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What is a Mutual Fund? Definition, Benefits & How They Work

Mutual funds have been the buzzword in the investment arena and a large number of budding investors are exploring this vehicle. Despite the awareness around this vehicle, the level of understanding of the nuances that exist in this investment route is very minimal.

If you have been boggled by the jargon in the industry and would like to understand “What are mutual funds?” and the various benefits of investing in them, you have clicked on the right link – as this article provides you with a starter kit to navigate the financial jargon labyrinth.

What is a Mutual Fund?

Mutual funds are investment vehicles that pool in money from a large set of investors and invest this net corpus into various asset classes such as government securities, corporate bonds, stocks of companies, and other money market instruments to earn the promised returns to its investors.

A fund manager is the one who plays the role of the driver to this investment train and channels the pool of investments to align with the investment mandate and objective. Multiple schemes are launched by Asset Management Companies (AMCs) or fund houses to match the investment objectives of various investors.

The profits (or losses) earned are apportioned according to the amount invested. For example, as shown in the figure below, 4 investors invest 1 to 4 coins in a mutual fund. After a year, the fund generates profits through these investments (capital gains or dividend earnings from the equity instruments or interest income through debt instruments). These are apportioned accordingly as 1 to 4 stars (representing units of profits) to the respective investors.

As an investor, when you invest in mutual funds, you receive units of the fund in return representing your investment – similar to buying stocks of a company (however, one does not get voting rights into any company). These units are easily redeemable in the market. The price of each unit is known as Net Asset Value (NAV) and is obtained after the profits earned from the fund are adjusted for expenses and liabilities of the fund.

Net Asset Value NAV = Fund Assets – Fund Liabilities or Expenses / Number of Units

For example, XYZ Asset Management Company has launched a new fund and collects Rs 1 lakh from 10 investors. The fund house determines the NAV of the fund to be Rs 10. Hence each of the 10 investors receives Rs 10,000/10 (Units = Investment Amount/NAV) = 1000 units.

Over a period of 1 year, the fund invests in multiple securities and earns profits which translates to an increase in NAV to Rs 15. Now, the investment value of each of the investors would have increased to Rs 15 * 1000 = Rs 15000 (New NAV * units held by the investor).

Why Should You Invest In A Mutual Fund?

Diversification, management of your money by financial experts, flexibility, higher returns than typical bank deposits are some of the reasons which make mutual funds an ideal investment option.

1. Money Managed by Experts

The fund managers who manage the pool of money are financial experts who are well versed with the market and its patterns and have an excellent track record of managing funds. An enormous amount of research is done by the research analysts on each of the stocks or assets or sectors. This aids in handpicking the best stocks in the market.

2. No Lock-in Period

Mutual funds do not have a lock-in period where an investor cannot withdraw the funds. Some of the instruments in the market do allow a withdrawal but charge a fat penalty for the same.

Most of the mutual funds are categorised under the umbrella of open-ended schemes and having different levels of exit loads (small fees charged by the AMC for exiting the fund). ELSS, which is a tax-deductible instrument comes with a lock-in period of 3 years.

3. Flexibility

Mutual funds provide the flexibility of entering and exiting the fund which is a highly desired option for most of the investors, which is not available in most of the options in the market. This is owing to the high liquidity in the secondary markets (buying and selling over exchanges) for the mutual funds. Investors have also started considering mutual funds as a vehicle to save for their emergency fund. 

4. Liquidity

With the absence of a lock-in period, an investor can redeem his/her investments in case of a financial emergency. There is also a high level of convenience of completing the process within a few button clicks when compared to the long procedures of other investment counterparts. Post the request, the fund house credits the money into your account within 3-7 business days.

5. Diversification

As a retail investor, one cannot mimic the market as our ticket sizes for investments would be very low compared to the level of diversification required to beat the market. Mutual funds invest across various asset classes or various sectors in the case of securities thus providing you with the benefit of diversification. Hence, an investor need not lose his sleep, over market volatility and fluctuations as the fund takes care of such market shocks. 

6. Lower Cost

Due to the economies of scale of managing a large pool of money, the funds charge a very small % as the fees (also known as the expense ratio) from the investors for managing their investments. The fees range from 0.5% – 1.5% and do not exceed 2.5% which is the maximum fee that a fund can charge as per the mandates of SEBI.

7. Fund Switch Options

Mutual funds also provide an option to the investor to switch to another fund under the fund house. It gives a smooth option to enter and exit the fund and to transfer the investments into another fund with another sector/objective of his/her choice based on the risk appetite and other factors. Systematic Transfer Plans are also available in the category which facilitates a smooth transfer of Debt to Equity hence enabling a reallocation of the portfolio of the investor.

8. Tax Saving

Equity Linked Savings Scheme (ELSS) can be used for tax deductions up to Rs 1.5 lakhs under Section 80C of the Income Tax Act of 1961. The instrument comes with the lowest lock-in period of 3 years when compared to other tax-saving instruments. It offers the benefits of wealth accumulation and tax savings.

9. Rupee Cost Averaging

Investing into mutual funds through SIPs averages the cost of purchase of the units of the fund. In a bull market, where the prices are on the high, one purchases a lower number of units, whereas in a bear market, one accumulates the units. Hence over a period of time, the cost of the units gets averaged providing the best price for the investor and eliminating the need to time the market.

10. Regulation

SEBI strictly monitors the functioning of the mutual funds and has sacrosanct guidelines to the AMCs, ensuring the safety of the investments of a large number of retail investors.

How to Invest in Mutual Funds?

There are multiple routes through which one can make investments to Mutual Funds

1. Fund Houses

Online website: Most fund houses provide the facility for opening an account through the fund house’s official website. The KYC or e-KYC process needs to completed by filling in the details – PAN and Aadhar number. Post the verification of information, the fund house intimates you, and you can start investing. This hassle-free and quick route is preferred by most investors.

Apps: Fund houses also allow investors to invest, sell and buy through mobile devices. A detailed account of your portfolio can also be viewed on these apps.

Offline: By visiting the nearest branch office of the fund house, where an application form is provided to initiate your account. Ensure to carry the following –

o   Passport Size Photograph

o   Identity Proof

o   Cancelled check

o   Address Proof

2. Broker

Also known as a mutual fund distributor, they will aid you through the end-to-end process of your investment. Information regarding the documents required and other guidelines will be provided to you along with guidance on the funds to invest in. A fee is charged by this intermediary for his/her services and is deducted as a % of your investments.

3. EduFund

EduFund is a simple to use app that helps you invest in over 4000 mutual funds in India from all the leading fund houses in the country. The process to begin takes very little time and is quite intuitive. You just have to download the app from the app store and fill in some information to get started.

Conclusion

It is nearly impossible to time the market. However, with mutual funds, you need not hunt for the right time to invest because the right time would be now!

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