in actively managed funds.
Debt, Equity and Hybrid Funds
Debt funds primarily invest in fixed income securities like corporate bonds, G-Sec, T-bill, NCDs etc. Debt funds are categorized based on the length of the investment horizon —liquid/money market funds have the shortest horizon, short term funds have a horizon of 6-12 months and long term funds have a horizon greater than 1 year. Investors also have the choice of fixed maturity plans (FMP) that have a fixed tenor wherein investors are locked in till maturity but have the benefit of capital protection
Types of Debt Funds:
Liquid/money market funds
These funds provide liquidity at a day’s notice. The money is invested in treasury bills, call and money market instruments that are maturing in 91 days. The returns of liquid funds are typically lower, as compared to funds that have a longer investment horizon.
Ultra Short Term/Short Term Funds
Investors with investment horizon of 6 months to 1 year can choose ultra short term/short term funds (USTs). The maturity of money market instruments in ultra short term funds is higher than the liquid funds so the return is also marginally higher.
Income funds invest in a mix of government and corporate fixed income securities such as bonds, debentures and commercial papers.
Gilts funds invest only in government securities like treasury bills and government bonds. These funds are considered to have no credit risk since government securities are considered to be risk free.
Fixed Maturity Plans (FMPs)
Fixed Maturity Plans have fixed tenure ranging from 3 months to 5 years. The maturities of debt investments are closely aligned with the tenure of a FMP. Since FMPs are close-ended schemes, investors can only invest during the NFO period. Investors who have fixed time horizon and low risk appetite prefer to invest in FMPs.
A diversified equity fund invests across sectors and company size whereas a focused fund invests in companies in one sector or those that fit in a narrow theme. A large cap fund invests in the largest companies by market capitalization (number of shares issued x current share price), while mid-cap and small-cap funds invest in progressively smaller companies. A growth fund buys stocks that grow faster than the industry average, while a value fund buys stocks that are available cheaper than its fair value.
Types of Equity Funds:
Large-Cap Equity Funds
Typically, large-cap funds invest in top 100 stocks, as per the market capitalization. These are the most liquid, big companies, possibly market leaders in their respective sectors. Certain funds may maintain sector weights similar to market indices – CNX Nifty or S&P BSE 100, whereas, others may be sector agnostic and just pick up the best large cap companies out of the available universe.
Mid-Cap Equity Funds
Mid-cap funds invest in emerging companies with market capitalization that is lower than large-caps. Since these companies are not often tracked by market analysts, mid and small cap stocks require more research and in-depth analysis to identify the best from the rest. Since mid-cap funds are more popular than large-caps during market downturn, one needs to have a long-term horizon for superior risk adjusted returns.
Small/Micro Cap Equity Funds
Small/Micro funds invest in small companies with market capitalization that is lower than mid-caps. Small-cap stocks require in-depth research and analysis to identify the best from the wide-array of stocks. Since small cap funds are popular during market downturn, one need to have a long-term horizon for superior risk adjusted returns.
Equity Linked Savings Schemes (ELSS)
Equity linked savings schemes are diversified equity funds that have a 3-year lock in period. These funds offer tax benefits upto Rs 1.50 lakh under Section 80 C of Income Tax Act.
Arbitrage Funds invest in the arbitrage opportunities available in the cash market and the futures and options market in such a way that the risk is neutral. However, the expected returns are in line with liquid funds.
Types of Hybrid Funds
Monthly Income Plan (MIPs)
MIPs invest a large portion of AUM in debt securities for regular income and a small portion in equity market to generate higher returns.
Balanced funds are those funds which invest a significant portion in debt securities and equity market. If a balanced fund has allocated more than 65% of its AUM to equity and equity-related instruments, and rest in fixed income securities, it is called ‘Equity-oriented Balanced Fund’. On the other hand if its investment in equities is less than 65% then it is called ‘Debt-oriented Balanced Fund’.
Capital Protected Schemes
Capital Protected Schemes are close-ended schemes, which are structured in such a way that ensures investors get their invested capital back. Some of these funds are also launched as Asset Allocation Fund. It is advisable that an investor goes through the Scheme Information Document to understand the unique characteristics of the schemes.
Other Type of Funds
Commodity funds invest in commodities like gold, silver, copper, aluminum, energy products, grains and pulses. A commodity fund ideally describes in which commodity it is investing. In India, mutual funds are not permitted to invest in commodity other than gold.
If an investor wants to diversify across geographies, one has the choice of international funds. These global funds might focus on a single country, such as the US or China, or a single region, such as Eurozone or Emerging Markets.
Exchange Traded Funds (ETF)
ETFs are open-ended funds, whose units’ trade on stock exchanges like stocks. This feature allows investors to buy and sell ETF units on exchanges. Since the ETFs trade on exchanges their trade price may differ from their intrinsic value i.e. NAV.
Fund of Funds
Fund of Funds invest in another pre-specified mutual fund schemes. They are designed to facilitate investors to invest in multiple schemes via a single scheme.
- Mutual fund is a pool of fund from various investors with a common investment objective and is managed by an investment professional, who invests in different asset classes to meet the investment objectives.
- The Net Asset Value is value of all investments and cash less the expenses and fund management fees) ÷ (Number of units issued by the mutual fund
- Advantages of Mutual Fund Investments - Professional Management, Diversification, Liquidity, Transparency, Low Cost and Flexibility
- Types of Funds - Open-Ended Funds, Close-Ended Funds and Interval Funds; Active Funds and Passive Funds; Debt, Equity and Hybrid Funds
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