Mutual fund introduction

The world of finance can be intimidating, but mutual funds are a powerful tool that can help you reach your financial goals. This introduction will give you a clear understanding of what mutual funds are and how they can benefit you.

Imagine a basket filled with different colored eggs. Each egg represents an investment, like a stock or bond. A mutual fund is like a bigger basket that holds a collection of these eggs, carefully chosen by a professional.

Benefits of Mutual Funds:

• Diversification: By holding a variety of investments, mutual funds spread your risk. Even if some investments perform poorly, others may balance it out.
• Convenience: You don’t need to research and pick individual stocks or bonds. The fund manager does the heavy lifting.
• Accessibility: Mutual funds allow you to invest with smaller amounts, making them a good option for beginners.
• Potential for Growth: The stock market has a history of offering good returns over time, and mutual funds can provide access to this growth potential.

How mutual fund work

• Pooling Money: Many investors contribute money to the mutual fund, creating a larger pool of capital.
• Professional Management: A fund manager, with expertise in the financial market, selects the investments that go into the basket (the mutual fund). Their goal is to achieve the fund’s specific objectives, such as growth or income generation.
• Shared Ownership: Each investor owns a share of the mutual fund, which represents their portion of the overall holdings.

Types of mutual funds

Organizational structure

Open-Ended Funds:

These are the most common type. They continuously issue new shares and redeem existing ones at the Net Asset Value (NAV) on all business days. This means you can easily enter or exit your investment whenever you want.

Closed-Ended Funds:

These funds raise a fixed amount of capital through an initial public offering (IPO) and have a fixed lifespan. They trade on stock exchanges like individual stocks, and their market price can fluctuate above or below the NAV. You cannot redeem your shares directly from the fund house, but you can sell them on the stock exchange.

Interval Funds:

These are a hybrid between open-ended and closed-ended funds. They offer limited redemption windows (typically a few days every quarter or year) where investors can buy or sell their shares at the NAV. This structure provides some liquidity while maintaining a more stable investor base compared to open-ended funds.

Based on how their portfolios are managed:

Actively Managed Funds:

• In actively managed funds, a fund manager plays a central role. These managers are financial professionals who research and select investments based on their analysis and market outlook.
• The goal of an active manager is to outperform a chosen benchmark index, like the S&P 500. They achieve this by strategically buying and selling securities within the fund.
• Actively managed funds tend to have higher expense ratios (fees) due to the costs associated with research and management.

Passively Managed Funds (Index Funds):

• Passively managed funds, also known as index funds, don’t involve active selection of securities.
• Instead, they aim to replicate the performance of a particular market index. For example, an S&P 500 index fund will hold the same stocks as the S&P 500 index, in the same proportions.
• Since there’s no need for extensive research and management, passively managed funds typically have lower expense ratios compared to actively managed funds.

Here’s a table summarizing the key differences:

Mutual Funds by Investment Objective

Mutual funds come in a variety of flavors, each catering to different investment goals. Here’s a breakdown of some popular types based on what you aim to achieve:

Growth Funds:

These funds prioritize capital appreciation for the long term. They invest heavily in stocks with the potential for high growth, but also carry higher risk.

Income Funds:

Looking for regular income? Income funds focus on investments that generate steady pay-outs, like bonds and dividend-paying stocks. While offering lower growth potential, they provide stability and predictability.

Liquid Funds:

Need easy access to your money? Liquid funds invest in ultra-short-term debt instruments (usually maturing within 91 days) and offer high liquidity with low volatility, making them ideal for short-term goals or emergency funds.

Tax-Saving Funds (ELSS):

These equity-linked saving schemes offer tax benefits along with capital growth potential. They come with a mandatory lock-in period of 3 years.

Balanced Funds (Hybrid Funds):

These combine stocks and bonds in varying proportions, offering a balance between growth potential and income generation. The risk profile depends on the specific asset allocation of the fund.

Aggressive Growth Funds:

As the name suggests, these funds aim for maximum capital appreciation by investing in high-growth stocks. However, they come with significantly higher risk and volatility.

Capital Protection Funds:

These funds prioritize protecting your principal investment while offering some potential for moderate returns. They typically invest in a mix of debt and low-risk equity instruments.

