Lots of people believe in investing their money in traditional investment tools, because of the concern of security. You must have seen your parents investing in FD and RD, which are considered as safe tools of investment. But now a days, lot of investors are choosing a trending tool of investment i.e. Mutual funds.
But before investing in MF, one should know all the basics of mutual fund. Most people still don’t know what is mutual fund. They are not clear about even the basics of MF’s in India as an investment instrument.
Through this article, I will try to answer all the questions related to mutual funds.
Mutual fund is an advanced, low cost and tax efficient tool of investment.
There are thousands of mutual funds in India which are almost similar to each other and this created confusion among investors; some of the examples of MF’s are Fidelity mutual funds, SBI mutual funds or Reliance mutual funds.
Here is a video on basics of Mutual Funds which will help you understand some facts about MF’s in easy manner. Let’s first understand from very basic which will be helpful of a person totally outside the personal finance space.
To know MF in detail, you must understand all the related factors like what is company, what are shares, how mutual funds are classified etc. So let me explain you each term in detail.
What is Company?
Company is a voluntary association of persons formed for the purpose of doing business having a distinct name and limited liability. These company needs to be registered under The Companies Act, 1956, however, company is not a citizen so as to claim fundamental rights granted to citizens.
What are Shares?
To put in simple terms, it’s a share in a company. So it can be a very minuscule part of ownership in some company.
For Example, if someone has 100 shares of Rs.100 each for Company XYZ, it means that he has invested that much money in that company and is owner for that much part, which is commonly called as “stocks” and “equities.”
As we have got some understanding of what are these terms, we can proceed further:
Now anyone who has good knowledge of Stock markets, good knowledge of analyzing the company performance, buying and selling of shares, timing the market, etc. can directly buy and sell shares and do the investment directly in stock market.
But there are people who have no good understanding of these things and they can’t take good decisions themselves, for them MF comes into picture.
Mutual Funds Pool the money
So, MF is a financial instrument that allows a group of people to pool their money to build a huge corpus, and then this money is invested by group of people (refereed as FUND MANAGERS), who are investment experts, have deep understanding of investing in stock market and overall financial markets.
All the mutual Funds have their Units just like “shares” in Company. So if someone wants to invest Rs.10,000 in ABC MF and price for a unit is Rs.10, he gets 1000 units of ABC MF, and over a period of time as the MF investment grows, the unit price also grows with almost same ratio.
The price of these units is referred as Mutual Funds NAV (Net Asset Value). When a new MF launches, it’s called NFO of Mutual Funds (New Fund Offer, just like IPO in case of new Company’s Share issue to public)
So for example the total corpus of the MF on 1/1/2007 was Rs.100,000,000 and per unit price was Rs.10. and after an year on 1/1/2008 the total investment has grown to Rs.134,000,000, the unit price will be now Rs.13.40 (approx. it may be little less as there are some administrative cost and other expenses to be incurred).
Classification of Mutual Funds
A mutual fund can invest your money in different kind of tools like shares, debentures, gold, Fixed Deposits and cash also. So based on where it will invest and what kind of risk it will take there are 2 different ways of classifying mutual funds.
#1 Open end or Close Ended mutual Funds
One way of classifying mutual funds can be close ended and open ended funds. An open ended mutual fund is open at all time for entry and exit. So one can invest in it anytime and can get out of it anytime.
Whereas, in a close ended fund, there is a specified entry time and exit time and it comes with duration.
#2. 10 types of Mutual Funds
Mutual funds are categorized on the basis of its objectives, style and strategy. Investing in Mutual Funds only is not enough to get good returns. You should know about the types of mutual funds and then invest in different funds by deciding your goal.
The different types of mutual funds are enlisted below:
- Diversified Equity Funds
- Tax saving Funds (ELSS)
- Balanced Funds
- Sectoral Funds
- Mid Cap and Small Cap Funds
- Index funds
- Exchange Traded Funds
- Fund of Funds
- Debt Funds
- Liquid Funds
1. Diversified Equity Funds :
These are those mutual funds which invests across all sectors and diversify their portfolio. They invest in large companies to small companies. Which results in wide diversification. It helps in spreading risk across all sector and return potential is very good.
2. Tax saving Funds (ELSS) :
These are special category of mutual funds which are tax saving funds called ELSS (Equity Linked Saving Schemes). These have a lock in period of 3 years. They are Diversified mutual funds in nature.
3. Balanced Funds :
These are the funds which put money in Equity and Debt in some balanced proportion. Balanced does not mean 50:50 , it may happen that they put money in ratio of 70:30 or 60:20 or may be 80:20 … but the ideal ratio would be 50:50. It depends on market conditions.
In a very fast booming market, a fund with 7:30 mat be a balanced one. And in a bearish market a combination of 50:50 may be considered are an aggressive fund. These funds have low risk and low return capacity in comparison with normal equity funds.
