Introduction to Mutual Fund
What is Mutual Fund?
Simply put, the money pooled in by a large number of investors is what makes up a Mutual Fund. This money is then managed by a professional Fund Manager, who uses his investment management skills to invest it in various financial instruments.
As an investor you own units, which basically represent the portion of the fund that you hold, based on the amount invested by you. Therefore, an investor can also be known as a unit holder. The increase in value of the investments along with other incomes earned from it is then passed on to the investors / unit holders in proportion with the number of units owned after deducting applicable expenses, load and taxes.
10 things you must know about mutual fund
What is an NAV?
Our next step is to understand NAV, which stands for Net Asset Value. Just like a share has a price, a mutual fund unit has an NAV. To put it simply, NAV represents the market value of each unit of a fund or the price at which investors can buy or sell units. The NAV is generally calculated on a daily basis, reflecting the combined market value of the shares, bonds and securities (as reduced by allowable expenses and charges) held by a fund on any particular day.
Type of Funds
Debt Mutual Funds
Are you looking to invest for a short period of time or are your plans long term? To be able to choose a fund that perfectly caters to your needs; you need to be aware of the various kinds of funds that exist.
As the name suggests, A Debt Mutual Fund works on borrowing. So what are the conditions that are usually laid down when one borrows?
- Reasonable assurance that the principal investment will be returned.
- The interest that will be generated based on the rate of interest (also known as the coupon rate).
- Tenure or the time over which the principal will be returned.
Companies, state governments and even the central government all require money to run their operations. They offer various debt based instruments like TBills, Debentures, GSecs etc., and Mutual Funds buy the debt that is issued by them.
Debt Funds help bring stability to your investment portfolio since they are lower in risk as compared to Equity Funds, yet riskier than Liquid Funds and their aim itself is to generate steady returns while preserving your capital.
These would typically invest in government securities, NCD, CDs, CPs bonds and other fixed income securities as well as lend money to large organisations or Corporates, in return of a fixed interest rate. Therefore, investing in Debt Mutual Funds would be ideal if you’re looking at a potentially higher return than Liquid Funds over a medium term time horizon, between 3 to 24 months.
Equity Mutual Funds
Unlike Debt Funds, you have absolutely no assurance whatsoever on the principal, rate of interest or tenure when investing in Equity Funds. When you invest in equity, you are considered as an owner of the particular company that you’ve invested in, to the extent of your investment. So naturally, like any owner, your profit is linked with the performance of the company. The higher the profits of the company, the better is the share price and hence the better your gains.
Like with any high risk action, Equity Funds also carry the potential to deliver high returns. And to help counter this risk, Mutual Funds are invested in multiple companies that usually don’t belong to one or correlated sectors. This is known as diversifying.
In the long run, one needs to be guarded against inflation and in the short run, market fluctuations. Equity, though volatile, has proved to be a better bet against inflation, provided one has a long term investment.
Liquid & Hybrid Mutual Funds
In financial terms, the word Liquid simply means “How fast can I get my invested money back?” A highly liquid asset is as good as hard cash. Liquid Mutual Funds have the least risk factor and may give you returns that are slightly higher than a savings account. These funds invest in faster maturing debt securities,therefore making them less risky. The concept here is that the closer the debt instrument is to its maturity, the higher the chances and surety of you getting the principal and interest if there is any.
When would you choose a Liquid Fund?
Without a doubt, a savings account is by far the best option for emergency funds. As the name suggests, a savings account is a savings option. It offers the highest liquidity since you can access your balance at any moment directly through the bank or through ATM machines. But if you are left with funds that are in excess of emergency funds, then Liquid Funds are good options. They endeavour to give you your money back the very next working day, subject to the receipt of a valid redemption request. In fact, Liquid Funds can be used for investments ranging from a day up to a month or even two.
As the name suggests, Hybrid Funds are those which have a combination of asset classes such as debt and equity in their portfolio. That is, they invest in a blend of debt, money market instruments and equity. Breaking it down even further, depending on the mix of equity and debt, there could be various types of Hybrid Funds as well.
Mutual Funds are flexible
Most people have differing patterns of earning and spending, which is why investments need to be flexible so as to allow you to invest as per your situation. In order to ensure this flexibility Mutual Funds have certain characteristics like: There are various types of Mutual Funds that invest in various schemes, from money market instruments to equities, thus catering to people who’d like to invest for duration ranging from a day to years. Minimum amounts of investment range from as low as Rs. 500, with no upper limit. In the case of open ended funds, daily investment and withdrawal is possible. Invested funds can be received within 1 to 5 working days. There is no maintenance charge on portfolios. You can invest either directly with the Asset Management Company or through a Financial Intermediary.