Pension Funds:

Designed for retirement planning, these funds invest with a long-term horizon, aiming to provide a steady income stream throughout your retirement years.

Mutual Funds: Unveiling the Underlying Assets

Equity Funds:

These funds primarily invest in stocks of companies. They offer the potential for high returns but also carry higher risk due to stock market fluctuations. Examples include large-cap funds (investing in big, established companies), mid-cap funds (focusing on medium-sized companies), and small-cap funds (investing in smaller companies with higher growth potential).

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Debt Funds:

These funds invest in fixed-income securities like government bonds, corporate bonds, and treasury bills. They offer lower risk and steadier returns compared to equity funds, making them suitable for income generation or short-term goals. Examples include income funds (investing in bonds for regular income payouts) and fixed maturity plans (investing in bonds with a specific maturity date).

Hybrid Funds:

As the name suggests, these funds are a hybrid of equity and debt investments. They offer a balance between risk and return, depending on the weightage given to each asset class. Examples include balanced hybrid funds (with a balanced mix of equity and debt) and aggressive hybrid funds (with a higher allocation to equity for potentially higher returns).

Money Market Funds:

These funds invest in highly liquid and short-term debt instruments like treasury bills and certificates of deposit. They offer minimal risk and low returns but provide easy access to your cash and ensure high liquidity.

Multi-Asset Funds:

These funds, as the name suggests, invest across various asset classes like equity, debt, and even real estate investment trusts (REITs). They offer diversification and cater to investors seeking a one-stop solution for their asset allocation needs.

Thematic & Solution-oriented

Thematic Mutual Funds:

These funds invest in companies or sectors based on a particular theme, like:

• Clean Energy: Companies focused on renewable energy sources like solar or wind power.
• Healthcare: Businesses involved in pharmaceuticals, medical devices, or biotechnology.
• Technology: Companies at the forefront of technological advancements.

Thematic funds can offer concentrated exposure to a growing industry, but also carry higher risk due to their narrow focus.

Solution-oriented Mutual Funds:

These funds are designed to help you achieve specific financial goals, such as:

• Retirement Planning: Invest in a mix of assets with a focus on long-term growth, gradually becoming more conservative as you near retirement.
• Children’s Education: Focus on capital appreciation to build a corpus for your child’s future educational needs.
• Wealth Creation: Invest aggressively in growth-oriented assets for long-term wealth accumulation.

Overseas funds

Global Funds:

These funds offer the broadest international exposure, investing in stocks and bonds from developed and emerging markets worldwide. They are like a one-stop shop for international diversification.

Regional Funds:

As the name suggests, regional funds focus on a specific geographical area, like Europe or Asia. This allows you to target specific regions with high-growth potential or economies you’re interested in.

Country Funds:

These funds concentrate their investments in a single country, like China or the United States. This offers the most focused exposure to a particular market’s potential, but also carries the highest concentration risk.

International Bond Funds:

While less common, some mutual funds focus on international bonds. These can provide diversification within your fixed-income portfolio and potentially offer exposure to different currencies.

Global Sector Funds:

These funds invest in companies from all over the world but within a specific sector, like technology or healthcare. This allows you to combine international exposure with your interest in a particular industry’s growth potential.

NAV: The Price Tag of Your Mutual Fund

Imagine a mutual fund like a big basket holding all the investments it owns (stocks, bonds, etc.). The Net Asset Value (NAV), in a nutshell, tells you the price of that basket on any given day.

Here’s a breakdown:

• NAV stands for Net Asset Value.
• It represents the per-unit market value of a mutual fund scheme.
• Calculated by: Total value of fund’s assets (minus liabilities) divided by the number of outstanding shares.
• NAV fluctuates daily based on the performance of the underlying investments.
• You buy and sell mutual fund units at the NAV price.

Think of it this way: If the basket’s contents become more valuable (stock prices go up), the NAV increases. Conversely, if the value of the holdings drops, the NAV falls.

NAV is crucial because:

• It reflects the intrinsic value of the mutual fund.
• It helps you understand how much your investment is worth on a particular day.

However, remember:

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• The NAV you see is typically the previous day’s closing value.
• The actual purchase or redemption price might differ slightly due to additional charges.

