“Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing”
Does this line scare you? Have you ever wondered what documents you need to read carefully before investing? What are the basics of investing in mutual funds? In today's post, we will be uncovering everything you need to know about investing in mutual funds, in detail.
What is a Mutual Fund?
A Mutual Fund is a professionally-managed fund, where money pooled from many investors is collectively invested and managed by a fund manager. This money is invested in various assets like stocks, bonds, short-term money market instruments, commodities (especially precious metals), and virtually anything that local regulation may allow, including real estate as well.
Simply put, a mutual fund is a basket of financial assets that is managed by a professional fund manager on your behalf, and which is bought and maintained using a common pool of funds contributed by many thousands of investors - just like you!
Investors in a mutual fund have a common financial goal. Based on this, as well as the fund’s investment objective, their money is invested in different asset classes. Because the funds are well diversified, they tend to offset potential losses better. Because mutual funds are actively managed by professional fund managers, they’re a great option for investors who lack the time or knowledge to make their own investment decisions.
What are the different types of Mutual Funds?
- Open-ended funds
In an open-ended mutual fund, an investor can invest or enter and redeem or exit at any point of time. It does not have a fixed maturity period.
- Close-ended funds
Close-ended mutual funds have a fixed maturity date. An investor can only invest or enter in these types of schemes during the initial period known as the New Fund Offer or NFO period.
His/her investment will automatically be redeemed on the maturity date. They are listed on stock exchange(s).
Types Of Mutual Funds
1. Equity or growth schemes
These are one of the most popular mutual fund schemes. They allow investors to participate in stock markets. Though categorised as high risk, these schemes also have a high return potential in the long run. They are ideal for investors in their prime earning stage, looking to build a portfolio that gives them superior returns over the long-term.
Equity funds can be further divided into three categories:
1.1. Sector-specific funds (Medium - High Risk):
These are mutual funds that invest in a specific sector. These can be industrial sectors like infrastructure, banking, mining, etc. or specific segments like mid-cap, small-cap or large-cap segments. Since they are concentrated on a specific market segment, these funds are suitable for investors having a higher risk appetite.
1.2. Index funds (Medium Risk):
Index funds are ideal for investors who want to invest in equity mutual funds but at the same time don't want to depend solely on the fund managers' investing strategies. An index mutual fund follows a similar growth trajectory as does the underlying index that the fund is based on.
For example, if an index fund follows the BSE Sensex Index as the replicating index and if the index has a 5.6% weightage in let's say Stock A, then the index fund will also invest 5.6% of its total capital available in Stock A.
Index funds promise returns in line with the index they mirror. Further, they also limit the loss to the proportional loss of the index they follow, making them suitable for investors with a medium risk appetite.
1.3. Tax saving funds (Low-Medium Risk):
Along with growth potential, these funds also enable investors to avail income tax benefits. They invest in equities and are also called Equity Linked Saving Schemes (ELSS). These types of schemes typically have a 3 year lock-in period. In India, such investments made in the scheme are eligible for tax deduction for an individual or HUF a deduction from total income of up to Rs. 1.5 lacs under Sec 80C of Income Tax Act 1961
2. Money market funds or liquid funds:
These funds invest in short-term debt instruments, looking to give a reasonable return to investors over a short period of time. These funds are suitable for investors with a low risk appetite who are looking at parking their surplus funds over a short-term. These are an alternative to putting money in a savings or fixed deposit bank account.
3. Fixed income or debt mutual funds:
These funds invest a majority of the money in debt - fixed income i.e. fixed coupon bearing instruments like government securities, bonds, debentures, etc. They have a low-risk-low-return outlook and are ideal for investors with a low risk appetite looking at generating a steady income. However, they still are subject to credit risk.
4. Balanced funds:
As you may have guessed from the name, these are mutual fund schemes that divide their investments between equity and debt. The allocation may keep changing based on market risks and fund manager’s decisions. They are more suitable for investors who are looking at a combination of moderate returns with comparatively low risk.
5. Hybrid / Monthly Income Plans (MIP):
It is a kind of mutual fund wherein the investment is allocated proportionally between the equity and debt markets. They are especially suitable for investors who are retired and want a regular income with comparatively low risk.