Mutual Funds are liquid
As you would have learnt earlier, liquidity is all about having access to the money you’ve invested at your convenience. After all, what is the point of getting high returns if you can’t use the funds when you need it? Solid liquidity gives you the advantage of getting your money when you need it the most.
In open ended funds, where you can buy and sell on any business day, you can get your money back generally within 3 working days. And to make things even better, there is a 15% penalty imposed on the Asset Management Company if you don’t get your money within 10 working days.
Mutual Funds are transparent and relatively safe
Naturally there is a feeling of uncertainty or cautiousness you feel when you’re handing over your savings to somebody. You obviously need to be able to trust the person and you definitely want to know what is happening with your money, at all times. In the case of Mutual Funds, your money is handed over to a professional, whose entire job is to keep track of markets and look out for the best opportunities for you. What’s more, Mutual Funds publish a monthly fact sheet which basically lists out all the important facts you need to know about the scheme you’ve invested in.
These facts are:
- Your portfolio of holdings, that shows details of the companies and the amount invested in each company and the rating of the company’s issuance in case the instrument is a debt instrument.
- Past returns, dividends and performance ratios.
In addition, the NAV is published on AMFI and on each of the fund company websites on a daily basis, ensuring that you’re always in the loop about your investments.
Mutual Funds help you diversify
Like the old saying, “Don’t keep all your eggs in one basket”, diversifying your investments will help you lower your risk. By spreading out your money across different types of investments, investing in multiple companies and investing in more than one sector, you ensure that you always have a back-up plan intact. So when you look to invest, always consider a wide range of options. As you have previously read, Equity Mutual Funds invest in shares of various companies whereas Debt Funds invest in government securities, NCD, CDs, CPs bonds and other fixed income securities. Thus as an investor, you will be able to have a diversified investment basket.
Mutual Funds reduce the transaction cost
The power of bargaining lies in buying anything wholesale. The rate of buying in wholesale will obviously be much lesser compared to the retail rates. Now apply the same principal to Mutual Funds and what do you get? With many people pooling in their savings, you get the advantage of the power of bargaining which reduces the overall transaction cost. And what’s more, as per prevalent tax laws, under provisions of Section 10 (23D) of the Act, any income received by the Mutual Fund is exempt from tax; which simply means that funds don’t pay any tax on the gains obtained from selling securities that they buy on behalf of their investors.
Myth About Mutual Fund
Fact : Part of the fear of Mutual Funds is that everything will go above your head and that only experts in finance can understand how they work. This is not true at all! Unlike the equity market, you don’t have to take the call on when to buy or sell shares, the fund manager will do it for you. It is his job to track various sectors and companies. He will help you decide where to invest your money. So in actuality, even if you aren’t a financial expert, you will still have access to someone who is, and with his help there’s no doubt you will make the right decisions. Though Mutual fund are handled by finance experts, they do have some amount of risk associated to them, based on the market movement.
Myth : Mutual Funds are only for the long term
Fact : Yes, long-term investments have a slight advantage, but that doesn’t mean that Mutual Funds are only for such investors. In fact, there are various short-term schemes where you can invest from a day to a few weeks.
Myth : Mutual Fund is an equity product
Fact : People usually associate Mutual Funds with Equity Funds, but this is not entirely true. Mutual Funds invest in a variety of instruments ranging from equity to debt. Within debt they may invest in debt instruments that mature in a day (also known as Money Market Instruments) to those that mature in 1 or even 10 years.
Myth : Mutual Funds with a Rs. 10 NAV are better than Mutual Funds having a Rs. 25 NAV
Fact : This simply comes down to a subconscious movement towards what seems to be cheaper. But the fact is that what matters is the percentage return on invested funds. For example, given a similar performance level of 10% appreciation, a Rs. 10 NAV will rise to Rs. 11 whereas a fund with a NAV of Rs. 200 will rise to Rs. 220. The reality is, due to an already demonstrated performance, the chance of the Rs. 200 scheme posting the 10% appreciation is higher than the one that has just started its journey. So instead of concentrating on a “low” NAV and more number of units, it is worthwhile to consider other factors like the performance track record, fund management and volatility that determine the portfolio return.