4. Sectoral Funds :
These are Funds which invests all its money in companies of a particular sector or a bunch of sectors related to each others. The reason for this is high faith in the sector for growth and return potential because of which these funds are very risky and have high return potential.
For example: Reliance Diversified Power Fund .
5. Large cap, Mid Cap and Small Cap Funds :
These funds are those funds which invest there money in Mid cap Stocks or small Cap stocks … Mid cap and Small Cap companies are companies categorized by there market capitalization.
- Large Cap : greater than $10 billion
- Mid Cap : Between $2 and $10 billion
- Small Cap : Less then $2 billion
Mid cap and Small Cap stocks are more riskier as they are small compared to large Cap stocks because of size and reachability in market. They also have huge potential for growth so they can give superb returns too. For eg:
“Sanghvi Movers” gave a return of around 4500% in 5 years from 1992 – 1997. An investment of Rs 1 Lac was worth Rs 45 lacs in just 5 years.
In the same period “Jindal Power and Steel” gave return of 20000% . So investment of Rs 50,000 was worth Rs 1 crore in just 5 years.
6. Index funds :
Index Funds are mutual funds which mirrors a particular mutual fund. They Put there money in the companies which are part of that index and in same proportion as per the weightage of the company in that index. For Eg:
Franklin India Index Fund which tracks S&P CNX Nifty Fund will invest in companies in that fund in the same ratio as their weights. Suppose following is the weightage table for index:
Reliance 10%
Infosys 8%
Wipro 8%
…..
…..
Ranbaxy 3%
Then the fund will also invest in these companies stocks in same proportion. The NAV’s of these mutual funds increase or decrease in the same way as the index. if index will grow by 2.4% then NAV will also increase by 2.4% .
7. Exchange Traded Funds :
ETFs are just like Index funds with some differences, ETFs are a mix of a stock and a MF in the sense that
- Like ‘mutual funds’ they comprise a set of specified stocks e.g. an index lik Nifty/Sensex or a commodity e.g. gold; and like equity shares they are ‘traded’ on the stock exchange on real-time basis
- ETFs are passively managed, have low distribution costs and minimal administrative charges. Hence most ETFs have lower expense ratios than conventional MFs.
- Convenient to trade as it can be bought/sold on the stock exchange at any time of the day when the market is open (index funds can be bought only at NAV based on closing prices)
8. Fund of Funds :
These are mutual funds which invests in other mutual funds. They put money in different mutual funds in some proportion depending on their goals and objectives.
9. Debt Funds :
Debt funds are mutual funds which have their major holdings in secure and fixed income instruments like Fixed deposits , bonds . They also put a small proportion in Equity (High risk , high returns). These are secure in nature and provide low returns.
10. Liquid Funds :
Liquid funds are used primarily as an alternative to short-term fix deposits. They invest with minimal risk (like money market funds).
Most funds have a lock-in period of a maximum of three days to protect against procedural (primarily banking) glitches, and offer redemption proceeds within 24 hours. Liquid funds score over short term fix deposits.
Watch the video given below to know about mutual funds schemes in detail.
Balanced mutual funds are those funds which invest in both equity and debt in a balanced ratio (like 60:40 or 50:50 for example).
Advantages and Disadvantages of Mutual Funds
Before investing in mutual funds an investor should understand if it suits his requirement of not . Therefore one should go through all the advantages and disadvantages of mutual funds .
Advantages of Mutual Funds
Management: One of the biggest advantage is that in very low cost the investor gets his investment managed by experts. If they want to get the services solely for their investment , it can be very expensive but by investing in MF they can take advantage of the scale.
Scale Advantage : The transaction costs of a single indivisual is very less because mutual funds buy and sell in big volumes.
Diversification : With mutual fund investment your money gets diversified in a lot of things, which helps in minimising the risk factor. Also if one particular sector does’nt perform well the loss can be compensated with profits made in other sectors.
Liquidity and Simplicity : You can sell or buy mutual funds anytime. So mutual funds are good if you want to invest in something which you can liquidate easily . Also MF are very simple to buy and sell .
Disadvantages of Mutual Funds
Risks and Costs: Changing market conditions can create fluctuations in the value of a mutual fund investment. Also there are fees and expenses associated with investing in mutual funds that do not usually occur when purchasing individual securities directly.
No Guarantees: As MF invest in debt as well equities , there are no sure returns . Returns depends on the market conditions .
No Control: Investor does not have control on investment , all the decisions are taken by the fund manager. Investor can just join or leave the show.
I am sure this must have given you a good enough idea of basics of Mutual Funds in India and a general idea of types of mutual funds. In case you have any comments or any query, please leave your message in the comment section.