What is a mutual fund?
A trust that accumulates the savings of a number of investors who share a common financial goal is known as a Mutual Fund. It is essentially a varied portfolio of financial tools ranging from bonds/debentures, equities or money market instruments. The compilation is then stationed in investment alternatives that connect to predefined investment targets. The income earned through these investments and the capital appreciation, are shared by its unit holders in proportion to the number of units owned by them.
A mutual fund is an appropriate investment for the common man as it presents an excellent chance to invest in a professionally managed basket of securities at a relatively low cost.
Money can be made from mutual funds in three main ways
Income is earned from dividends declared by various Mutual Fund schemes from time to time.
If the securities sold by the fund have increased in price, there is a gain in capital, which is reflected in the price of each unit. If investors sell these units at higher prices than what they purchased it at, they make a gain.
The unit price of the fund increases if the fund holdings increase in price but are not sold by the fund manager. They can later be sold at higher margins and huge profits can be made.
Benefits of investing in a mutual fund
Liquidity:Investors can sell their holdings in Mutual Fund investments at anytime without worrying about looking for buyers to buy it at the right price as open ended Mutual Funds are always prepared to buy back units from investors. When it comes to other investment ventures like bonds and stocks, buys are not always available and these are therefore less liquid compared to the open ended schemes of Mutual Funds.
Diversification:Mutual Funds try to reduce the unpredictability of returns through varying by investing in a number of companies across a large section of sectors and industries. Thus with a small surplus, an investor can achieve diversification that would otherwise not be possible. It minimizes the risk by preventing the investor from putting ‘all eggs in one basket’.
Transparency:Regular updates on the value of investments are easily available and declared on a daily basis. The investment strategy and outlook of the fund manager is also disclosed regularly along with the portfolio.
Access to money managers:There will be experienced fund managers who use advanced techniques to manage your money.
Economical transaction costs:Mutual Funds are a large sum of money from a number of investors. The amount of investments made in securities is also very large, therefore resulting in paying lower brokerage due to the scale of the economy.
Skillful industry:All of the Mutual Funds function under strict regulations, designed to protect the interests of investors and are registered with SEBI.
Suitable for small scale investments:A Mutual Fund allows individual investors to display various securities due to the fact that it invests in a number of stocks. It allows risk diversification without an investor having to invest a large amount of money.
Mutual Funds offer a number of tax benefits. Tax advisors should be consulted for further details.
Types of Mutual Funds:
Mutual Funds are classified on the basis of structure and their investment objective:
Open ended funds: Investors can enter and exit the fund scheme that is available for subscription throughout the year. They do not have a fixed maturity. Units can be bought and sold conveniently by investors at it’s NAV (Net Asset Value).
Close ended funds:It has a stipulated maturity period of around 3-15 years. Repossession can only take place after the period of the scheme is over. The fund is available for subscription only during a specified period and investors cannot invest in the scheme at the time of the new fund offer. The price at the stock exchange could vary based on the demand and supply situation, unit holders expectations and other market factors.
Growth funds: Growth schemes are perfect for investors who have long term outlooks and are looking to grow bigger over a period of time. The aim of the growth fund is to appreciate the capital over a certain period of time.
Income funds:The aim of this fund is to provide a steady and regular income to its investors. They generally invest in fixed security incomes like corporate debentures, bonds and government securities and are ideal for regular income and capital stability.
Balanced funds:Along with fixed income security, balanced funds are ideal for investors looking for a combination of income and moderate growth. These schemes regularly distribute a part of their earnings and invest in fixed income securities, aiming at providing both, growth and regular income.
Money market funds:These schemes generally invest in safe short term tools like Commercial paper, Certificates of Deposit, Treasury Bills and inter-Bank Call Money. It aims at providing easy liquidity, preservation of capital and moderate income. These schemes are ideal for corporate and individual investors to help them safeguard their funds for short periods of time.
What are the plans offered by Mutual Funds?
To cater to different needs of various customers, Mutual Funds have a number of investment options. Some of them are:
Insurance option:Certain funds offer schemes that deliver insurance cover to investors as an added benefit.
Dividend payout option:Dividends are paid out to investors under this option though the NAV (Net Asset Value) of the scheme fails to the extent of the dividend payout.
Retirement pension option: Some of the schemes are lined with retirement pension. Individuals participate in these for themselves while corporates, for their employees.
Growth option:Dividend is not paid out under this option and the investor realizes only the capital appreciation on the investment.
Systematic Investment Plan (SIP):The investor is allotted units on a predetermined date specified in the offer document at the applicable NAV. The option of preparing a predetermined number of post-dated cheques in favor of the fund is given to the investor.
Systematic Encashment Plan (SEP):This allows the investor to withdraw a certain predetermined amount/unit from the fund at a particular interval. As opposed to the SIP, SEP lets the investor withdraw a predetermined amount/units from his fund at a particular interval.
What are the Risks of investing in Mutual Funds?
Risks are an intrinsic aspect of every form of investment. For Mutual Funds, risks would include fluctuations on return.
Market risk:Change in stock prices of profitable companies and corporations may be affected due to the yields of all the securities in a particular market rise or fall because of outside influences.
Credit risk:Risks of how stable the company is, how it will be able to pay the interest you are promised or repay the principal when the investment matures, etc. are some of the credit risks.
Liquidity risk: It is a characteristic of the Indian fixed income market.
Inflation risk:Referred to as ‘the loss of purchasing power’, when the rate of inflation exceeds the earnings on investment, there is a risk that the ability to purchase will be less, not more.
Interest rate risk:Equities and bonds are both affected by changing interest rates. When the rate of interest rises, prices of securities fall, and vice versa. Interest rates can be unpredictable leading to the possibility of large price movements up or down in money market and debt securities.
Changes in the government policy: Business prospects and investments made by the fund may be hugely impacted due to the change in government policy especially with regard to tax benefits.
Are returns guaranteed?
Mutual Funds do not usually offer guaranteed returns to investors. SEBI allows Mutual Funds to offer guaranteed returns on subject to the fund meeting certain conditions but most funds do not offer any such guarantees. The Government of India, The Reserve Bank of India, or any other government body does not guarantee investments in Mutual Funds.