Mutual Funds Basics

Imagine you wanted to start investing in the stock market. There are thousands of stocks to choose from, and being only one human you can only research about a few before you begin.
Imagine you did your research and shortlist say 2 stocks - A & B. A seems to be a better bet so you go ahead and invest your money in A. Imagine things work out as per plan and you’re seeing a return of 10% or so in a year. Then, you happen to check on how stock B is doing, and you see a return of 18%! Suddenly, you realise you could’ve made almost double the returns.

What do you do now? How were you to know anyway? There probably wasn’t enough time to research all the stocks, and even if there was, there’s only so much you as a retail investor can know, especially when there are bigger sharks in the market. Is there really a fix for this? Or must you live with missing out on bigger returns?

It’s time for you to take a look at mutual funds.

A mutual fund is an investment option where a group of investors pool in their money, to be collectively invested across stocks, shares, bonds and other securities. There is usually a fund manager who invests this money on their behalf and charges a small fee.

Mutual funds are an ideal investment option for people who are looking to invest their money but do not have the time to look for the right investment option. Or for those who do not have a lot of knowledge about the stock market. That’s not to say they’re not ideal for any other sort of investor - in fact, mutual funds can offer pretty solid returns and boost your portfolio.

The Basics

Mutual fund investments can be done via two routes. You can either invest directly in a mutual fund, or take the services of mutual fund distributors (advisors/brokers) . If you’re investing directly, you will invest in a direct plan of a mutual fund scheme. In case of investing through an advisor or fund manager, you can invest in what is called the regular plan of the scheme.

If you are investing directly in a mutual fund, you save on commission charges that you pay might end up paying a traditional broker. This money that you save can add a significant amount to the returns over a long period. Investing directly with an AMC also means that you have to conduct a lot of independent research, monitor your portfolio and assess your risks. A broker won’t be there to help you with research in that case. A company that puts together a mutual fund is called an Asset Management Company (AMC). They have several fund schemes depending on your investment objectives and purpose.

You can invest in mutual funds with the help of discount brokers as well. Upstox, for example, has a separate mutual funds platform where you can search from the available different types of mutual funds. With discount brokers you would usually need to open a demat account and then start investing in mutual funds.

Benefits of investing in mutual funds

• Convenience - Unless you’re feeling very adventurous, stock market investments require more research and time. Since mutual funds are managed by financial experts, the research is already done for you!
• Safe and Transparent - Even though you’re handing your investment for someone else to manage - it’s being managed by experienced professionals, whose results are available for you to see at all times. Nothing is opaque.
• Diversification - The golden rule of investments is something mutual funds follow by their very definition. By diversifying your investments into multiple stocks and funds, your money is safer.
• Expert managers - Mutual fund managers are experts in their fields, usually managing thousands of crores of assets that they are responsible for. There’s very little room for error, and the returns most mutual funds deliver are testament to the fact they succeed.
• Liquid investment - Mutual funds ensure liquidity in the markets, and many times do influence market movements when they move thousands of crores of funds in and out of stocks - leading to sentimental reactions from the market.

Types of Mutual Funds

Each mutual fund is tailored for a specific objective, allowing investors to pick the ones that are in sync with their goals. Some of the popular funds types we see are:

1. Equity (Growth) Funds – These are funds with their assets invested only in stocks. They grow faster than money market and fixed-income funds. Naturally, they usually also involve more risk. There are different types of equity funds - including those that specialize in growth stocks, income funds, value stocks or a combination of these.
2. Fixed-Income Funds – These are funds invested only in fixed-income securities. These funds pay a fixed rate of return, similar to government bonds, investment-linked corporate bonds and high-yield corporate bonds. Obviously, these are considered safe investment options as the risk is less and the returns are usually consistent.
3. Balanced - These funds are invested partly in stocks and partly in fixed-income securities in order to maintain a balance between high returns and risk (i.e. the potential of losing money). The money is split among different investments. The risk would be placed somewhere more than fixed income funds but lesser than that of pure equity funds. Aggressive funds consist of more equity funds and fewer bonds while Conservative funds consist of fewer equities in relation to bonds.
4. Money market funds - These are funds invested in short-term fixed income securities such as government bonds, treasury bills, commercial paper and certificates of deposit. Money market funds are considered a safe investment option, but with a lower potential return than other mutual funds.
5. Index Funds - These funds aim to track the performance of a specific index such as Sensex or Nifty. The value of the mutual fund will fluctuate with the value of the index. Index funds typically have lower costs than actively managed mutual funds because the portfolio manager doesn’t have to do as much research or make as many investment decisions.
6. Sectoral Funds - These funds focus on specialized securities such as real estate, commodities or socially responsible investing such as a fund for a company that supports environmental causes, human rights, etc.
7. Fund-of-funds - These funds invest in other funds. They are similar to balanced funds, where they make asset allocation and diversification easier. The MER (managing costs) for Fund-of-funds tend to be higher than exclusive mutual funds.