Understanding Expense Ratio in Mutual Funds

Think of the expense ratio as the annual cost of managing your mutual fund investment. It’s a percentage of the fund’s total assets under management (AUM) that covers the fees associated with running the fund. These fees can include:

• Management Fees: Paid to the fund manager for their expertise in selecting and overseeing investments.
• Administrative Fees: Costs associated with operating the fund, like recordkeeping and legal fees.
• Other Expenses: Marketing, distribution costs, and any other operational expenses.

Why Expense Ratio Matters:

The expense ratio directly impacts your potential returns. A higher expense ratio means a larger chunk of your investment is used to cover fees, leaving less for growth. While a low expense ratio is generally desirable, it’s not the only factor to consider when choosing a fund.

Investment types

SIP: Invest Small, Win Big

Imagine turning a cup of coffee every month into a pot of gold over time. That’s the magic of Systematic Investment Plans (SIPs)! Let’s see how a small monthly investment can blossom into a significant amount over the long term.

Systematic Investment Plan (SIP) is a popular method for investing in mutual funds. It allows you to invest a fixed amount of money, like ₹500 or ₹1000, at regular intervals (monthly, quarterly, etc.). It’s like a recurring deposit for mutual funds, but with the potential for higher returns.

Why SIPs are Important:

Discipline: SIP enforces a habit of regular saving and investing, regardless of market conditions.

Rupee-Cost Averaging: Over time, you purchase units at different NAVs (Net Asset Value). This helps average out the cost per unit, potentially benefiting from market fluctuations.

Low Investment Threshold: SIPs allow you to start with small amounts, making them accessible to almost everyone.

Compounding: Reinvesting your earnings over time allows your money to grow exponentially, boosting your wealth creation.

Building Wealth with SIPs:

Let’s say you start an SIP with a monthly contribution of Rs. 5,000. Now, while predicting future returns is tricky, for this example, let’s assume an annual return of 12% (remember, historical performance is not a guarantee of future results). You plan to stay invested for a long period – 30 years!

The Math Behind the Magic:

There are online SIP calculators available, but here’s a simplified way to understand the potential:

• Total Investment: Monthly investment (Rs. 5,000) x Number of months (12 months/year x 30 years) = Rs. 18,00,000. In simpler terms, this is the total amount you would have invested over 30 years.
• Power of Compounding: Over these years, your investment earns returns, and those returns themselves start earning returns (compounding). This accelerates the growth significantly.

The Grand Result:

While actual returns may vary, an SIP calculator with the above assumptions might show an end value close to Rs. 2.38 crore! This is a substantial amount compared to the total investment of Rs. 18 lakh.

Lumpsum Investing in Mutual Funds: A Double-Edged Sword

Lumpsum investment refers to investing a significant amount of money in a mutual fund scheme all at once. It’s like putting all your chips on the table in one go.

Importance in Mutual Funds:

Potential for Higher Returns: If you invest during a market upswing, your entire investment benefits from the growth. This can be advantageous compared to a Systematic Investment Plan (SIP) where the average cost is spread across different market points.

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Creating Wealth with Lumpsum:

Power of Compounding: When you invest a lump sum, your returns start compounding earlier, potentially leading to greater wealth creation in the long run.

Why Experts Might Advise Against Lumpsum:

Market Timing: The stock market is unpredictable. Investing a lump sum during a market peak could expose your entire investment to a downturn.

Rupee-Cost Averaging: SIPs benefit from rupee-cost averaging, where you buy units at different price points, potentially lowering your overall investment cost. Lumpsum investing forgoes this advantage.

Emotional Investing: Market volatility can trigger panic selling if you’ve invested a lump sum. SIPs inculcate discipline and prevent rash decisions.

Lumpsum investment example:

Say you invest Rs. 1,00,000 (one lakh) today in a hypothetical investment that offers a consistent 12% annual return for 30 years. This is a long-term investment, so fluctuations in the market average out over time (but remember, past performance doesn’t guarantee future results).

The Magic of Compound Interest: Here’s the beauty of this scenario. Your money grows not just on the initial investment, but also on the accumulated interest each year. This is the power of compound interest.