Myth : One needs a large sum to invest in Mutual Funds
Fact : This is one of the most long standing myths which today have absolutely no value whatsoever. Most funds today allow investments as low as Rs. 1000, with no limits on the maximum amount. In fact, even for Equity linked savings schemes the amount is as low as Rs. 500. What’s more, there is no monthly or annual maintenance charge even if you don’t transact further. Mutual Funds also offer the SIP facility in many of their schemes which allows you to invest small amounts of your choice regularly.
Myth : One needs to have a Demat account to invest in Mutual Funds
Fact : This is not true. There are multiple ways in which you can buy Mutual Funds, some of which are Offline: By filling up a form through financial intermediaries like independent financial advisors, banks, financial distribution houses etc.
- Online: Through the many accessible distributor websites
- Online: Through AMC websites
If you have a Demat account, you can even consolidate the Mutual Fund holdings along with other holdings in the Demat account. You can even buy Mutual Funds through the same intermediary who helps you buy and sell shares on exchanges.
Myth : Funds with a higher NAV have reached the peak
Fact : This is a very common misconception because of the general association of Mutual Funds with shares. Buy you must remember that Mutual Funds invest in shares, so they can get in and out whenever the Fund Manager deems appropriate. If the Fund Manager feels that a stock has peaked, he can choose to sell it.
To understand the reality of this myth better you need to understand that the NAV is nothing but a reflection of the market value of the shares held by the fund on any day. In all probability the NAV is high on account of a good performance over the years.
Imagine two schemes. Scheme A is a new scheme with an NAV of Rs. 15 and Scheme B is an old scheme with an NAV of Rs. 150. If the holdings of both these schemes increase by 10%, the NAV of both schemes will go up by 10%. The NAV of scheme A will be Rs. 16.5 and that of scheme B be Rs. 165. So you realise that it doesn’t really matter if the NAV is Rs. 15 or Rs. 150.
Dreams Can Be Fullfilled With The Help Of Mutual Fund
Starting early pays well
Now that you've understood the benefits of investing long-term, logic would also imply that you start investing early. It's crucial for you to start early in order to truly maximize the end returns.
Here's an example why:
Let's assume there's two friends—Sam and Kunaal. Now both of them start investing Rs. 2000 every month, earning interest at 8% p.a. on a monthly compounding basis. The only difference is that Sam starts at the age of 25, whereas Kunaal starts at the age of 35. Both of them have a principal investment of Rs. 1.2 Lakh over a period of 5 years and then hold their investments till they turn 60. But Sam's investment appreciates to over Rs. 14 Lakh while Kunaal's investment grows to only about Rs. 6 Lakh.
With the figures in place, you can clearly see the stark difference between the two and the clear advantage of investing early.
The power of long-term
Mutual Funds offer schemes of various tenures, but there is a special advantage with long-term investments — compounding. Albert Einstein called compounding mankind's greatest mathematical discovery, the 8th wonder of the world! So what exactly is compounding? Simply put, it is when the interest you gain is reinvested back in the fund. Every time this happens, your investment is allowed to grow, paving the way for a systematic accumulation of wealth. Your investment literally starts to snowball, multiplying as it goes along. Imagine, a small amount of Rs. 1000 invested every month at an interest rate of 8% for 25 years would give you Rs. 9.57 Lakh! That means your investment of Rs. 3 Lakh would have snowballed three times over!
Here is a graph that represents the same for a time period of 15 years.
Why do we invest?
There are many a thing that you may desire, from a comfortable lifestyle to securing your children's future. Investing is what takes you one step closer to achieving these goals. The fact is that merely saving for these desires may not actually help in achieving them. You need to take a certain level of risk, according to the nature of the objective, to ensure that these goals are actually met.
Usually when a person saves and invests, it would be for any of the following reasons:
- Capital Preservation
- Income Generation
- Capital Appreciation
Start with yourself
In a way investing is very personal in nature. Since your needs and desires are specific to you, so what works for you may not work for your friend. The world of investments is constantly evolving and the sheer number of options and alternatives available can leave even a seasoned investor confused. And there is always a conscious need to avert risks and choose an option that delivers the highest with the least amount of risk. Unfortunately, this is not always possible.
But the learning in this should be not to give up and completely switch off, but instead to list down your needs, expectations and desires. It may sound like an easy task, but sometimes the simplest of things are the hardest. You need to have a healthy debate with your family on balancing your spends with your investments. Once a consensus has been reached and you are certain of what you need, you can then shop around and find the Mutual Funds that are just perfect for you. Your safest bet to eliminating risk is not by simply choosing what seems to be a risk-free fund, but by thorough and methodical planning.