What are Mutual Funds? - Mutual Fund Definition
Mutual funds are one of the most popular investment options these days. A mutual fund is an investment vehicle formed when an asset management company (AMC) or fund house pools investments from several individuals and institutional investors with common investment objectives. A fund manager, who is a finance professional, manages the pooled investment. The fund manager purchases securities such as stocks and bonds that are in line with the investment mandate.
Mutual funds are an excellent investment option for individual investors to get exposure to an expert managed portfolio. Also, you can diversify your portfolio by investing in mutual funds as the asset allocation would cover several instruments. Investors would be allocated with fund units based on the amount they invest. Each investor would hence experience profits or losses that are directly proportional to the amount they invest. The main intention of the fund manager is to provide optimum returns to investors by investing in securities that are in sync with the fund’s objectives. The performance of mutual funds is dependent on the underlying assets.
Mutual Funds: Detailed Break 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 Mutual Funds
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:
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.
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.
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.
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.
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.
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.
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:
Dynamic Bond Funds
Dynamic Bond Funds are those debt funds whose portfolio is modified depending on the fluctuations in the interest rates.
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.
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.
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.
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.
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.
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:
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.
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.
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.
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.
Why Should You Invest in Mutual Funds?
Investing in mutual funds provides several advantages for investors. To name a few, flexibility, diversification, and expert management of money, make mutual funds an ideal investment option.
Investment Handled by Experts ( Fund Managers )
Fund managers manage the investments pooled by the asset management companies (AMCs) or fund houses. These are finance professionals who have an excellent track record of managing investment portfolios. Furthermore, fund managers are backed by a team of analysts and experts who pick the best-performing stocks and assets that have the potential to provide excellent returns for investors in the long run.
No Lock-in Period
Most mutual funds come with no lock-in period. In investments, the lock-in period is a period over which the investments once made cannot be withdrawn. Some investments allow premature withdrawals within the lock-in period in exchange for a penalty. Most mutual funds are open-ended, and they come with varying exit loads on redemption. Only ELSS mutual funds come with a lock-in period.
Low Cost
Investing in mutual funds comes at a low cost, and thereby making it suitable for small investors. Mutual fund houses or asset management companies (AMCs) levy a small amount referred to as the expense ratio on investors to manage their investments. It generally ranges between 0.5% to 1.5% of the total amount invested. The Securities and Exchange Board of India (SEB) has mandated the expense ratio to be under 2.5%.
SIP ( Systematic Investment Plan )
The most significant advantage of investing in mutual funds is that you can invest a small amount regularly via a SIP (systematic investment plan). The frequency of your SIP can be monthly, quarterly, or bi-annually, as per your comfort. Also, you can decide the ticket size of your SIP. However, it cannot be less than the minimum investible amount. You can initiate or terminate a SIP as and when you need. Investing via SIPs alleviates the need to arrange for a lump sum to get started with your mutual fund investment. You can stagger your investments over time with an SIP, and this gives you the benefit of rupee cost averaging in the long run.
Switch Fund Option
If you would like to move your investments to a different fund of the same fund house, then you have an option to switch your investments to that fund from your existing fund. A good investor knows when to enter and exit a particular fund. In case you see another fund having the potential to outperform the market or your investment objective changes and is in line with that of the new fund, then you can initiate the switch option.
Goal-Based Funds
Individuals invest their hard-earned money with the view of meeting specific financial goals. Mutual funds provide fund plans that help investors meet all their financial goals, be it short-term or long-term. There are mutual fund schemes that suit every individual’s risk profile, investment horizon, and style of investments. Therefore, you have to assess your profile and risk-taking abilities carefully so that you can pick the most suitable fund plan.
Diversification
Unlike stocks, mutual funds invest across asset classes and shares of several companies, thereby providing you with the benefit of diversification. Also, this reduces the concentration risk to a great extent. If one asset class fails to perform up to the expectations, then the other asset classes would make up for the losses. Therefore, investors need not worry about market volatility as the diversified portfolio would provide some stability.
Flexibility
Mutual funds are buzzing these days because they provide the much-needed flexibility to the investors, which most investment options lack in. The combination of investing via an SIP and no lock-in period has made mutual funds an even more lucrative investment option. This means that people may consider investing in mutual funds to accumulate an emergency fund. Also, you can enter and exit a mutual fund plan at any time, which may not be the case with most other investment options. It is for this reason that millennials are preferring mutual funds over any other investment vehicle.
