What Is A Mutual Fund: 7 Things To Know How It Works

The mutual fund industry manages assets worth nearly ₹38 lakh crores, according to the Association of Mutual Funds in India.

The industry has seen rapid growth too: more than 2 fold in a span of 5 years and 5 fold over 10 years. 

As the first part of its BOOM Money series of personal finance explainers, we explore the concept of a mutual fund. 

1. What is a mutual fund?

A mutual fund is a means to invest in a wide range of stocks, bonds and various other securities.

Think of it like a group of people stand around an empty box. Each person takes out ₹500 and places it in the box.

What just happened? Everyone in the group' mutually funded' that box. Now that becomes a kind of a mutual fund. That pooled money in the box can now be used by investing in a company or an asset.

2. How do mutual fund investments work?

Say you want to invest in shares by yourself, but find the process tedious, expensive and time consuming. 

With a mutual fund, you get to invest in a basket of prime securities that cuts down the risk of choosing individual securities. By pooling in your money along with other investors, a mutual fund invests in several assets that become affordable for you.

In a single mutual fund scheme, there are several stocks and securities. That means you do not need to worry about putting all your eggs in one basket, as it provides you with instant diversification.

3. Who manages mutual funds?

Mutual funds are handled by a professional fund manager who chooses all the investments in the portfolio.

As a novice, you may not have sufficient experience in selecting individual stocks. But when you invest in a mutual fund, the fund manager who actively manages the pooled money studies and researches the securities before choosing the right blend of investments.

Since these managers actively manage your money, the funds are referred to as actively managed mutual funds. Fund managers charge fees for the work they put in to select and monitor the investments in the fund.

4. What are the types of mutual funds available?

While mutual funds that invest in shares - or equity mutual funds are the most popular - there are several types of funds available investing in different asset classes. 

Based on the tenure and termination of funds, there are:

1. Open ended funds: Where investors can enter and exit at any time
2. Closed ended funds: They come with a fixed tenure. Some funds allow investors to exit the fund only after maturity, while some let closed-ended funds become open-ended to investors after they have invested for a certain lock-in period. 

Based on asset classes, the funds available are:

1. Equity funds: These funds primarily invest in shares or equity. These are typically high-growth funds with high risk. The risk in these funds depend on the type of companies that they invest in (large, mid or small cap companies, or a combination of them)
2. Debt funds: Such funds invest in corporate or government through bonds, debentures etc. They are for investors who want a steady income and are typically low growth. 
3. Hybrid or balanced funds: These funds invest in a combination of debt and equity
4. Index funds: These funds are largely equity funds that tracks the returns generated by a stock market index like NIFTY or Sensex. Say stock 'X' has a weight of 5% in an index, then a fund tracking that index will also have stock 'X' with a weight of 5% in its allocation. 
5. Liquid funds: These funds are for investors looking to park their investment for a short period of time, and generating reasonable returns for row-risk debt instruments
6. Tax Saving Funds (or ELSS): These funds may be linked to equity or debt, but carry with them certain tax benefits. They come with a lock-in period of three years.

5. What risks should I expect?

Compared to stocks, mutual funds are less risky. That's because it diversifies investments and cuts down risk. That means if one asset in the fund decreases in value, the others may not be affected. Also, the Securities and Exchange Board of India (SEBI) stringently regulates fund companies on how they must operate.

1. Debt mutual funds — interest rate and credit rate risks
2. Balanced mutual funds —exposure to equities, longer debt holdings
3. Liquid funds — inflation risk and opportunity loss
4. Equity funds — volatility, performance and concentration risks
5. Closed-ended mutual funds — liquidity risk

6. How should I choose a fund?

Your choice of a mutual fund may want to depend on:

1. What you wish to achieve [Financial Goals]
2. How long you'll stay invested [Time Horizon]
3. The chances you'll take [Risk Tolerance]

You the can choose a fund by referring to its metrics such as:

1. The fund's objective
2. The Fund manager's experience
3. Investment sectors and shares
4. Rates of return
5. Fees
6. Turnover ratio (How often a mutual fund replaces its holdings)

A financial professional can be consulted for such decisions.

7. How can I purchase mutual funds?

If you are buying mutual funds for the first time, you will need to create an investment account with an Asset Management Company [AMC], broker, mutual fund house or a mutual fund distributor. You must complete your e-KYC [electronic-Know Your Customer] and, upon successful verification, start to invest in mutual funds.

Depending on the completion of your financial goal, you can redeem your mutual fund units. You can exit directly through the AMC, demat and trading account or the agent/distributor.

Also Read: Indian Economy Grows At 8.4% In Q2 FY22 As Economic Recovery Continues

This story is part of the BOOM Money explainer series on personal finance