The Basics of Mutual Funds

Have you heard about Mutual Funds investments but aren't part of the investing crowd yet? Make informed decisions by first understanding what Mutual Funds are and how they work. Watch our educational and easy-to-understand video from the #LearnWithUpstox series.

These days we watch a lot of advertisements for mutual funds. It makes us wonder about what it is and if we should invest in it. If we do, will I lose my money? If this sounds like you, continue reading because we are going to cover all the basics of mutual funds in this article.

And Welcome to our new series - Learn with Upstox. Here, we shall try to make investing easy and simple. Whether you want to invest in IPOs, Mutual Funds, Digital Gold, Stock Market or Real Estate, don’t worry because we are going to discuss all of these topics here.

For now - Let’s look at the basics of Mutual Funds.

We will talk about the concept of mutual funds, how it works, and how to choose and invest in the right mutual funds.

Introduction

When we invest in mutual funds, we think that we’re only investing in the share market. But that’s not true. Via mutual funds, we can invest in Gold, Real Estate, Debt Instruments and even Equity. Mutual funds are used to make investments in all these assets, but usually when people talk about the risk and returns or the volatility of the market, they are talking about equities or the mutual funds which invest in the share market.

To understand Mutual Funds properly, it is important to understand the share market.

The Ways to Invest in the Share Market

So, there are three ways in which we can invest in the share market.

1. Through research. You can do your own research and pick which shares to invest in. The advantages here are that you don’t have to depend on anyone else and you also don’t have to pay for a fee. But the disadvantage is that it’s very time consuming to look for good undervalued shares and you also need knowledge of how to find them.
2. Through a research analyst. The second option is that you can take help from a research analyst or an investment advisor. The pros here are that you don’t have to spend any time researching because you can depend on the advisor. But the cons are that in the end it’s your money and only the advisor’s opinion which is at stake and that you also have to pay for the fees.
3. Through Mutual funds. You can invest your money in the share market via mutual funds. Here, you don’t have to spend time researching, you don’t have to keep tracking regularly, the fees are also quite affordable and you need no knowledge about stock picking. You just have to select a good fund.

We just saw what the purpose of mutual funds is. The purpose of MFs, especially that of an equity fund, is to give you an exposure in the stock market and to invest your money in the share market.

How does a Mutual Fund Work?

Now let’s take a look at how Mutual Funds work.

Say, you want to invest Rs 20,000. You do this directly or via an advisor and now you want to invest in a share of MRF or Page Industries. But the thing is, a single share of these industries costs a lot more than Rs 20,000. Which means that you won’t be able to invest. This is a problem that arises while investing directly or via an advisor.

Now, what a mutual fund will do is take Rs 500 from you and also from other investors who have a similar amount to invest. Say, it takes these Rs 500 from 100 investors. Which means that now the fund has Rs 50,000 in total and it bought two shares of Page industries with that money.

You or other investors like you would not have been able to buy a share of Page industries. But when a little of everyone’s money was pooled together, the fund could buy two shares. Now, the problem is that there are 100 people and only two shares. How will the fund distribute these shares?

What it does is that it doesn’t give investors the share. Instead it gives investors a unit of their scheme. Which means that 100 people collectively own two shares and the individuals get a unit from it which is worth Rs 500. This makes the 100 people co-holders of the share.

Mutual funds allow investors to invest in many shares for a small amount of money, which isn’t possible to do if they invest directly or via an advisor.

How is it done?

Mutual funds do this by making a fund management company known as the AMC or the Asset Management Company. This company first launches a fund and then asks people to put money in it. People are told that a Multi Cap fund is launched which means that the fund will invest in companies of different sizes like small cap, mid cap and large cap. Then whoever is interested, people like you and me, will start putting in the money. Some will put Rs 500, some Rs 1000 and some Rs 10000 and so on. Now, the total money which will be collected by the fund is known as the AUM or the Assets Under Management.

Take for example that the fund collected Rs 2000 from each investor and there were 50 investors in total. This means that now the AMC has Rs One lakh of AUM.

