What Is a Mutual Fund? Meaning, Types & Benefits

What is Mutual Fund?

To understand what is mutual fund investment, we can think of it as a group of friends pooling their money to buy a complete cricket kit. Alone, no one can afford it, but together they not only own the kit, but also benefit from using it. Similarly, in a mutual fund, money from various investors is pooled together and invested in a mix of assets like stocks, bonds, money market instruments, and more. A professional fund manager is responsible for managing this fund by making effective choices that work in the best interest of the investors.

Mutual funds, with their diverse portfolio, help in mitigating investment risks. If one security underperforms others in the portfolio may perform well, helping to offset the loss. This diversification reduces risk while aiming for growth. Mutual funds in India are regulated by SEBI, ensuring transparency and investor protection.

When you invest in mutual funds, you buy units of the fund, and their price is called the Net Asset Value (NAV). NAV is simply the (Market value of the fund’s investments – applicable expenses and liabilities) divided by total outstanding units . As the portfolio’s value changes, so does your return.

 

How do Mutual Funds Work?

To comprehend what mutual funds are and how they work, you must consider how the portfolio is managed. As explained before, each fund possesses a Net Asset Value (NAV), or per-unit price. NAV goes up or down based on market conditions and the portfolio of the fund. The NAV is revised at the end of every trading day, and that is taken as the price at which investors sell or purchase their units.

Most mutual funds are liquid (except ELSS funds which have a 3 year lock-in). They allow you to enter or exit the fund based on market conditions. Mutual funds are attractive because with even small amounts, you have professional management, diversification, and flexibility. The table below explains the process very clearly:

 

Types of Mutual Funds

Mutual funds are grouped in several ways - by structure, asset class, or financial goals. Here’s a simple breakdown:

 

By Structure

Open-Ended Funds: These funds are open for subscription and repurchase on a continuous basis on all business days. They are highly suited for investors looking for flexibility, as there is no lock-in period.

Close-Ended Funds: These funds have a fixed maturity date and can be traded on stock exchanges. They can be suitable for long-term, disciplined investment.

Interval Funds: As the name suggests, these funds allow transactions at specific intervals. They can be bought or sold when the trading window opens.

 

By Asset Class

Equity Funds: These invest in shares of the companies listed on the stock exchanges . They are high-risk, high-return funds that can help you create a good corpus over time. They are further categorised as large-cap, small-cap, mid-cap, multi-cap, value funds, etc.

Debt Funds: These invest mainly in fixed-income securities like bonds, treasury bills, and other low-risk options. They are ideal for conservative investors who need a steady income.

Hybrid funds: A mix of equity and debt funds gives a balanced growth as well as safety. Hybrid funds can be balanced, aggressive, conservative, Dynamic Asset Allocation, Multi Asset Allocation etc.

 

By Objective

Equity-Linked Savings Schemes (ELSS): These are equity-based funds with a minimum lock-in period of 3 years. They provide tax deductions under Section 80C and help in long-term growth.

Sectoral/thematic Funds: These high-risk funds focus on specific industries or theme.

Solution-Oriented Funds: These funds come with a minimum lock-in period of 5 years to achieve specific life goals like children’s education or retirement planning.

Liquid Funds: Short-term options like liquid or ultra-short funds fall in this category. They aid in fulfilling short-term financial goals.

Fixed Maturity Funds: These types of mutual funds invest in debt instruments having a fixed tenure. These are low-risk funds providing predictable returns.

Capital Protection Funds: These are a mix of debt and equity shares designed to safeguard capital. They are best-suited for risk-averse investors seeking safety.

Plus, there are active and passive funds, too, depending on the fund management style.

 

Benefits and Limitations of Mutual Funds

While it may seem like a lucrative investment option, it’s equally important to understand both mutual funds benefits and limitations before investing .

 

Benefits:

• Diversification distributes money among various assets, potentially reducing overall risk.
• Liquidity enables you to withdraw units with ease in most open-ended schemes.
• Compounding increases small, frequent investments to substantial amounts over the years.
• Low entry threshold allows you to start with a small sum using SIPs
• Tax benefits are provided under ELSS funds, with exemptions under Section 80C.

 

Limitations:

• Management and transaction charges (expense ratio) reduce your net returns.
• Market volatility implies that your investment's absolute worth can decrease or increase at any moment.
• Certain mutual fund schemes might not perform well even with professional fund management. This is because of several factors like exposure to specific sectors, market timing, entry point, etc..

 

Fees and Charges Associated with Mutual Funds

When you invest, consider the associated expense ratio that can impact returns. The most common fee is the expense ratio, a percentage charged for fund administration, operations, and management. Because it gets deducted straight from the fund's assets, it affects what you are paid.

Knowing the fees makes you wiser in making decisions and approximating actual returns.

 

Difference Between ULIPs and Mutual Funds

ULIPs are life insurance plans that offer the element of investing in market-linked securities. Mutual funds are purely investment products. Here’s a quick comparison between the two choices based on various parameters:

 

Key Takeaways

• Mutual funds pool money from various investors and are managed by professionals.
• Different types of mutual funds exist based on asset category, objective, and structure.
• Key mutual fund benefits include diversification, liquidity, and compounding.
• Entry into mutual funds is easy with a low minimum investment amount.
• Investors should be aware of various mutual fund fees to calculate net return accurately.
• Mutual funds focus solely on wealth creation, while ULIPs include life insurance cover along with market linked investment.
• Know the advantages and disadvantages of investing in mutual funds to make an informed decision.

 

Conclusion

Investing in mutual fund schemes can be a clever method of accumulating wealth, but it involves its own set of risks. The secret is knowing how they function, the categories they belong to, and the costs attached. Employing tools such as a mutual fund calculator aids you in calculating returns and planning more effectively. Finally, select a scheme you're comfortable with that suits your financial needs and risk appetite. If handled properly, mutual funds can reconcile growth, convenience, and flexibility to achieve long-term wealth creation.

 

FAQs

 

Are mutual funds safe investments?

All mutual fund investments are subject to market risks, and returns depend on the type of funds you choose and your risk appetite. As such, mutual fund returns are not guaranteed.

 

What is the minimum amount required to invest in mutual funds?

You can start investing in mutual funds with a small amount, however it depends on the Asset Management Company . You can increase the amount over time as per your financial goals.

 

How is the return on mutual fund investments calculated?

Returns are measured by the Net Asset Value (NAV) of the fund. The NAV reflects the market value of all the assets held under the respective fund. Your gain or loss can be computed by comparing the NAV at the time of purchase and at redemption, usually expressed as a yearly annualised return.

 

Can I withdraw my money anytime from mutual funds?

Yes, you can withdraw the money at any time from open-ended mutual funds. Some schemes may also have exit loads or lock-ins (like ELSS), but check the terms and conditions of your particular fund before investing.

 

What are the tax implications of investing in mutual funds in India?

Tax varies with the type of mutual fund and the holding period. Equity funds that are held for over one year are subject to long-term capital gains tax at 12.5% over gains over ₹1.25 lakhs. Equity funds redeemed earlier attract a short-term capital gains tax of 20%. Debt funds are taxed at your income tax slab rates, irrespective of the holding period. ELSS funds also qualify for deductions under Section 80C up to ₹1.5 lakh on the investment made if you choose the old tax regime.

 

How do I choose the right mutual fund for my financial goals?

Begin by specifying your goals—low-risk or growth-oriented, short-term or long-term. Compare funds along such factors as past performance, expense ratio, and level of risk. A mutual fund calculator can assist you in comparing projected returns to goals. Consult a professional if uncertain.