Mutual Funds: Meaning, Benefits, How They Work, and How to Invest

Team AckoAug 23, 2024

Mutual Funds are a popular investment avenue in India, as they provide individuals with an opportunity to invest in a varied portfolio of securities managed by professionals. With diversified portfolios, professional management, and various types to choose from, these funds offer flexibility, transparency, and the potential for attractive returns.

However, it is crucial to assess the risks associated with them and align investments with individual financial objectives. Read ahead to gain a better understanding of Mutual Funds and their intricacies.

Contents

• What is Mutual Funds?
• How do Mutual Funds work?
• Advantages of Mutual Funds
• Risks associated with Mutual Funds
• Types of Mutual Funds
• How to invest in Mutual Funds
• Frequently Asked Questions

What is Mutual Funds?

A Mutual Fund is a hassle-free investment vehicle. It pools money from multiple investors, which is invested in a diverse range of securities; for example, stocks, bonds, etc. These funds are managed by fund managers. 

How do Mutual Funds work?

Mutual Funds function by accumulating funds from various investors and investing them in a diversified portfolio of securities. The funds are managed by experienced professionals who analyse market trends, perform research, and make investment decisions to maximise returns and mitigate risks.

Here’s how Mutual Funds generally work.

1. Fund creation: The fund is created by an Asset Management Company (AMC), which collects money from investors through the sale of Mutual Fund units.

2. Portfolio creation: The collected funds are then used to create a portfolio of various securities such as stocks, bonds, and money market instruments. The selection of securities is based on the investment objective of the scheme.

3. Professional management: The portfolio is managed by experienced fund managers. They analyse market trends, perform research, and monitor the performance of the securities.

4. Buying and selling: The fund manager buys and sells securities within the portfolio based on market conditions and the investment strategy of the scheme. The aim is to generate returns and maximise the value of the portfolio.

5. Net Asset Value (NAV) calculation: At the end of each business day, the NAV of the fund is calculated. It represents the per-unit value of the fund and is determined by dividing the total value of the fund's assets by the number of units outstanding.

6. Purchase and redemption of units: Investors can purchase Mutual Fund units at the prevailing NAV. When investors want to redeem their units, they can sell them back to the fund at the NAV. The redemption proceeds are based on the number of units held by the investor.

7. Distribution of dividends and capital gains: If the Mutual Fund scheme generates income from dividends or capital gains, it is distributed among the investors in proportion to their holdings. This distribution can be in the form of dividends or reinvested back into the scheme.

8. Regular reporting and communication: The scheme provides regular updates and disclosures to investors. This includes periodic reports, fact sheets, and information regarding any changes in the scheme's portfolio or investment strategy.

Advantages of Mutual Funds

Investing in Mutual Funds offers several advantages to investors. Here’s a list. 

• Diversification: They allow investors to diversify their investments across different securities, reducing the risk associated with investing in a single security.

• Professional management: They are managed by experienced professionals who possess in-depth knowledge of the market, helping investors make informed investment decisions.

• Liquidity: They offer high liquidity as investors can easily buy or sell their fund units at the NAV on any business day.

• Flexibility: They provide investors with flexibility in terms of investment amounts, allowing both small and large investors to participate.

• Transparency: They are regulated by the Securities and Exchange Board of India and are required to provide regular updates and disclosures to investors, ensuring transparency.

Risks associated with Mutual Funds

While Mutual Funds offer numerous benefits, it is important to understand the risks involved.

• Market risk: These investments are subject to market fluctuations. The value of the investments may fluctuate based on the performance of the underlying securities.

• Credit risk: Some funds invest in bonds or debt securities. There is a risk of default by the issuer, leading to a potential loss of principal and interest income.

• Interest rate risk: Funds that invest in fixed-income securities are exposed to interest rate risk.

• Liquidity risk: In certain market conditions, it may be difficult to sell the units at the desired price, resulting in potential liquidity risks for investors.

Types of Mutual Funds

Here are some of the common types of Mutual Funds.

• Equity funds: They invest primarily in stocks or equity-related securities. They aim to generate capital appreciation over the long term and are suitable for investors with higher risk tolerance.

• Debt funds: These funds aim to generate regular income by investing in fixed-income securities and are considered relatively less risky than equity funds.

• Balanced funds: Here, the investment is in a mix of equity and debt securities. They aim to provide both capital appreciation and regular income, making them suitable for investors seeking a balanced approach.

• Index funds: They aim to match the returns of the underlying index (for example, Sensex) and are passively managed.

• Tax-Saving funds: Tax-saving funds offer certain tax benefits. These funds have a lock-in period of three years and provide investors with the dual advantage of tax savings and potential capital appreciation.

How to invest in Mutual Funds

In general, here are the steps to get started with Mutual Funds. 

• Identify investment goals: Determine your investment objectives, risk appetite, and investment horizon. This will help you choose the most suitable fund category.

• Research and select funds: Conduct thorough research on different schemes, considering factors such as historical performance, fund manager expertise, expense ratio, and investment philosophy. Shortlist the funds that align with your investment goals.

• KYC Compliance: Complete the Know Your Customer (KYC) process by submitting necessary documents such as identity proof, address proof, and PAN card. This can be done through the website of a Mutual Fund or a KYC registration agency.

• Choose an investment platform: Select a reliable investment platform, such as an online aggregator or a direct platform that provides easy access to a wide range of schemes. You can also invest via your bank.

• Invest and monitor: Once you have chosen the desired scheme, make the investment through the selected platform. Monitor your investments periodically and make any necessary adjustments based on changes in your financial goals or market conditions.

Frequently Asked Questions

Here are some FAQs about Mutual Funds in India.

What is Net Asset Value (NAV)?

NAV refers to the per-unit value of a scheme. 

What is Expense Ratio?

The expense ratio of a Mutual Fund represents the annual expenses incurred by the fund, expressed as a % of its average net assets. 

What is the meaning of a Systematic Investment Plan (SIP) in Mutual Funds?

SIP refers to a disciplined approach to investing. Here, investors can place a fixed amount periodically in a chosen scheme and benefit from the power of compounding. It  mitigates the impact of market volatility through rupee-cost averaging.

Can Mutual Funds guarantee returns?

No, they do not guarantee returns. 

Are Mutual Funds safe?

Mutual Funds carry a certain level of risk as they are subject to market fluctuations. However, investing in diversified funds and understanding the associated risks can help mitigate the potential downsides.

Are there any tax implications on Mutual Fund investments?

Yes, Mutual Fund investments can be subject to tax implications. It is advisable to consult a tax advisor for a better understanding of the tax implications.

Disclaimer: The content on this page is generic and shared only for informational and explanatory purposes. It is based on several secondary sources on the internet, and is subject to changes. Please consult an expert before making related decisions. 

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