Introduction to Mutual Funds 

WHAT ARE MUTUAL FUNDS?

A mutual fund is a collective investment vehicle that collects & pools money from a number of investors and invests the same in equities, bonds, government securities, money market instruments.

The money collected in mutual fund scheme is invested by professional fund managers in stocks and bonds etc. in line with a scheme’s investment objective. The income / gains generated from this collective investment scheme are distributed proportionately amongst the investors, after deducting applicable expenses and levies, by calculating a scheme’s “Net Asset Value” or NAV. In return, mutual fund charges a small fee.

In short, mutual fund is a collective pool of money contributed by several investors and managed by a professional Fund Manager.

Mutual Funds in India are established in the form of a Trust under Indian Trust Act, 1882, in accordance with SEBI (Mutual Funds) Regulations, 1996.

The fees and expenses charged by the mutual funds to manage a scheme are regulated and are subject to the limits specified by SEBI.

How a mutual fund works?

One should avoid the temptation to review the fund's performance each time the market falls or jumps up significantly. For an actively-managed equity scheme, one must have patience and allow reasonable time - between 18 and 24 months - for the fund to generate returns in the portfolio.

When you invest in a mutual fund, you are pooling your money with many other investors. Mutual fund issues “Units” against the amount invested at the prevailing NAV. Returns from a mutual fund may include income distributions to investors out of dividends, interest, capital gains or other income earned by the mutual fund. You can also have capital gains (or losses) if you sell the mutual fund units for more (or less) than the amount you invested.

Mutual funds are ideal for investors who –

1. lack the knowledge or skill / experience of investing in stock markets directly.

2. want to grow their wealth, but do not have the inclination or time to research the stock market.

3. wish to invest only small amounts.

Why invest in Mutual Funds?

As investment goals vary from person to person – post-retirement expenses, money for children’s education or marriage, house purchase, etc. – the investment products required to achieve these goals too vary. Mutual funds provide certain distinct advantages over investing in individual securities. Mutual funds offer multiple choices for investment across equity shares, corporate bonds, government securities, and money market instruments, providing an excellent avenue for retail investors to participate and benefit from the uptrends in capital markets. The main advantages are that you can invest in a variety of securities for a relatively low cost and leave the investment decisions to a professional manager.

Source : AMFI

TYPES OF MUTUAL FUND SCHEMES

Mutual Fund Scheme classification

Mutual funds come in many varieties, designed to meet different investor goals. Mutual funds can be broadly classified based on –

1. Organisation Structure – Open ended, Close ended, Interval

2. Management of Portfolio – Actively or Passively

3. Investment Objective – Growth, Income, Liquidity

4. Underlying Portfolio – Equity, Debt, Hybrid, Money market instruments, Multi Asset

5. Thematic / solution oriented – Tax saving, Retirement benefit, Child welfare, Arbitrage

6. Exchange Traded Funds

7. Overseas funds

8. Fund of funds

Scheme Classification by Organization Structure

• Open-ended schemes are perpetual, and open for subscription and repurchase on a continuous basis on all business days at the current NAV.

• Close-ended schemes have a fixed maturity date. The units are issued at the time of the initial offer and redeemed only on maturity. The units of close-ended schemes are mandatorily listed to provide exit route before maturity and can be sold/traded on the stock exchanges.

• Interval schemes allow purchase and redemption during specified transaction periods (intervals). The transaction period has to be for a minimum of 2 days and there should be at least a 15-day gap between two transaction periods. The units of interval schemes are also mandatorily listed on the stock exchanges.

Scheme Classification by Portfolio Management

Active Funds

In an Active Fund, the Fund Manager is ‘Active’ in deciding whether to Buy, Hold, or Sell the underlying securities and in stock selection. Active funds adopt different strategies and styles to create and manage the portfolio.

• The investment strategy and style are described upfront in the Scheme Information document (offer document)

• Active funds expect to generate better returns (alpha) than the benchmark index.

• The risk and return in the fund will depend upon the strategy adopted.

• Active funds implement strategies to ‘select’ the stocks for the portfolio.

Passive Funds

Passive Funds hold a portfolio that replicates a stated Index or Benchmark e.g. –

• Index Funds

• Exchange Traded Funds (ETFs)

In a Passive Fund, the fund manager has a passive role, as the stock selection / Buy, Hold, Sell decision is driven by the Benchmark Index and the fund manager / dealer merely needs to replicate the same with minimal tracking error.

Active v/s Passive Funds

Active Fund –

• Rely on professional fund managers who manage investments.

• Aim to outperform Benchmark Index

• Suited for investors who wish to take advantage of fund managers' alpha generation potential.

Passive Funds –

• Investment holdings mirror and closely track a benchmark index, e.g., Index Funds or Exchange Traded Funds (ETFs)

• Suited for investors who want to allocate exactly as per market index.

• Lower Expense ratio hence lower costs to investors and better liquidity

Classification by Investment Objectives

Mutual funds offer products that cater to the different investment objectives of the investors such as –

1. Capital Appreciation (Growth)

2. Capital Preservation

3. Regular Income

4. Liquidity

5. Tax-Saving

Mutual funds also offer investment plans, such as Growth and Dividend options, to help tailor the investment to the investors’ needs.

