What Are Mutual Funds?
A mutual fund is a pool of money managed by a professional Fund Manager.
It is a trust that collects money from a number of investors who share a common investment objective and invests the same in equities, bonds, money market instruments and/or other securities. And the income / gains generated from this collective investment is distributed proportionately amongst the investors after deducting applicable expenses and levies, by calculating a scheme’s “Net Asset Value” or NAV. Simply put, the money pooled in by a large number of investors is what makes up a Mutual Fund.
Here’s a simple way to understand the concept of a Mutual Fund Unit.
Let’s say that there is a box of 12 chocolates costing ₹40. Four friends decide to buy the same, but they have only ₹10 each and the shopkeeper only sells by the box. So the friends then decide to pool in ₹10 each and buy the box of 12 chocolates. Now based on their contribution, they each receive 3 chocolates or 3 units, if equated with Mutual Funds.
And how do you calculate the cost of one unit? Simply divide the total amount with the total number of chocolates: 40/12 = 3.33.
So if you were to multiply the number of units (3) with the cost per unit (3.33), you get the initial investment of ₹10.
This results in each friend being a unit holder in the box of chocolates that is collectively owned by all of them, with each person being a part owner of the box.
Next, let us understand what is “Net Asset Value” or NAV. Just like an equity share has a traded price, a mutual fund unit has Net Asset Value per Unit. The NAV is the combined market value of the shares, bonds and securities held by a fund on any particular day (as reduced by permitted expenses and charges). NAV per Unit represents the market value of all the Units in a mutual fund scheme on a given day, net of all expenses and liabilities plus income accrued, divided by the outstanding number of Units in the scheme.
Mutual funds are ideal for investors who either lack large sums for investment, or for those who neither have the inclination nor the time to research the market, yet want to grow their wealth. The money collected in mutual funds is invested by professional fund managers in line with the scheme’s stated objective. In return, the fund house charges a small fee which is deducted from the investment. The fees charged by mutual funds are regulated and are subject to certain limits specified by the Securities and Exchange Board of India (SEBI).
India has one of the highest savings rate globally. This penchant for wealth creation makes it necessary for Indian investors to look beyond the traditionally favoured bank FDs and gold towards mutual funds. However, lack of awareness has made mutual funds a less preferred investment avenue.
Mutual funds offer multiple product choices for investment across the financial spectrum. As investment goals vary – post-retirement expenses, money for children’s education or marriage, house purchase, etc. – the products required to achieve these goals vary too. The Indian mutual fund industry offers a plethora of schemes and caters to all types of investor needs.
Mutual funds offer an excellent avenue for retail investors to participate and benefit from the uptrends in capital markets. While investing in mutual funds can be beneficial, selecting the right fund can be challenging. Hence, investors should do proper due diligence of the fund and take into consideration the risk-return trade-off and time horizon or consult a professional investment adviser. Further, in order to reap maximum benefit from mutual fund investments, it is important for investors to diversify across different categories of funds such as equity, debt and gold.
While investors of all categories can invest in securities market on their own, a mutual fund is a better choice for the only reason that all benefits come in a package.
A plethora of schemes to choose from
Mutual funds are favoured globally for the variety of investment options they offer. There is something for every profile and preference.
Chart 1: Risk/Return trade-off by mutual fund category
Type of Mutual Fund schemes
Mutual Fund schemes could be ‘open ended’ or close-ended’ and actively managed or passively managed.
Open-Ended and Closed-End Funds
An open-end fund is a mutual fund scheme that is available for subscription and redemption on every business throughout the year, (akin to a savings bank account, wherein one may deposit and withdraw money every day). An open ended scheme is perpetual and does not have any maturity date.
A closed-end fund is open for subscription only during the initial offer period and has a specified tenor and fixed maturity date (akin to a fixed term deposit). Units of Closed-end funds can be redeemed only on maturity (i.e., pre-mature redemption is not permitted). Hence, the Units of a closed-end fund are compulsorily listed on a stock exchange after the new fund offer, and are traded on the stock exchange just like other stocks, so that investors seeking to exit the scheme before maturity may sell their Units on the exchange.
Actively Managed and Passively Managed funds
An actively managed fund is a mutual fund scheme in which the fund manager “actively” manages the portfolio and continuously monitors the fund's portfolio , deciding on which stocks to buy/sell/hold and when, using his professional judgement, backed by analytical research. In an active fund, the fund manager’s aim is to generate maximum returns and out-perform the scheme’s bench mark.
A passively managed fund, by contrast, simply follows a market index, i.e., in a passive fund , the fund manager remains inactive or passive inasmuch as, she does not use her judgement or discretion to decide as to which stocks to buy/sell/hold , but simply replicates / tracks the scheme’s benchmark index in exactly the same proportion. Examples of Index funds are an Index Fund and all Exchange Traded Funds. In a passive fund, the fund manager’s task is to simply replicate the scheme’s benchmark index i.e., generate the same returns as the index, and not to out-perform the scheme’s bench mark.