What are mutual funds? A Detailed Guide for Beginners

In this blog, we will talk about what are mutual funds. Mutual funds provide investment options to investors by way of pooling capital from multiple investors to invest in a pre-defined portfolio of stocks, bonds, and other securities. Benefits of mutual funds include diversification of assets, professional management, tax benefits, ease of buying and liquidity.

In the following sections of the blog, we will cover mutual funds meaning, how mutual funds work, the mutual funds advantages, terms/abbreviations one must know related to mutual funds, and things to remember while investing in mutual funds.

What are Mutual funds?

Mutual funds are a type of investment vehicle that collects money from multiple investors having a common investment objective to invest in a diversified portfolio of stocks, bonds, and other securities based on a pre-defined investing theme and the risk appetite of the investor. Investors can select the type of mutual funds based on their investment goals, risk tolerance, investment horizon and other factors.

The schemes of Mutual Funds are managed by professional investment managers, also known as fund managers, who invest investors' capital on their behalf. Various categories of mutual fund schemes are available such as equity schemes, debt schemes, hybrid schemes, solution-oriented schemes and other schemes.

How Mutual funds work?

Mutual fund schemes pool money from investors which is then invested by the Fund Managers of the respective schemes in various asset classes such as equities, bonds, government securities, treasury bills, etc., depending upon the investment objective and asset allocation of the respective scheme.

If the investment objective is to achieve capital appreciation, then exposure of the scheme towards equity and equity-related instruments will be higher. If the aim is to generate income, then exposure of the scheme towards money market instruments, bonds, government securities etc., will be higher. Experienced fund managers are responsible for managing the mutual fund schemes to ensure the fund meets its investment objectives.

The funds of investors are allocated in various asset classes by the Fund Managers, and the value of their investment is determined by the net asset value (NAV) of the fund. The NAV is calculated by dividing the market value of securities of a scheme by the total number of units of the scheme on a given date. Investors can easily buy or sell their units, making it a convenient investment option.

Benefits of investing in mutual funds

Now that we understand what a mutual fund is and how it works, we will try to understand the advantages of investing in mutual funds. Below is a comprehensive list of its benefits:

1. Tax saving option

Some mutual funds provide tax benefits, such as tax deductions upto Rs. 1,50,000/- under section 80C of the Income Tax Act, 1961 (old regime). This makes them an effective tax-saving option for investors.

2. Diversification of assets

Mutual funds provide diversification by investing in a variety of asset classes such as stocks, bonds, treasury bills, government bonds, government securities and other asset classes.This helps to reduce the risk of a single investment or asset class negatively impacting the entire portfolio. Diversification can assist in providing more stable returns over a long period of time and allows investors to manage risk.

3. Liquidity

Mutual funds offer liquidity by allowing investors to easily buy or sell units of a mutual fund scheme at the net asset value (NAV) price. This makes investment in mutual funds a convenient option for investors who need access to their money quickly, as they can be bought or sold on any business day.

4. Accessibility

Mutual funds can be considered a relatively accessible investment option as investors can start their investment in mutual fund journey by directly investing in a scheme on the basis of their own financial knowledge or by taking the advice of their financial advisor, or by investing through a distributor. This makes them a viable investment option for individuals as they can invest with ease and at their own convenience.

5. Affordability and convenience (invest small amounts)

Mutual funds offer affordability and comfort, allowing investors to start with a relatively small investment amount and make additional investments regularly through systematic investment plans. This makes it easier for individuals to build their investment portfolio over time without needing significant upfront investment.

What are the Fees involved while investing in Mutual Funds?
Investing in mutual funds may involve certain costs such as expense ratios, load fees, and transaction-related charges. Reviewing these costs can help investors understand how fees may influence their overall investment experience.

1. Expense ratio

This is an ongoing fee charged by mutual funds to cover the operating costs of the fund, such as management fees, administrative expenses, and other costs.