What the fund will do now is to appoint a fund manager. This person is an expert and will pick the shares in which this total amount will be invested. He/ She will make a strategy as to how much money will be invested in each chosen share. Once this is done the investors will get a Mutual Fund Unit.

This is basically how mutual funds work. Mutual means shared and it is a pool of funds where the MF collects money to buy shares or other assets.

Now let’s take a look at the advantages and disadvantages of Mutual Funds.

Advantages

1. The first advantage is mutual funds allow diversification even with a small capital. For example, if you want to invest Rs 2000 to Rs 4000, you can’t buy many shares. But because MFs pool many people’s money together, it is possible that you can invest in as many shares as you want.
2. The second advantage is that it is an expert who is managing your money. If you go by yourself to an expert and want investment advice, the expert’s fees might be more than the amount that you want to invest. On the other hand, when you go through mutual funds, all the investors are collectively paying for the expert and at a cheaper rate. The fee charged by the fund manager is called the Expense Ratio. For example, if you want to invest Rs 100 and you give it to the fund. The fund will invest 98 or 99 rupees and the remaining will be the expense ratio. It obviously depends on the fund, but lower the expense ratio, the better it is for you.
3. The third advantage is that you only have to invest in the funds once and your work is done. After that all the regular transactions of buying and selling are done by the fund on your behalf.
4. The fourth advantage is that of the SIP.

SIP stands for Systematic Investment Plan and it means that you can make a mandate at your bank so that every month Rs 2000, Rs 5000 or whatever amount you decide will get invested automatically and you don’t have to worry about it. You can stop this SIP, increase the amount or decrease it whenever you want. It’s flexible and doesn’t require you to pay a charge.

Now let’s look at the next point.

Types of Mutual Funds

You may have heard about the debate between which funds are good - Active or Index. Active funds are good. Index funds are good. People keep shuffling but nobody probably gave you the right information. Someone might have told you that active funds are good when that is not the case. And what is that thing about Index funds that I don’t like.

By the end of this article, you will be able to decide for yourself as to which funds are good for you.

The discussion on Index funds was very popular in the last one or two years. This happened because Warren Buffet had said that passive funds are a good investment option. Even in India the inflow was growing rapidly and is it good or bad? Giving a blank statement like that would be bad practice but we have to understand Index funds in the context of India. Because when Warren Buffet said that Index funds were a good investment, it’s first reason was that in the American and European countries, the stock market is efficient and most of the people invest in it. Which is why undervalued stocks aren’t easily available there and this makes it very difficult for even fund managers to beat them. And hence, rather than taking so many efforts, it’s better to invest in index funds and keep getting returns as given by companies in sensex and nifty in India.

Index funds are the funds that invest in a broader market like Sensex or Nifty.

The second reason was that if you take an Active fund which is a multi cap fund, you get the allocation of all small, mid or big companies and then the fund manager can actively manage the funds and decide where to invest specifically.

SIP vs Lumpsum

Now let’s discuss if we should do SIP or Lumpsum and how both of them work? We will also see how to invest and how to choose the right mutual fund.

Remember, that two things need to be done for investing correctly:

1. Invest in the right place
2. Invest at the right time

When you invest in mutual funds, you’ve already done the first thing right. Now, the question is, “How to invest at the right time?” because mutual funds don’t decide when you should invest as it is your own decision.

Entering the market isn’t always profitable. And that is why market timing is very important while making a lumpsum investment. If you return at the wrong time, the returns will be reduced. But no one can really judge a market at the right time. This prediction is really difficult to make and no one can tell this perfectly.

That is why, we can completely remove this question by investing through SIP. SIP allows us to invest on a monthly basis in a fixed amount, irrespective of the ups and downs in the market. These ups and downs don’t really matter because we invest every month and it balances out.

And that is all for this article. If you found it to be useful, you can check out our blog and find many other articles like these. In fact, we have an entire series dedicated to this. Plus, you could also check out our YouTube channel for the same.

Thank you and have a great day!