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Understanding Mutual Funds: How it works and its benefits

Who doesn’t want to make money?

For sure, most of us, and that’s how it goes. Right?

There’s an ultimate source, i.e., “investment of money.” Investors invest its money, and their primitive goal is to grow their money. More often, people get confused about where to invest money to grow the money to some reasonable extent. The best option out there for both the concerns would be “Mutual Funds.”

Here, I will brief you step by step on the crucial aspects that one needs to understand before investing in mutual funds:

What are mutual funds?

Mutual funds are one of the smart as well as a crucial option for investment. Mutual funds are a type of investment schemes. It is an approach to pool in money for investment in various underlying securities such as stocks, bonds, gold, government securities, and other financial instruments.

An Asset Management Company (AMC) invests the pooled funds from clients into the underlying securities. When, where, and how to invest the money is decided by the fund house. The fund manager manages pooled investment. They are finance professionals. The decisions will be in accordance with their expressed investment objectives.

Types of Mutual Funds

Plenty of mutual funds categories are there that are offered by the financial institutions and fund houses.  The categories are based on the assets invested, fund objectives, type of schemes rely on the willingness to take the risk, their goals, the investment term, the investable amount, and so on.

Majorly as per SEBI, three categories of mutual funds are there (i.e., Equity Funds, Debt Funds, and Hybrid Funds):

  1. Equity Funds

It is a mutual fund scheme that invests chiefly in equity stocks. As per SEBI, an equity mutual funds scheme must invest at least 65% of its assets in equities and equity-related instruments. It can invest the amount up to 0% – 35% in debt or money market securities.

The equity funds are blessed with certain tax advantages as per the tax regime in India. Equity funds can be actively or passively managed. It is supremely classified in accordance with the company size, style of investment of the holdings in the portfolio, and geography. The equity fund size is ascertained by a market capitalization, whereas the investment style, reflected in the fund’s stock holdings, is also used to categorize the equity mutual funds.

Equity fund has relatively higher risk and higher return capability as they invest in stocks that are highly responsive to changes in the stock market and the economy.

SEBI classified equity funds into 11 categories, but a mutual fund company has ten categories, and it has to opt between value fund or Contra fund.

  1. Multi-Cap Fund
  2. Large Cap Fund
  3. Large and Mid-Cap Fund
  4. Mid Cap Fund
  5. Small Cap Fund
  6. Dividend Yield Fund
  7. Value Fund
  8. Contra Fund
  9. Focused Fund
  10. Sectoral/Thematic Fund
  11. ELSS

Among the above mentioned, some famous ones are:

ELSS: As per the Equity Linked Saving Scheme, the minimum investment is 80% of the total assets. It is an open-ended equity-linked saving scheme. It comes with a statutory lock-in duration of 3 years and tax benefit (the only equity fund, i.e., eligible for a tax deduction of up to Rs. 1.5 lac u/s 80C of the Income Tax Act).

Large Cap Fund: The minimum investment in large-cap companies is 80% of the total assets. The Large Cap Funds mainly invest in Large Cap stocks. These types of funds are used to offer stable and sustainable returns over a duration of time. It tends to hold up quite well in recessions. It is less risky and less volatile than mid-cap and small-cap stocks.

Small Cap Fund: The minimum investment in small-cap companies is 65% of the total assets. The Small-Cap Funds mainly invest in Small Cap stocks. The risk is higher with small-cap stocks than with large-cap and mid-cap stocks. Hence, it tends to be more volatile in nature.

  1. Debt Funds

Debt funds are also known as Income Funds or Bond Funds. It is a mutual fund scheme that invests its assets in fixed income instruments like corporate debt securities, money market instruments, corporate and government bonds, and so on that offer capital appreciation.

In accordance with the Income Tax Act, a debt fund invests less than 65% of its total assets inequities. Debt funds have stable returns, low-cost structure, highly liquid, and reasonably safe. Most investor’s choice is Debt Funds as it has come with relatively lower risk levels.

SEBI classified debt funds into 16 categories under debt schemes:

  1. Overnight Fund
  2. Liquid Fund
  3. Ultra Short Duration Fund
  4. Low Duration Fund
  5. Money Market Fund
  6. Short Duration Fund
  7. Medium Duration Fund
  8. Medium to Long Duration Fund
  9. Long Duration Fund
  10. Dynamic Bond
  11. Corporate Bond Fund
  12. Credit Risk Fund
  13. Banking and PSU Fund
  14. Gilt Fund
  15. Gilt Fund with 10 Year Constant Duration
  16. Floater Fund

Among the above mentioned, some famous ones are:

Liquid Funds: Liquid Funds are the liquid schemes. These are low duration funds. It has an investment in debt and money market securities with portfolio maturity of up to or less than 91 days. The risk is relatively low among all debt funds as it has a shorter maturity period.

Dynamic Bond: It is a dynamic debt scheme investing across duration. It is effectively managed by decreasing the portfolio maturity in an increasing interest rate environment and increasing portfolio maturity in a falling interest rate environment. It is ideal for investors who have difficulty in getting the movement of the interest rate. As the flexibility to alter the portfolio maturity according to the interest rate scenario has been offered, it tends to help the investors minimize interest rate risk. When interest rates fall, maturity is longer, and when interest rates rise, it is shorter.

  1. Hybrid Funds

Hybrid mutual funds invest in two or more asset classes, including debt, equities, money market instruments, gold, overseas securities, and so on. Basically, hybrid funds are the blend of Equity and Debt assets, and sometimes they also include Gold or even Real estate.

