Mutual funds are one of the easiest ways to get exposure to Equities, debt instruments, commodities, and real estate and as people are becoming aware of the opportunities that the markets can provide, they want to start their investing journey as soon as possible.

But, if we invest in any product without having adequate knowledge, we are bound to make some mistakes.

So, in this article, we will be talking about the basics of mutual funds, like what mutual funds are, how they work, what are the different types of mutual funds and we’ll also try to explain some jargon that are used in the mutual fund industry.

So let’s jump straight into it.

What are mutual funds?

A Mutual fund is a professionally managed fund, where an AMC (Asset management company) pools the money of investors to invest into stocks, bonds, commodities, etc.

The major reason why most people are interested in investing via mutual funds is that it allows you to have diversification in your portfolio, without the hassle of you taking any of the decisions, like in which stocks, bonds, commodities, etc to invest into or how much to invest. Mutual funds are managed by a team of investment professionals, who manage your money and promise to give a good return over the long term.

So, Mutual funds have the advantage of scale, diversification, liquidity, and professional management.

Now, there are various kinds of mutual funds available, these can be broadly categorized on the basis of the following characteristics ~

1. Based on the asset class.

2. Based on the structure.

3. Goal-based funds.

Based on the asset class

1. Equity Funds

As the name suggests, these mutual funds mainly focus on investing in the Equity segment and mainly focus upon either long term capital appreciation or earning a regular income from these stocks, in the form of dividends, Generally, these funds are considered to be risky as compared to debt, or hybrid funds (we will talk about them later), but the reward is also on the higher side.

Equity funds are further subdivided into various categories ~

a. Large-cap funds - These mutual funds invest more than 80% of their assets in shares of large-cap companies (Top 100 companies in terms of market capitalization), these mutual funds are considered to be less risky as they invest in companies that have a proven track record, but the reward is also on the lower side as compared to the mid and small-cap funds.

b. Mid-cap funds - These mutual funds invest around 65% of their assets in shares of mid-cap companies (101-250th placed companies according to market capitalization), these funds offer higher returns than the large-cap funds, but the risk is also on the higher side.

c. Small-cap funds - These mutual funds invest around 65% of their assets in shares of small-cap companies (those which have a market capitalization of less than 5000 Crores), these funds offer higher returns as compared to the mid and large-cap funds, but they are also highly volatile.

2. Debt funds

These mutual funds aim to invest in the debt instruments, like bonds, Treasury bills, corporate bonds, etc, these funds are usually considered as “less risky” as compared to the Equity funds, though these funds also have some risks like credit risk, liquidity risk, Interest rate risk, we’ll cover these in detail some other day.

Debt funds are of 4 types :

a. Gilt funds

These funds mainly invest into government securities, these are high-rated securities with very low credit risk, Since the government seldom defaults on the loan it takes in the form of debt instruments; gilt funds are an ideal choice for risk-averse fixed-income investors.

b. Junk bond schemes

These funds invest in corporate bonds that do not have an investment-grade credit rating, these are low-rated securities with very high credit risk. Junk bonds are also known as high-yield bonds because the interest payments are higher than for the average corporate bond.

c. Fixed maturity plans

These are closed-ended funds that come with a fixed lock-in period, and a limited investment window (you can only invest in these funds when these AMC’s come with new NFO’s), these funds mainly invest in T-bills, CD’s and corporate bonds.

3. Money market funds

These funds are basically short-term debt funds, they invest into money market instruments like T-bills, CD’s, Repos, and are considered to be highly liquid, the average maturity of a money market fund is 1 year.

4. Hybrid funds

As the name suggests these mutual funds can invest into a variety of assets, like equity, debt, so they try to provide you the best of both worlds, and the major advantage of these funds is that the fund can adjust their holdings depending upon the changing market conditions, like sometimes it’s more beneficial to have a bit more exposure in equities sometimes it’s not, but yes, there are some rules that these funds have to follow like they can’t just put everything into one asset type, they typically hold 60% in stocks and 30% in bonds.