Liquidity
Since most mutual funds come with no lock-in period, it provides investors with a high degree of liquidity. This makes it easier for the investor to fall back on their mutual fund investment at times of financial crisis. The redemption request can be placed in just a few clicks, and the requests are processed quickly, unlike other investment options. On placing the redemption request, the fund house or the asset management company would credit your money to your bank account in just business 3-7 days.
Seamless Process
Investing in mutual funds is a relatively simple process. Buying and selling of the fund units are all made at the prevailing net asset value (NAV) of the mutual fund plan. As the fund manager and his or her team of experts and analysts are tasked with choosing shares and assets, investors only need to invest, and the rest would be taken care of by the fund manager.
Regulated
All mutual fund houses and mutual fund plans are always under the purview of the Securities and Exchange Board of India (SEBI) and Reserve Bank of India(RBI). Apart from that, the Association of Mutual Funds in India (AMFI), a self-regulatory body formed by all fund houses in the country, also governs fund plans. Therefore, investors need not worry about the safety of their mutual fund investments as they are safe.
Ease of Tracking
One of the most significant advantages of investing in mutual funds is that tracking investments is easy and straightforward. Fund houses understand that it is hard for investors to take some time out of their busy schedules to track their finances, and hence, they provide regular statements of their investments. This makes it a lot easier for them to track their investments and make decisions accordingly. If you invest in mutual funds via a third party, then you can also track your investments on their portal.
Tax-Saving
ELSS or Equity-Linked Savings Scheme is an equity-oriented mutual fund which provides tax deductions of up to Rs 1,50,000 a year under the Section 80C provision. By making full utilisation of the Section 80C limit, you can save up to Rs 46,800 a year in taxes. ELSS is the most popular tax-saving investment option under Section 80C of the Income Tax Act, 1961. It comes with a lock-in period of just three years, the shortest of all tax-saving investments. Investing in ELSS provides you with the dual benefit of tax deductions and wealth accumulation over time.
Rupee Cost Averaging
On investing in mutual funds via an SIP, you get the benefit of rupee cost averaging over time. When the markets fall, you buy more units while you purchase fewer units when the markets are booming. Therefore, over time, your cost of purchase of fund units is averaged out. This is called the rupee cost averaging. Investing in mutual funds via an SIP is beneficial during both market ups and downs, and there is no need to time the markets. This benefit is not available when you invest in mutual funds via a lump sum.
No Need to Time Markets
When you are investing in mutual funds via an SIP, there is no need to time markets. This is because the rupee cost averaging phenomenon ensures that your cost of purchase of fund units is on the lower side. However, you have to continue investing via an SIP for a long period. Therefore, you can invest in mutual funds whenever you feel like. There is no ‘right time’ as such to investing in mutual funds. The best time is now!
Who Should Invest in Mutual Funds?
Everyone who has a particular financial goal, be it short-term or long-term, should consider investing in mutual funds. Investing in mutual funds is an excellent way to accomplish your goals faster. There are mutual fund plans that suit all personas. Investors need to assess their risk profile, investment horizon, and goals before getting started with their mutual fund investment. For example, if you are risk-averse and planning to purchase a car in five years, then you may consider investing in gilt funds. If you are ready to take some risk and are planning to buy a house in a period of fifteen to twenty years, then you may consider investing in equity funds. If your investment horizon is less than two years and you are looking to earn higher returns than a regular savings bank account, then you may consider parking your surplus funds in a liquid fund.
How to Invest in Mutual Funds?
Investing in mutual funds is a simple process. The in-house experts at ClearTax have handpicked the best performing funds that suit your needs and goals. We have researched the top fund houses in the country and offer only the best performing funds on our platform. You can invest in mutual funds through ClearTax by following the steps mentioned below:
Log onto https://cleartax.in/save
Signup for an account
Complete your KYC process if you have not already done so. With ClearTax, you can verify your KYC within five minutes.
Choose the most suitable fund among our handpicked mutual fund plans.
Duly fill the online application form by providing all the details.
Choose the preferred mode of investment (lumpsum or SIP)
If you choose SIP, then select the frequency and ticket size of your SIP.
Link your bank account and transfer the amount.
You will receive the details of your investment, such as folio number through an email or SMS.