The Grand Total: After 30 years, using a simple investment calculator, you could be looking at an estimated amount of around Rs. 28,96,000! That’s a whopping Rs. 17,96,000 growth on your original investment

Understanding the Risks in Mutual Funds

While mutual funds offer a compelling path to wealth creation, it’s important to be aware of the inherent risks involved. Here’s a breakdown of some key risks to consider:

• Market Risk: This is the overall risk that the financial markets will decline, causing the value of your mutual fund holdings to go down. Global events, economic downturns, and interest rate fluctuations can all contribute to market risk.
• Credit Risk: This risk applies specifically to debt mutual funds. It refers to the possibility that an issuer of bonds or other debt securities held by the fund might default on their repayment obligations. In such a scenario, the fund’s value could decrease.
• Liquidity Risk: Unlike stocks that can be readily bought and sold on exchanges, some mutual funds, particularly those investing in less-traded assets, might be less liquid. This means it could take longer to sell your holdings when you need the money.
• Concentration Risk: Some mutual funds might focus their investments on a specific sector or industry. If that particular sector experiences a downturn, the fund’s value could be significantly impacted.
• Expense Ratio: This is the annual fee charged by the fund to cover management and operational expenses. Higher expense ratios can eat into your returns over time.

Advantages of Investing in Mutual Funds

Mutual funds offer a variety of benefits that make them attractive investment options, especially for beginners. Here’s a breakdown of some key advantages:

Diversification:

This is a major strength of mutual funds. By pooling your money with other investors, you gain exposure to a variety of assets like stocks, bonds, and even commodities. This spreads out your risk – if one holding performs poorly, others may compensate.

Professional Management:

Mutual funds are overseen by experienced fund managers who continuously research and make investment decisions on your behalf. This saves you significant time and effort compared to picking individual stocks or bonds.

Liquidity:

Unlike some investments like real estate, many mutual funds offer high liquidity. This means you can easily redeem your units (shares) and get back your money, typically within a few business days.

Affordability:

Mutual funds allow you to start investing with smaller amounts compared to buying individual stocks or bonds. This makes them accessible to a wider range of investors, even those just starting their investment journey.

Convenience:

Investing in mutual funds is generally hassle-free. You can invest directly with the fund house or through a financial advisor. Many platforms allow for online transactions and easy tracking of your investments.

Potential for Growth:

Historically, the stock market has provided good returns over the long term. By investing in equity mutual funds, you gain access to this growth potential and can benefit from rising stock prices.

Variety of Choice:

Mutual funds come in a wide range of options to suit different risk appetites and investment goals. You can choose from equity funds, debt funds, hybrid funds (a mix of equity and debt), and even sector-specific funds.

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SEBI Categorization of Mutual Fund Schemes

To simplify investor understanding and facilitate better comparison between schemes, the Securities and Exchange Board of India (SEBI) introduced a categorization system for mutual funds in 2017. This system classifies mutual funds into five broad categories based on their investment objective and asset allocation.

The five categories under SEBI’s categorization are:

1. Equity Schemes
2. Debt Schemes
3. Hybrid Schemes
4. Solution Oriented Schemes
5. Other Schemes

Equity Schemes

Equity schemes invest primarily in stocks of companies. These schemes are further categorized based on the market capitalization of the underlying stocks:

Large Cap Funds:

These funds invest a minimum of 80% of their corpus in stocks of large-cap companies, which are typically the biggest and most well-established companies in the Indian stock market.

Mid Cap Funds:

These funds invest a minimum of 65% of their corpus in stocks of mid-cap companies, which are generally medium-sized companies with good growth potential.

Small Cap Funds:

These funds invest a minimum of 65% of their corpus in stocks of small-cap companies, which are relatively new and smaller companies with high growth potential but also higher risk.

Multi Cap Funds:

These funds invest in stocks across market capitalizations (large, mid, and small cap). The fund manager has the flexibility to allocate the corpus as per their investment strategy.

Sectoral/Thematic Funds:

These funds invest in a specific sector or theme, such as infrastructure, healthcare, or technology.

Debt Schemes

Debt schemes invest primarily in fixed-income securities such as government bonds, corporate bonds, and money market instruments. These schemes are categorized based on their maturity profile:

• Short-Term Debt Funds: These funds invest in debt instruments with maturities of up to 3 years.
• Medium-Term Debt Funds: These funds invest in debt instruments with maturities ranging from 3 to 7 years.
• Long-Term Debt Funds: These funds invest in debt instruments with maturities of more than 7 years.

