Mutual Funds

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A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Understanding Mutual Funds

Mutual funds pool money from the investing public and use that money to buy other securities, usually stocks and bonds. The value of the mutual fund company depends on the performance of the securities it decides to buy. So, when you buy a unit or share of a mutual fund, you are buying the performance of its portfolio or, more precisely, a part of the portfolio’s value. Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give its holders any voting rights. A share of a mutual fund represents investments in many different stocks (or other securities) instead of just one holding.

That’s why the price of a mutual fund share is referred to as the net asset value (NAV) per share, sometimes expressed as NAVPS. A fund’s NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Outstanding shares are those held by all shareholders, institutional investors, and company officers or insiders. Mutual fund shares can typically be purchased or redeemed as needed at the fund’s current NAV, which—unlike a stock price—doesn’t fluctuate during market hours, but it is settled at the end of each trading day. Ergo, the price of a mutual fund is also updated when the NAVPS is settled.

 The average mutual fund holds hundreds of different securities, which means mutual fund shareholders gain important diversification at a low price. Consider an investor who buys only Google stock before the company has a bad quarter. He stands to lose a great deal of value because all of his dollars are tied to one company. On the other hand, a different investor may buy shares of a mutual fund that happens to own some Google stock. When Google has a bad quarter, she loses significantly less because Google is just a small part of the fund’s portfolio.

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Mutual fund will either invest in equities, debt or a mix of both.  They can be open-ended or close-ended mutual funds.

Open-ended funds

Investor can invest / enter and redeem / exit at any point of time. It does not have a fixed maturity period.

Close-ended funds

Close-ended mutual funds have a fixed maturity date. An investor can only invest or enter in these types of schemes during the initial period known as the New Fund Offer or NFO period. His/her investment will automatically be redeemed on the maturity date. They are listed on stock exchange(s).

Equity or growth schemes

Allow investors to participate in stock markets. Though categorized as high risk, these schemes also have a high return potential in the long run. They are ideal for investors in their prime earning stage, looking to build a portfolio that gives them superior returns over the long-term. Normally an equity fund or diversified equity fund as it is commonly called invests over a range of sectors to distribute the risk.

Equity funds can be further divided into three categories: 

Sector-specific funds:

Funds are invested in sectors like infrastructure, banking, mining, etc. or specific segments like mid-cap, small-cap or large-cap segments. They are suitable for investors having a high-risk appetite and have the potential to give high returns. Specific sectors with bright outlook over a period of time can give excellent returns.

Index funds:

Index funds are ideal for investors who want to invest in equity mutual funds but at the same time don’t want to depend on the fund manager. An index mutual fund follows the same strategy as the index it is based on.

Index funds promise returns in line with the index they mirror.

Tax saving funds:

These funds offer tax benefits to investors. They invest in equities and are also called Equity Linked Saving Scheme (ELSS). These types of schemes have a 3-year lock-in period. The investments in the scheme are eligible for tax deduction u/s 80C of the Income-Tax Act, 1961.

 Money market funds or liquid funds:

These funds invest in short-term debt instruments, looking to give a reasonable return to investors over a short period of time. These funds are suitable for investors with a low risk appetite who are looking at parking their surplus funds over a short-term. These are an alternative to putting money in a savings bank account.

Fixed income or debt mutual funds:

These funds invest a majority of the money in debt – fixed income i.e. fixed coupon bearing instruments like government securities, bonds, debentures, etc. They have a low-risk-low-return outlook and are ideal for investors with a low risk appetite looking at generating a steady income. However, they are subject to credit risk.

Balanced funds:

As the name suggests, these are mutual fund schemes that divide their investments between equity and debt. The allocation may keep changing based on market risks. They are more suitable for investors who seek moderate returns with comparatively low risk.

Hybrid / Monthly Income Plans (MIP):

These funds are similar to balanced funds but the proportion of equity assets is lesser compared to balanced funds. They are especially suitable for investors who are retired and want a regular income with comparatively low risk.

Gilt funds:

These funds invest only in government securities. They are preferred by investors who are risk averse and want no credit risk associated with their investment. However, they are subject to high interest rate risk.