What Is a Mutual Fund?
A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund's assets and attempt to produce capital gains or income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.
Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market cap of the fund—derived by the aggregating performance of the underlying investments.
Mutual Funds:Detailed Breaking Down
Mutual fund, unlike stocks, do not invest only in a particular share. Instead, a mutual fund plan would invest across several investment options to provide investors with the best possible returns. Also, investors are not required to do their research to pick best-performing stocks as the fund manager, and his team of analysts and market researchers do the research and choose the top-performing instruments that have the potential to offer high returns.
The mutual fund investors are allocated with fund units proportional to the amount they have invested. The returns that an investor would get will depend on the number of fund units held by them. Each fund unit has exposure to all the securities that the fund manager has chosen to include in the portfolio. Holding fund units does not provide investors with the voting rights of any company.
By investing in mutual funds, the investors need not worry about the concentration risk as the fund manager mitigates this by investing across several instruments. Therefore, investing in mutual funds is an excellent way of diversifying your investment portfolio. The price of the fund unit of a mutual fund is referred to as the net asset value (NAV). It is the price at which you buy or sell fund units of a mutual fund scheme. The NAV of a mutual fund is calculated by dividing the total worth of assets in the portfolio, minus liabilities. All mutual fund units are sold and bought at the prevailing NAV of the mutual fund.
Types of Mutual Funds
Mutual funds in India are broadly classified into equity funds, debt funds, and balanced mutual funds, depending on their asset allocation and equity exposure. Therefore, the risk assumed and returns provided by a mutual fund plan would depend on its type. We have broken down the types of mutual funds in detail below:
- Equity funds , as the name suggests, invest mostly in equity shares of companies across all market capitalisations. A mutual fund is categorised under equity fund if it invests at least 65% of its portfolio in equity instruments. Equity funds have the potential to offer the highest returns among all classes of mutual funds. The returns provided by equity funds depend on the market movements, which are influenced by several geopolitical and economic factors. The equity funds are further classified as below:
- i. Small-Cap Funds
Small-cap funds are those equity funds that predominantly invest in equity and equity-linked instruments of companies with small market capitalisation. SEBI defines small-cap companies as those that are ranked after 251 in market capitalisation.
- ii. Mid-Cap Funds
Mid-cap funds are those equity funds that invest primarily in equity and equity-linked instruments of companies with medium market capitalisation. SEBI defines mid-cap companies as those that are ranked between 101 and 250 in market capitalisation.
- iii. Large-Cap Funds
Large-cap funds are those equity funds that invest mostly in equity and equity-linked instruments of companies with large market capitalisation. SEBI defines large-cap companies as those that are ranked between 1 and 100 in market capitalisation.
- iv. Multi-Cap Funds
Multi-Cap Funds invest substantially in equity and equity-linked instruments of companies across all market capitalisations. The fund manager would change the asset allocation depending on the market condition to reap the maximum returns for investors and reduce the risk levels.
- v. Sector or Thematic Funds
Sectoral funds invest principally in equity and equity-linked instruments of companies in a particular sector like FMCG and IT. Thematic funds invest in equities of companies that operate with a similar theme like travel.
- vi. Index Funds
Index Funds are a type of equity funds having the intention of tracking and emulating the performance of a popular stock market index such as the S&P BSE Sensex and NSE Nifty50. The asset allocation of an index fund would be the same as that of its underlying index. Therefore, the returns offered by index mutual funds would be similar to that of its underlying index.
- vii. ELSS
Equity-linked savings scheme (ELSS) is the only kind of mutual funds covered under Section 80C of the Income Tax Act, 1961. Investors can claim tax deductions of up to Rs 1,50,000 a year by investing in ELSS.
- Debt Mutual Funds
Debt mutual funds invest mostly in debt, money market and other fixed-income instruments such as treasury bills, government bonds, certificates of deposit, and other high-rated securities. A mutual fund is considered a debt fund if it invests a minimum of 65% of its portfolio in debt securities. Debt funds are ideal for risk-averse investors as the performance of debt funds is not influenced much by the market fluctuations. Therefore, the returns provided by debt funds are very much predictable. The debt funds are further classified as below:
- i. Dynamic Bond Funds
Dynamic Bond Funds are those debt funds whose portfolio is modified depending on the fluctuations in the interest rates.
- ii. Income Funds
Income Funds invest in securities that come with a long maturity period and therefore, provide stable returns over time. The average maturity period of these funds is five years.
- iii. Short-Term and Ultra Short-Term Debt Funds
Short-term and ultra short-term debt funds are those mutual funds that invest in securities that mature in one to three years. These funds are ideal for risk-averse investors.
- iv. Liquid Funds
Liquid funds are debt funds that invest in assets and securities that mature within ninety-one days. These mutual funds generally invest in high-rated instruments. Liquid funds are a great option to park your surplus funds, and they offer higher returns than a regular savings bank account.
- v. Gilt Funds
Gilt Funds are debt funds that invest in high-rated government securities. It is for this reason that these funds possess lower levels of risk and are apt for risk-averse investors.
- vi. Credit Opportunities Funds
Credit Opportunities Funds mostly invest in low rated securities that have the potential to provide higher returns. Naturally, these funds are the riskiest class of debt funds.
- vii. Fixed Maturity Plans
Fixed maturity plans (FMPs) are close-ended debt funds that invest in fixed income securities such as government bonds. You may invest in FMPs only during the fund offer period, and the investment will be locked-in for a predefined period.
- Balanced or Hybrid Mutual Funds
Balanced or hybrid mutual funds invest across both equity and debt instruments. The main objective of hybrid funds is to balance the risk-reward ratio by diversifying the portfolio. The fund manager would modify the asset allocation of the fund depending on the market condition, to benefit the investors and reduce the risk levels. Investing in hybrid funds is an excellent way of diversifying your portfolio as you would gain exposure to both equity and debt instruments. The debt funds are further classified as below:
- i. Equity-Oriented Hybrid Funds
Equity-oriented hybrid funds are those that invest at least 65% of its portfolio in equities while the rest is invested in fixed-income instruments.
- ii. Debt-Oriented Hybrid Funds
Debt-oriented hybrid funds allocate at least 65% of its portfolio in fixed-income instruments such as treasury bills and government securities, and the rest is invested in equities.
- iii. Monthly Income Plans
Monthly income plans (MIPs) majorly invest in debt instruments and aim at providing a steady return over time. The equity exposure is usually limited to under 20%. You can decide if you would receive dividends on a monthly, quarterly, or annual basis.
- iv. Arbitrage Funds
Arbitrage funds aim at maximising the returns by purchasing securities in one market at lower prices and selling them in another market at a premium. However, if the arbitrage opportunities are not available, then the fund manager may choose to invest in debt securities or cash equivalents.