Introduction to Mutual Funds

Generally, people don’t buy things until and unless they get a mutual benefit out of the money they invested in buying them. The same goes with mutual funds as well. You should always have a defined objective before you put your money in mutual funds. By doing so, you get the mutual benefit of fulfilling your short-term or long-term objective.

In this chapter, we will touch upon the basic concepts of mutual funds, their functionality, advantages, and disadvantages of mutual funds, and much more details. Now, before we leap into the concepts in detail, here’s a small financial talk between a newlywed couple. This brief tale gives you a gist of what we will be discussing in this chapter. So, let’s begin

Introduction

Raju, 27, and Shalini, 25, are two newlyweds. They both were sitting in the park and having a serious discussion about their future. They both want to buy a beautiful house. So, they came up with an investment solution. As both are having the same dream, they decided to save together to make their dream come true. Raju and Shalini were ecstatic about their plan. But the question they have in mind is “how to multiply their savings?”. Raju, then, asked his wife Shalini whether she had any viable investment options in mind. She firmly replied, “I heard that Mutual Funds are the best way to multiply our investments.” 

Raju became curious after hearing Shalini’s idea, and asked her, “how so?”. To his question, she gave a befitting reply: “It’s simple, every fund has an objective to meet, and people invest in mutual funds with a set objective in mind.” Isn’t that wonderful? Indeed, it is. All that’s fine, but who oversees our investments?asked Raju to his wife. Well, Raju, you must know, every fund is assigned a fund manager. He handles all the investments made by the people into the fund. After hearing these words from Shalini, Raju felt assured to go with the option. 

Meanwhile, Raju decided to gather a lot of information about mutual funds. Going forward, Shalini will help you and Raju learn everything about mutual funds. So, let’s start with the basic concepts first.   

What is a Mutual Fund?

Mutual Funds are basically an investment vehicle that collects all the money from different investors having a common objective to fulfill and invests them in equity, bonds, commodities, ETFs, and other securities with an aim to spawn profits. Some of the key attributes of mutual funds are low cost, diversification, being managed by qualified professionals, can be easily redeemable at any time, and generating huge returns in the long term. All the trading decisions, both buying, and selling are in the hands of the fund manager. The growth and performance of the fund depend on how the fund managers move the investors’ mutual fund investments.

Understanding Mutual Funds

Raju and Shalini are traveling from Delhi to Ooty by train for their honeymoon trip. On their journey, there’ll be other passengers who’ll board along with them right? Some couples travel to Ooty just like Raju and Shalini, while a few get off in between when their destiny arrives. However, there will be issues in between like sudden halts or delays due to another train crossing the tracks, or some compartments might not be spick and span. Now, regardless of the state of affairs, the train reached Hyderabad. Mutual funds are just the same. 

In the above example, the train driver is the fund manager, passengers are investors, and compartments are different mutual fund investment schemes. Based on the risk and return factors, the fund manager shuffles the investments from one compartment to another to see which one is performing well. At the end of the trading day, the fund manager calculates the net asset value to find out the overall performance of the fund. The higher the NAV, the better the fund’s performance. And vice-versa.

The Big Question: Do Mutual Funds Work?

The answer to this question depends on the personal context, as the needs vary from person to person. Some take less risk, or no risk at all by parking their hard-earned savings in bank fixed deposits, hence, fewer returns or negative returns. While a few, like to try hands-on different things, also called the risk-takers. They prefer putting their money in the stock market for quick returns or playing safe by opting for mutual funds and staying patient for a certain period. The best part of investing in mutual funds is that they unquestionably beat inflation.

Over the years, fixed deposits, recurring deposits, post-office saving deposits have garnered enough popularity due to their less-risk-free nature and fixed returns. But that’s slowly changing now, as a lot of investors are understanding the risk-return concept of mutual funds. The less the risk you are willing to take, the less will be your returns, and vice-versa. Investors who comprehend the framework behind every mutual fund investment stay in the field for a long-time, and subsequently, relish more benefits. And yes, mutual funds work like magic for investors who make the right investment choices, diversify their savings, and keep a tab after investing, instead of leaving it vaguely. So, just do your bit too.   

Types of Mutual Funds

Mutual funds are broadly based on structure, risk, investment objective, specialty, and asset class. 

Mutual funds based on structure

Open-ended funds

Close-ended funds

Interval funds

Mutual funds based on asset class

Equity funds

Debt funds

Hybrid funds

Money market funds

Mutual funds based on investment objective

Growth funds

Liquid funds

Income funds

Tax-Saving funds (ELSS)

Pension funds

Fixed maturity funds

Capital protection funds

Mutual funds based on speciality 

Index funds

Global funds

Sector funds

Commodity funds

Real estate funds

Asset allocation funds

Gilt funds

Exchange-traded funds

International funds

Fund of funds

Retirement funds

Mutual funds based on risk

Very low risk

Low risk

Medium risk

High risk

You’ll learn about these in detail in the upcoming chapter. 

Mutual Fund Fees

The reason investors put their money in mutual funds is that their trading activities are taken care of by a professional expert. For the services offered, they charge a certain fee that covers up their compensation and any investment-related outlays. Now if you ask us why they charge fees for their services, here’s a simple example for your better understanding. 