6. Gilt funds:
These funds invest primarily in government securities. They are preferred by investors who are risk averse and want no credit risk associated with their investment. However, they are subject to high interest rate risk.
Among the reasons why an individual may choose to buy mutual funds instead of individual stocks are diversification, convenience, and lower costs.
Why to choose Mutual Funds?
Ask any investment professional, and they'll likely tell you that one of the most important ways to reduce your risk is through diversification. Mutual funds offer investors a great way to diversify their holdings instantly. Unlike stocks, investors can put a small amount of money into one or more funds and access a diverse pool of investment options.
Mutual funds also invest in a variety of different sectors. So a large cap fund may invest across different industries like financials, technology, health care, and material.
Some investors find that buying a few shares of a mutual fund that meets their basic investment criteria is easier than finding out what the companies the fund invests in actually do, and if they are good quality investments. They'd prefer to leave the research and decision-making up to someone else.
As we know that mutual funds have more than one investor involved, the cost of trading is also spread over all investors in the fund, thereby lowering the cost per individual. All fund operating expenses, popularly known as the “expense ratio” - is the percentage of assets payable to the fund manager (AMC) as the maintenance fee. This fee is managed, allocated and utilized by the asset manager, and his team of analysts and other experts (like the auditor, advisor, etc) for everyday operations, and also for advertising the fund to maximise returns and manage risks.
Now when we have a better understanding about what mutual funds are all about, lets understand the steps of investing in mutual funds:
How to invest in Mutual Funds?
- Understand your risk capacity and risk tolerance. This process of identifying the amount of risk you are capable of taking is referred to as risk profiling.
- The next step is asset allocation. Once you identify your risk profile, you should look to divide your money between various asset classes. Ideally your asset allocation should have a mix of both equity and debt instruments so as to balance out the risks.
- Then you should identify the funds that invest in each asset class. You can compare mutual funds based on investment objectives and past performance.
- Shortlist on the mutual fund schemes you will be investing in and make the application online, on ShareIndia’s web portal or mobile apps (after your KYC verification is done).
- Diversification of your investments and follow-ups are important to ensure that you get the best out of your investment.
What are the risks associated with Mutual Funds Investments?
Though mutual funds offer broader diversification and value-for-money to an individual, there are a few risks associated with investing in mutual funds.
Risk arises in mutual funds owing to the reason that mutual funds invest in a variety of financial instruments such as equities, debt, corporate bonds, government securities and many more.
The price of these instruments keeps fluctuating owing to a lot of factors which may result in losses, the different types of risks are:
Market risk is a risk which may result in losses for any investor due to multiple factors that impact the performance of different financial instruments listed in the markets. A few examples are a natural disaster, uncontrolled inflation, recession, political unrest, fluctuation of interest rates, and so on. Market risk is also known as systematic risk. Few important reasons which makes mutual fund investment a risky investments are discussed below:
Risks associated with Mutual Funds
- Interest Rate Risk
Mutual fund investments are subject to interest rate risk due to the rise or fall in interest rates. SInce there is no way to predict the interest rate, it becomes
the most important mutual funds risks to be aware of.
- Credit Risk
This is applicable to the underlying fixed income securities of mutual funds. When the issuer of the bonds is unable to pay what was promised as interest, then the issuer has defaulted or committed credit loss, making it a loss in investment.
- Lack Of Control
Undoubtedly mutual funds offer the convenience of investing, but the biggest risk is that the investors cannot determine the exact composition of a fund’s portfolio, nor can they directly influence which securities the fund manager can buy.
Mutual funds, like any other investment scheme, are subjected to these and many more risks at all times. While you cannot avoid these risks completely or the factors that cause them, you can very well plan and invest your money in a way so that the risks are minimized and returns maximized.
We at ShareIndia help you identify the best mutual funds based on your investment profile so that you can achieve the short and long term financial goals you intend to. To begin investing in mutual funds, download the ShareIndia App or visit the web portal here.
Disclaimer: Any advice or information in the post is general advice for education purposes only and is not responsible for generating any trading profits for anyone, please do not trade or invest based solely on this information.