Understanding Mutual Funds: A Beginner’s Guide

Ways to Invest in the Stock Market

There are three primary methods of investing in the Stock Market:

Through Personal Research

You conduct your own study on the stock market and thus decide when to buy which stocks. The benefit here is independence—you need not rely on anyone else or pay advisory fees.

The downside is that this method will take considerable time and effort and you will require a thorough understanding of how to recognise stocks that are undervalued.

Through a Research Analyst or Investment Advisor

In this case, you rely on someone else to assist you. The benefit here is that you will save time and effort. The obvious downside is that you will pay advisory fees, and the responsibility ultimately lies with you.

Through Mutual Funds

A mutual fund is a professional management investment choice, meaning you won’t have to conduct any research, analysis, or selection of any of the stocks it holds in the fund.

You won’t have to worry about pulling together prior knowledge of the stocks you want to trade or the time it may take to monitor the trades. A mutual fund will have relatively low fees and you can invest small amounts of initial capital working with an investment advisor, an excellent scenario for beginning investors.

The primary purpose of a mutual fund, especially for equity-based mutual funds, is to grant investors exposure to the stock market without requiring individual purchases of stock.

What Are Mutual Funds?

When typically considering mutual funds, most people assume that the fund requires their investments to be entirely in the stock market. This is not completely accurate. Mutual funds allow investors to invest their money across a range of assets, including equity, gold, real estate and debt instruments.

While mutual funds provide exposure to all types of investment vehicles, when discussing risk, volatility, or returns, people are typically referring to equity mutual funds, which principally invest in equity shares of the stock market.

In order to fully understand mutual funds, it is critical to first understand how the stock market is an investment.

How Do Mutual Funds Work?

Let's say you want to invest ₹20,000 and purchase shares of companies like MRF or Page Industries, but the price of one share is higher than ₹20,000 or even ₹100,000. Therefore, you cannot purchase even one share.

This is where mutual funds come in. A mutual fund assembles money from many investors. For example, if 100 investors aggregate ₹500 each, the combined receipts total ₹50,000. The combined money can then be used to purchase shares with a higher value, such as Page Industries.

A mutual fund won't take the amount of money and distribute shares in owning the underlying stock. Instead, it issues mutual fund units to each investor. Equity fund units can be thought of as shares equal to the total ownership amounts in the overall diversified mutual fund portfolio.

Role of the AMC and Fund Manager

Each mutual fund is operated by an Asset Management Company (AMC). The AMC creates various schemes, such as a multi-cap fund that would invest in small-cap, mid-cap, and large-cap companies, and then invites the public to invest.

For instance, if 50 investors each invest ₹2,000, the total Assets Under Management (AUM) is ₹1 lakh.

The AMC then appoints the Fund Manager, who is a skilled individual who decides which shares to buy and in what amount. Fund managers ensure the investors’ money is being managed strategically.

"Mutual" actually corresponds to shared and that’s what mutual funds refer to a collective pool of resources (money), being pooled together for collective results.

Mutual Funds Types: Active Funds vs Index Funds

A frequently asked question of investors is, Which is a better investment vehicle - Active Fund or Index Fund?

Active Fund

These are actively managed by portfolio manager(s), and they take the liberty to select where and when to invest - such as actively investing in a multi-cap type active fund, you could hold small, mid, and/or large cap stocks and switch your holdings based on market environment.

Index Funds (Passive Funds)

They are similar to an index fund in that they refer to a market index like the Sensex or Nifty, and they replicate the composition of the index to a fairly degree.

They do not actively manage the stock selection, and just buy and hold securities that mimic the index fund, therefore providing returns based on the index fund's market performance.

In India, Active Funds can still outperform due to a lesser degree of market efficiency, especially when fund managers take the time and process credit research to find the best potential stock selection to hold, even when looking for stocks that may be undervalued potentially by a significant degree. Hence, both are to be utilised depending on the goals and risk profile of the investor.

SIP or lump sum: Which one is better for you?

To invest the right way, two things have to be achieved:

• You have to invest in the right place, and
• You have to invest at the right time.

When you invest in a mutual fund, the first condition will be satisfied, but the second condition is usually the harder of the two to manage.

When you invest with a lump sum, you are investing in one upfront transaction of a significant amount. If you time your investment in the right cycle of the market, lump-sum investing can provide significant returns, but it is risky because the highs and lows of the market are unpredictable.