Hybrid funds are further sub-divided into 3 types ~ Monthly income plan, a balanced fund, an arbitrage fund.

Based on Structure

1. Open-ended funds

These funds do not have any restrictions on the number of units they can create, So, you can enter and exit into these funds at any time after the NFO, they are usually considered to be highly liquid funds.

2. Closed-ended funds

You can enter into these funds only when their NFO comes, and you can not exit before the maturity period (usually between 3-5 years), though SEBI has mandated these funds to be traded on exchanges, So you can buy or sell them at the exchange, but they are usually considered to be highly illiquid.

3. Interval funds

These funds have the features of both open-ended as well as closed-ended funds, as the name suggests, these funds are opened for the repurchase and offloading of the shares at different intervals during the fund tenure.

Goal-based funds

1. Growth funds

These funds focus upon investing for the purpose of providing capital appreciation in the long term via investing in the equities, as these funds focus upon equities they are considered to be risky, so they are mainly suited for those who are looking to take higher risks to generate higher returns in the long term.

2. Income funds

These funds primarily invest in Fixed income instruments like bonds, debentures, etc, these are considered to be “less risky” and are less volatile as compared to the growth funds, as the main focus of the income funds is capital protection.

3. Liquid funds

These funds primarily focus on investing in the very short term, liquid instruments like T-bills, CD’s, their purpose is to provide liquidity whenever you want it, like say you got some spare cash and you think that you might need that in the next 1 -2 years, so if you keep that into savings account you will only get about 3-4%, whereas if you invest that cash into liquid funds you will be able to get around 6-7% return with the option of liquidating your units whenever you want. These mutual funds provide you with high liquidity with very little volatility.

4. Tax saving funds (ELSS)

These are open-ended mutual funds with at least 80% of their assets invested in stocks, they also aim to provide you tax benefits under section 80C of the income tax act, these mutual funds have a minimum lock-in period of 3 years.

Now, let’s understand some key terms used in the mutual fund’s industry ~

1. AMC ~ An AMC (asset management company) is a financial institution that manages your fund, they invest your money in various avenues like stocks, bonds, real estate, etc.

There are about 44 AMC’s in India.

These are some of the top AMC’s in India ~ HDFC mutual fund, ICICI prudential mutual fund, SBI mutual fund, UTI mutual fund, and DSP fund.

2. NAV ~ Net asset value of an AMC is its total assets less its liabilities, the NAV for each mutual fund is calculated at the end of each trading day based on the closing market prices of the portfolio’s constituents.

3. NFO ~ When an AMC launches a new fund, they raise their initial capital by announcing a new fund offering(NFO), It’s similar to that of the concept of IPO (initial public offering).

4. AUM ~ Asset under management is the total value of the assets which are being managed by the fund. It’s the sum total of the investments made by the fund plus the cash held in reserves.

5. Exit load ~ It is generally the fees that is charged at the time of exiting from the mutual fund, if we exit from the fund before a specified time period, It is generally 0.5 - 1% of the total amount withdrawn, Mutual fund charges exit load to discourage investors from redeeming before a certain time period.

6. Expense Ratio ~ This is probably one of the most important criteria that investors look at before investing in a mutual fund, Expense ratio is the annual fee charged by AMC’s to its investors, for managing their money, a high expense ratio can reduce your returns drastically over the long term, so it’s always advisable to check the expense ratio of the fund before investing in it. Generally, the expense ratio varies between 1% to 2.5%.

7. SIP ~ Systematic investment plan (SIP) is a tool that helps you to invest in mutual funds at regular intervals, typically in an equity mutual fund scheme, it helps you to stay disciplined, and also it helps you to stay sane even in the high volatility periods, as you are always investing in a staggered manner, and not at once, and you can start investing in mutual funds via SIP with a minimum investment of 500 Rs.

So, that’s it for today from our side, if you learned something new from this article then do share it with your friends over social media.

Thanks for reading!