Growth funds

• Growth Funds are schemes that are designed to provide capital appreciation.

• Primarily invest in growth oriented assets, such as equity

• Investment in growth-oriented funds require a medium to long-term investment horizon.

• Historically, Equity as an asset class has outperformed most other kind of investments held over the long term. However, returns from Growth funds tend to be volatile over the short-term since the prices of the underlying equity shares may change.

• Hence investors must be able to take volatility in the returns in the short-term.

Income funds

• The objective of Income Funds is to provide regular and steady income to investors.

• Income funds invest in fixed income securities such as Corporate Bonds, Debentures and Government securities.

• The fund’s return is from the interest income earned on these investments as well as capital gains from any change in the value of the securities.

• The fund will distribute the income provided the portfolio generates the required returns. There is no guarantee of income.

• The returns will depend upon the tenor and credit quality of the securities held.

Liquid / Overnight /Money Market Mutual Funds

• Liquid Schemes, Overnight Funds and Money market mutual fund are investment options for investors seeking liquidity and principal protection, with commensurate returns.
  – The funds invest in money market instruments* with maturities not exceeding 91 days.
  – The return from the funds will depend upon the short-term interest rate prevalent in the market.

• These are ideal for investors who wish to park their surplus funds for short periods.
  – Investors who use these funds for longer holding periods may be sacrificing better returns possible from products suitable for a longer holding period.
  
  * Money Market Instruments includes commercial papers, commercial bills, treasury bills, Government securities having an unexpired maturity up to one year, call or notice money, certificate of deposit, usance bills, and any other like instruments as specified by the Reserve Bank of India from time to time.

Classification by Investment Portfolio

• Mutual fund products can be classified based on their underlying portfolio composition
  – The first level of categorization will be on the basis of the asset class the fund invests in, such as equity / debt / money market instruments or gold.
  – The second level of categorization is on the basis of strategies and styles used to create the portfolio, such as, Income fund, Dynamic Bond Fund, Infrastructure fund, Large-cap/Mid-cap/Small-cap Equity fund, Value fund, etc.
  – The portfolio composition flows out of the investment objectives of the scheme.

Source : AMFI

Advantages of investing in Mutual Funds

1. Professional Management — Investors may not have the time or the required knowledge and resources to conduct their research and purchase individual stocks or bonds. A mutual fund is managed by full-time, professional money managers who have the expertise, experience and resources to actively buy, sell, and monitor investments. A fund manager continuously monitors investments and rebalances the portfolio accordingly to meet the scheme’s objectives. Portfolio management by professional fund managers is one of the most important advantages of a mutual fund.

2. Risk Diversification — Buying shares in a mutual fund is an easy way to diversify your investments across many securities and asset categories such as equity, debt and gold, which helps in spreading the risk - so you won't have all your eggs in one basket. This proves to be beneficial when an underlying security of a given mutual fund scheme experiences market headwinds. With diversification, the risk associated with one asset class is countered by the others. Even if one investment in the portfolio decreases in value, other investments may not be impacted and may even increase in value. In other words, you don’t lose out on the entire value of your investment if a particular component of your portfolio goes through a turbulent period. Thus, risk diversification is one of the most prominent advantages of investing in mutual funds.

3. Affordability & Convenience (Invest Small Amounts) — For many investors, it could be more costly to directly purchase all of the individual securities held by a single mutual fund. By contrast, the minimum initial investments for most mutual funds are more affordable.

4. Liquidity — You can easily redeem (liquidate) units of open ended mutual fund schemes to meet your financial needs on any business day (when the stock markets and/or banks are open), so you have easy access to your money. Upon redemption, the redemption amount is credited in your bank account within one day to 3-4 days, depending upon the type of scheme e.g., in respect of Liquid Funds and Overnight Funds, the redemption amount is paid out the next business day.

However, please note that units of close-ended mutual fund schemes can be redeemed only on maturity. Likewise, units of ELSS have a 3-year lock-in period and can be liquidated only thereafter.

5. Low Cost — An important advantage of mutual funds is their low cost. Due to huge economies of scale, mutual funds schemes have a low expense ratio. Expense ratio represents the annual fund operating expenses of a scheme, expressed as a percentage of the fund’s daily net assets. Operating expenses of a scheme are administration, management, advertising related expenses, etc. The limits of expense ratio for various types of schemes has been specified under Regulation 52 of SEBI Mutual Fund Regulations, 1996.

6. Well-Regulated — Mutual Funds are regulated by the capital markets regulator, Securities and Exchange Board of India (SEBI) under SEBI (Mutual Funds) Regulations, 1996. SEBI has laid down stringent rules and regulations keeping investor protection, transparency with appropriate risk mitigation framework and fair valuation principles.

7. Tax Benefits —Investment in ELSS upto ₹1,50,000 qualifies for tax benefit under section 80C of the Income Tax Act, 1961. Mutual Fund investments when held for a longer term are tax efficient.

Source : AMFI

Disclaimer :

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. The NAVs of the schemes may go up or down depending upon the factors and forces affecting the securities market including the fluctuations in the interest rates. The past performance of the mutual funds is not necessarily indicative of future performance of the schemes.