Mutual Funds : Everything you need to know about them

Mutual Funds and everything you need to know about them

With the craze for mutual funds at an all time high, how many of us truly understand mutual funds? How is our money invested? What are the types of mutual funds? Well, fear not. We aim to answer these questions and many more as we delve deep into mutual funds.

What is a mutual fund?

A mutual fund is a financial instrument in which money from several investors is pooled together, to invest in securities such as stocks, bonds, and other assets. Also read Benefits of using a credit card

The image explains how mutual funds work

What are the advantages of mutual funds?

  1. Diversification – Diversification helps to reduce the risk as the investment is spread out various categories of assets.
  2. Economies of scale – The small amount that an investor wishes to invest may not be sufficient to buy stocks of blue chip companies. However, when several people pool in their money expensive stocks can be bought easily.
  3. Professional management – A mutual fund is managed by a professionally qualified person, known as Fund Manager. These professionals conduct research and decide where to prudently invest your money.
  4. Ease of access – One can invest in a mutual fund very easily by submitting the basic KYC documents.
  5. High liquidity – One can easily deposit and withdraw their money any time they wish to. The lock-in period is usually just a year. Even in the lock-in period the investor may withdraw his money by paying a small fee.

What are the disadvantages of mutual funds?

  1. High fees – Since mutual fund houses have expenses of advertisements, salary of professionals and many such expenses, these expenses are usually passed over to investors in the form of high fees. Beware of any fund that charges more than 1.5% in fees. There most likely is a cheaper alternative out there in the market. Fees will reduce your return percentage.
  2. Difficulty in comparing funds – Comparing funds from different mutual fund houses and within the same mutual fund house is a very tedious task and can exhaust one’s patience.
  3. Tax inefficiency – Several mutual funds are not structured to minimize your tax payouts. This results in huge capital gains taxes for investors.

Types of Mutual Funds

Based on Investment objective

  1. Debt Funds – These funds primarily invest in debt instruments such as bonds. The objective of these funds is to provide a regular income. The risk factor is low. SBI Savings Fund is one such fund.
  2. Equity Funds – These funds invest in equities in equities/stocks. They aim to provide growth and capital appreciation over a long term. The risk factor is high. SBI Small Cap Fund is one such fund.
  3. Hybrid Funds – These funds invest in equity and debt securities. The % of debt and equity will vary from one fund to another. They aim to provide capital appreciation as well as income. The risk factor is moderate. SBI Debt Hybrid Fund is one such fund.

Based on investment style

  1. Passive Funds – Passive funds are those that mimic an index. The money is invested in the same securities in the same proportion as it is in that index. The expense ratio is lower. Changes are made to the fund only when there are changes to the Index composition. SBI Nifty Index fund and SBI Nifty Next 50 Index fund are some examples of passive funds.
  2. Active Funds – Active funds are those that may offer a better return than than the index. They invest in securities that are carefully analysed. The proportion of investment will vary basis the analysis. These funds may perform better or worse than the index depending on their constitution. These funds have higher expense ratios as compared to passive funds. SBI Small Cap Fund and SBI Focused Equity Fund are some examples of active funds.

How to invest in mutual funds?

You can invest in mutual funds through the direct route or through the regular route. Direct route is when you invest directly with the mutual house. Regular route is when you invest in a mutual fund through a broker such as Zerodha.

The expense ratio is lower when you invest through the direct mode as compared to regular route. However, the regular route offers more convenience, better analytics and aggregates all your investments at one place.

Once you have decided whether you want to proceed for investment via the direct or regular route, you need to decide whether you want to invest in a lumpsum or SIP.

Lumpsum is when you do a one time investment. The amount is usually huge.

SIP a.k.a Systematic Investment Plan is a staggered investment. The investment will be at regular investments of fortnightly, monthly or half-yearly. The amounts may be as small as ₹500. They will give you the power to invest as per your convenience.

Terms to know

Before you start you investment journey in mutual funds, there are a couple of terms you need to know.

Expense Ratio – It is the fees/ annual maintenance charges levied to handle your mutual fund. Lower the expense ratio, the more beneficial it is to you.

AUM – AUM stands for Assets Under Management. This refers to the total market value of assets the mutual fund manages at a given point of time. The higher the number, the less likely it is to fail and have higher liquidity.

IDCW option – IDCW stands for Income Distribution cum Capital Withdrawal Plan. The dividend of the mutual fund is paid out to the investor as an income. This income is withdrawn from your capital. For example, if you receive an income of ₹10,000 from your mutual fund under this plan, your capital too will be reduced by ₹10,000.

Growth option – Under this plan, the investor will not receive any money from the dividend earned by the mutual fund. This money is once again reinvested in the mutual fund.

NAV – NAV stands for Net Asset Value. Just like stocks have share prices, mutual funds have NAV. The NAV can help track the performance of the mutual fund. NAV is calculated as (Assets of the fund – Liabilities of the fund)/ Total number of outstanding units of the fund.

Terms such as Lumpsum, SIP, Regular and Direct scheme have been covered over the course of the article.

Happy investing!!

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