SEBI classified Hybrid Funds into seven categories under hybrid schemes:

  1. Conservative Hybrid Fund
  2. Balanced Hybrid Fund
  3. Aggressive Hybrid Fund
  4. Dynamic Asset Allocation or Balanced Advantage
  5. Multi-Asset Allocation
  6. Arbitrage Fund
  7. Equity Savings

Among the above mentioned, the famous one is:

Dynamic Asset Allocation or Balanced Advantage

The investment in equity and debt (between 0%-100%), i.e., managed dynamically. All popular dynamic funds or balanced advantage will fall into this category. It will change its equity exposure based on market conditions. This sort of fund aims to sell equities and book profits in overvalued equity market conditions while doing the converse when equity market valuations are alluring. A Dynamic Asset Allocation Fund diminishes its debt exposure in undervalued markets and increases its debt holding during a bull run. These funds are suitable for investors who want to automate their asset allocation.

  1. Solution-Oriented Schemes

i) Retirement Fund

ii) Children’s Fund

  1. Other Schemes

i) Index Funds/ ETFs

ii) FoF’s (Overseas/ Domestic)

Also Read: 8 Powerful Ways To Make Extra Money Without Quitting Job

How does Mutual Fund Work?

The most smoother way of investment in Mutual Funds. It ascertains easy liquidity as when you need funds; you can encase the money. There are various ways where you can invest, be it online, offline, directly, or through a fund manager, and the minimum investment amount is Rs. 500.

The investment objective of the mutual fund ascertains what types of securities it buys. It can focus on a definite kind of investment. For instance, a fund may invest mainly in stocks from large companies, government bonds, or stocks from certain countries; it may also invest in different investments.

There is thorough clarity of the investments, and a monthly report has been shared with the investors as per SEBI guidelines.

A mutual fund collects money from you and various investors and allots units. The price of each fund unit is known as the Net Asset Value (NAV).

The strategy lies in 4 steps. Here, starting with the New Fund Offer (NFO) where investors get the chance to subscribe to a mutual fund scheme and say invested in it right from its outset. After that, money is pooled from various small investors to invest in securities. Then, the pooled money is invested in securities like shares, bonds, and government securities. At last, the fund returns as the portfolio manager constantly hustles to earn good returns from the investments they make on behalf of the fund investors. Thus, all their mutual fund research efforts, monitoring, and rebalancing the portfolio increases the fund’s NAV.

For Instance:

Let’s say Canara Robeco Mutual Fund has launched a mutual fund scheme. Let’s take one Canara Robeco Bluechip Equity Fund, although this is already existing. For now, suppose the scheme collects INR 1 crore from 100 investors. Investment per investor being INR 1 lakh. The fund house allots the units at a NAV of INR 10. Therefore, each investor gets 10,000 units. Thus, the total number of units issued and allocated by the fund house is 10 lakh units.

Mutual Fund Calculators:

Mutual Fund can be calculated as there are several Mutual fund calculators:

Inflation Calculator: It calculates the impact of inflation on the money. You can find out how much you will require in the future to meet your current expenses when sustaining inflation.

SIP Calculator: You can calculate the future value of your monthly/quarterly SIP investment.

Goal SIP Calculator: You can ascertain the monthly SIP investments you need to reach a specified goal.

Things to keep in mind while investing in Mutual Funds

Proper Planning: A proper systematic investment plan or SIP is crucial in the financial decision. As each month, some extent of money will be cut from your account and invested in the fund.

Risk Factor: The risk and return factor relies on what the funds invest in. Equity funds will be a good option if you have a good risk profile, Debt funds if you are a minimal risk-taker, and wish to earn a stable income. Hybrid funds have both such features of equity and debt funds hence, it provides you dual exposure.

Time Factor: It’s crucial to know the market condition as to whether it is sinking or soaring before investing. Although for both matters, mutual funds are good to invest in regardless of market fluctuations. It tends to come up with some good extent of growth over a while.

Historic Fund’s Performance: The performance of mutual funds in the past can’t just tell you how it might perform in the future. Instead, past performance can help you ascertain how volatile or risky the fund’s returns may be. It will provide you with a good brief.

NAV Factor: Most crucial element I would say for an investor to make a mutual fund investment. A fund with lesser NAV will give higher growth, whereas high NAV will give lower growth.

Also Read: How To Build An Emergency Fund. Personal Finance Guide

Benefits Mutual Funds

Blessed with tax benefits: The tax amount for your Mutual Fund investments will be much lesser than other investment like fixed deposits if you are into the highest tax brackets.

Diverseness: The money is invested in multiple securities as it has diverse options out there. Plenty of mutual funds investment schemes are out there. As per the investment goals, investment horizon, risk appetite, one can choose to invest.

Regulatory Control: As mutual funds schemes are regulated by SEBI. It led to transparency in the context of its investment decisions and holdings. It helps the investors to maintain the track and reports.

The Perk of Fund Exchange: It is a blissful feature where an investor can switch from one scheme to the other within the fund family without paying any extra charges.

Benefits of Compounding: It means the interest that an investor earns on the interest accrued on the principal, and this led to the value of the investment keeps growing. Apart from that, it also rises over time as the company grows or increases in asset price.

Well, Happy Investing!

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Ayushi Sinha
Ayushi Sinha
Ayushi is free-spirited, a learner, listener, observer, nature, and wildlife enthusiast. She has experience working as a Research Analyst and Content Writer. She loves singing, creative writing, reading, arts, cooking, and exploring places. She believes hard work through smart ways is more important than talent as you can't master your talent unless and until you work on it. She is adaptable, way determined, and positive towards her work.

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