Hybrid Schemes

Hybrid schemes invest in a combination of equity and debt instruments. They are categorized based on their equity-debt allocation:

• Aggressive Hybrid Funds: These funds invest in a higher proportion of equity (65% – 80%) compared to debt, offering higher growth potential but also higher risk.
• Balanced Hybrid Funds: These funds invest in a balanced proportion of equity (40% – 60%) and debt, offering a moderate level of risk and return.
• Conservative Hybrid Funds: These funds invest in a higher proportion of debt (75% – 90%) compared to equity, offering lower risk and potential returns.

Solution Oriented Schemes

Solution oriented schemes are designed to meet specific financial goals, such as retirement planning or children’s education. These schemes invest in a mix of equity and debt instruments, with the asset allocation changing as the investor approaches their goal.

Other Schemes

This category includes other types of mutual fund schemes that do not fit neatly into any of the other categories, such as index funds and funds of funds.

Direct Plans vs. Regular Plans in Mutual Funds: Understanding the Cost Advantage

Imagine you’re buying groceries. There’s a product on the shelf with two price tags: one slightly lower because you’re picking it directly, and another a bit higher because it comes with the service of a store assistant who helped you find it. That’s similar to direct and regular plans in mutual funds.

Direct Plans:

• You invest directly with the mutual fund company (AMC) without involving a distributor or advisor.
• Lower Expense Ratio: Since there’s no commission paid to distributors, the ongoing cost of managing the fund (expense ratio) is lower. This translates to potentially higher returns for you.
• Invest Online or Through AMC Platform: You manage your investments directly through the AMC’s website or mobile app.
• Do-It-Yourself Approach: You’re responsible for researching and choosing the fund.

Regular Plans:

• You invest through distributors or financial advisors who guide you through the process.
• Higher Expense Ratio: A commission is paid to the distributor, reflected in a slightly higher expense ratio. This can slightly lower your returns.
• Personalized Service: Distributors can offer investment advice and hand-holding, especially for beginners.
• Convenience: Distributors can help with paperwork and transactions.

Choosing Between Direct and Regular Plans:

• Cost-Conscious Investors: If you’re comfortable with research and managing your investments online, direct plans can save you money in the long run due to the lower expense ratio.
• Need Guidance: If you’re a beginner or prefer personalized advice, a regular plan with a good advisor can be helpful.

Remember: Both plans invest in the same underlying assets and are managed by the same fund manager. The key difference lies in the cost structure.

Myth & Facts of Mutual Funds

Myth: To Invest in Mutual Funds, One Needs a Substantial Amount of Money

• The Truth: This is one of the most common misconceptions. Investing in mutual funds does not require a large sum of money. In fact, you can start with as little as Rs. 500 through Systematic Investment Plans (SIPs). There’s no maximum investment amount, so you don’t need to be wealthy to invest in mutual funds

Myth: One Must Be a Skilled Expert to Invest in Mutual Funds

• The Truth: You do not need to be an expert. Mutual fund companies use their experience to allocate your money effectively. While expertise helps, even amateurs can invest in mutual funds. Gain experience over time and explore other investment tools as you learn

Myth: Mutual Fund Investments Guarantee Returns

• The Truth: Mutual funds can produce high returns based on risk, but they do not guarantee returns. They are market-related investments that fluctuate with market conditions. Expecting guaranteed returns is unreasonable.

Myth: Financial Planning Is a One-Time Activity

• The Truth: Financial planning isn’t a one-time event. Regular investing through SIPs is crucial for achieving financial goals. Additionally, reviewing your portfolio periodically is essential to adapt to changing circumstances¹².

Myth: Mutual Fund Investments Require a DEMAT Account

• The Truth: Mutual fund investors can choose to receive their units in dematerialized or physical form. A DEMAT account is not mandatory for investing in mutual funds.

Myth: Mutual Funds Are Only for the Long Term

• The Truth: Mutual funds cater to various investment horizons—long, medium, and short term. They offer options beyond just long-term investments.

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