Raju and Shalini invest their monthly savings of Rs 10,000 in a mutual fund. The AMC or Asset management company collects the amount from Raju and Shalini and invests in different mutual fund schemes. Every AMC has a fund manager, followed by a group of finance experts, research analysts, market experts to support as a team. From buying to selling, the fund manager is the decision-maker for all the trading activities. Just like Raju and Shalini, plenty of people invests in mutual funds. 

To handle a huge ton of pooled money with market risk in hand, it’s a must to have someone who’s a highly qualified expert with decent knowledge in the field, a terrific understanding of the markets, and relevant industry experience. And fund managers are exactly that, and sometimes even more capable professionals. For services, research work, and investments made to beat inflation and achieve the benchmark to generate returns, they charge a certain fee. 

Classes Of Mutual Fund Shares

If you remember your school days, teachers used to shuffle students based on their performance and put them in class-wise. For instance, class A consists of top-performing students, class B with average performers, and above-average performing students, and class C with poor performance. 

In the same way, mutual funds are categorized into 3 classes, namely, Class A, Class B, Class C. Each class has different charges. The higher the charges, the more the risk fund managers take to generate a higher return on investment. If things don’t go as planned by the fund manager, investors end up in losses. Hence, knowing these classes will help you to figure out which class is appropriate for you.  

Class A: Under this class, investors are charged with a front-end sales load. The charges are deducted upfront from your investment. However, they have lower annual costs and lower 12b-1 fees. (12b-1 charges cover the costs for distribution, marketing, fund advertising, and shareholder services).

Class B: Unlike Class A, here the investors pay the back-end sales load or contingent deferred sales load, 12b-1 fees, and other annual costs. There’s no upfront front-end sales charge in Class B. So, the returns you get from your investment, like interest income and capital gains, are all yours. If you are a beginner in mutual fund investment, this class would be a good fit. Moreover, the back-end sales load dwindles if the investor holds his shares in the mutual funds for a long period. The longer you hold the shares, the lesser your back-end load fees. 

Class C: This class type is apt for investors who want to redeem their shares in less time period. Under this class, investors are charged the following: annual fee, no front-end load but only a small percent of back-end sales load. However, if the investors hold the share for 1 year, the back-end load is removed too. 

Advantages Of Mutual Funds

While most people know mutual funds as risky, yet, they are the most popular investment avenues for accumulating your money. Here are some of the advantages that you must know before you invest in mutual funds. 

• Can start with a small amount: Investors don’t need to have a huge sum of money to invest in mutual funds. One can start small, say, with Rs 500, and invest in the Systematic Investment Plan, also known as SIP. In order to encourage investors to invest in mutual funds, the domestic players are accepting minimal SIP investments starting from Rs 100.   

• Tax saving option: Everyone wants to save a little tax money, and the best way to do so is by investing in mutual funds schemes like Equity Linked Saving Schemes (ELSS). Investors who invest in the aforementioned mutual fund scheme get a tax deduction of up to Rs 1.5 lakh per annum under Section 80C of the Income Tax Act. ELSS has outperformed other 80C categories like Public Provident Fund, National Saving Certificate, ULIPS, etc. 

Diversification: To grow your money, you need to diversify it through proper allocation. Mutual funds offer such diversification by investing the money into different schemes. Investing solely in equity is like taking a chance to either win or lose, as the results are based on stock market fluctuations. This is not the case with mutual funds, as they are handled by professional experts in the subject matter. To build the investor’s portfolio, fund managers diversify the risk by investing in multiple securities like stocks, bonds, ETFs, metals, gold, and other commodities.

Disadvantages Of Mutual Funds

As you have read the benefits of mutual funds, they have their share of disadvantages too. 

• Lock-in period: Investing in mutual funds requires patience because of long lock-in periods. Case-in-point, ELSS, a tax-saving mutual fund scheme, has a lock-in period of 3 years. Here, you can’t withdraw your money until the maturity period comes to an end. But if you are willing to withdraw from ELSS before the lock-in period, you are presupposed to pay the price in the form of a penalty.   

• High charges: Managing a fund requires costs such as advertising, marketing, distribution, and offering services. The investors should pay the front-end load when stocking their money in the fund. In case, if the investor is willing to exit from the scheme in the mid-way or before maturity, he/she is charged with an exit load fee. It’s important for investors to be aware of other charges like 12B-1, back-end load, and other annual expenses.

• Misusing Authority: The success of star fund managers, their experience, and outcomes may startle you to invest in mutual funds. But if that’s the only reason you are investing, and expecting the returns based on the previous performances delivered by the star fund managers – that’s totally a clouded judgment. As fund managers are the supreme authority, there are chances where they might misuse their powers and play with your money by churning your portfolio. Constant portfolio churning leads to higher taxes and costs for the investors to pay, resulting in low returns on the investments made.

In nutshell

• Mutual funds are an investment vehicle that collects funds from different investors who have a common objective i.e. to make profits.

• Mutual funds are broadly classified based on structure, risk, investment objective, specialty, and asset class. 

• Apart from the different types, mutual funds can be differentiated based on their risk level which is Class A, Class B and Class C.

• Mutual funds are beneficial because they don’t require a large sum of money to invest, are tax saving and diversified. However, they have a lock-in period for which charges may be extra incase you withdraw before the expiry of the lock-in period.