2. Load fees

These are commissions paid while buying or selling units and are utilized to pay intermediaries such as brokers or advisors.

3. Transaction fees

These are trading expenses are levied on investors during buy sell transactions and are designed to cover the costs of executing the trades.

While expense ratio and transaction fees are ongoing costs that affect returns over time, load fees are a one-time charge that can reduce the initial investment.

Mutual fund terms you must know

Certain terms and abbreviations are commonly used in mutual fund discussions. Understanding these terms can help investors read scheme-related information and compare mutual fund options more easily.

1. AMC

Also known as 'Asset Management Company', an AMC is a trust that manages the pooled money of investors by investing in various securities while also handling administrative and regulatory compliance functions. Kotak Mutual Fund is an example of an AMC.

2. NAV

NAV stands for 'Net Asset Value', which is an indicative measure of a scheme's performance. NAV reflects the market value of the mutual fund scheme's portfolio.

3. SIP

SIP or 'Systematic Investment Plan' is a method of investing an amount periodically in a mutual fund scheme of your choice. SIPs can be made either monthly, weekly, quarterly or yearly, and the amount can be as low as ₹100 per month. This investment strategy is designed to help investors avoid timing the market and take advantage of disciplined investing. For a deeper explanation of the concept, benefits, and types, see our detailed blog on what is SIP which will definitely help you build your knowledge.

4. STP

STP stands for Systematic Transfer Plan, a facility offered by mutual funds that allow investors to transfer a fixed amount or units from one mutual fund scheme to another regularly. STP can be used to shift investments from one type of mutual fund to another based on market conditions or investment goals.

5. SWP

SWP stands for Systematic Withdrawal Plan, a facility offered by mutual funds that allow investors to withdraw sums from their investments in a scheme at periodic intervals. SWP can be useful for child education, paying EMIs, retirement etc.

6. AUM

AUM stands for 'Asset under Management' and refers to the total market value of securities managed by a mutual fund scheme. The amount of AUM can change depending on the inflow and outflow of funds and the performance of the securities.

Things to keep in mind while investing in Mutual funds

Before investing in mutual funds, investors may consider factors such as their financial goals, investment horizon, risk tolerance, KYC status, scheme features, costs, and portfolio diversification.

1. Identify investment goal

Firstly, it is very important to determine your investment objective and, the tentative investment horizon, your risk appetite, amongst other things, to increase the chances of achieving your investment goals. Hence, set clear investment goals, identify why you're investing, what you aim to achieve and when you need the money.

2. Complete your KYC

KYC (Know Your Customer) is a mandatory process for investing in mutual funds. It involves verifying the identity and address of investors to prevent fraudulent activities. Investors must submit their KYC documents online/offline to register with a mutual fund. It is a one-time process to be completed by the investors before investing in a mutual fund schemes.

3. Learn about the scheme available

Before starting investments, investors should read all mutual fund scheme-related documents like scheme information documents (SID) and Key Information Memorandum (KIM) carefully.

One should thoroughly research the scheme with respect to the performance of the scheme (however, past performance may or may not be sustained in future), the fund house, the experience of the fund manager managing the scheme, etc. Also, check the sectors, asset classes and other instruments in which the investment has been diversified.

Spread your investments across different types of schemes which allocate your capital in different asset classes to reduce risk. Also, look for funds with low fees and expenses to maximize your returns. Avoid making frequent changes to your portfolio and stay invested for the long haul to potentially reap the benefits of compounding.

Conclusion

In conclusion, mutual funds can be a great investment option for individuals looking for potential wealth creation over the long term. Understanding your investment objective and the fund's objective, choosing a credible fund, diversifying your portfolio, considering fees and expenses and staying invested for the long term is essential.

Additionally, completing the KYC process is mandatory for investing in mutual funds. By following these guidelines and regularly reviewing your portfolio, you can make informed investment decisions and aim to achieve your goals by investing in mutual funds. Remember, investing involves risk, and it's crucial to consult with a financial advisor before making any investment decisions.