What Are Mutual Funds? Definition & Types

What are mutual funds? It is a common question asked when starting to invest. It's simply an investment method that doesn't involve stock picking. You pool your money with others', and the investment is spread. This helps spread risk. Over the years, this practice has grown as it seems simpler than investing on your own. But to do it right, you must know how it works and what it can do.

Key Takeaways

●        Mutual funds pool investor money into diversified portfolios, where returns depend on market performance and underlying asset growth over time.

●        NAV reflects daily fund value, guiding unit allocation and redemption, while gains or losses depend on price movements and timing decisions.

●        Returns come from capital appreciation and income payouts, and tools like calculators help estimate outcomes across different investment horizons.

●        Long-term investing, diversification, and disciplined contributions like SIPs help manage volatility and build wealth despite short-term market fluctuations.

What Are Mutual Funds?

Mutual funds pool funds from several investors and invest in a diversified portfolio of securities. These professionally managed funds offer a way for individuals to invest in a variety of assets, including stocks, bonds, and money market instruments. Mutual fund investing offers instant diversification, and the fund's holdings help mitigate risks. In India, mutual funds are regulated, which makes them transparent and highly popular with new and experienced investors.

How Does a Mutual Fund Work?

When you invest in a Mutual Fund, think of it as units, rather than shares. You get units at the value of the fund (NAV). This value changes every day. That's based on the performance of the assets in the fund. If they do well, the NAV rises. If they don't, the NAV falls. This movement affects your returns. If you buy and sell for a higher value, you make a profit. If the value is lower, you may lose money. So, rather than keeping track of several stocks, you keep track of a single value that represents the whole portfolio.

How is Mutual Fund Return Calculated?

Returns in mutual funds are not fixed. They depend on how the fund grows over time. You can look at simple measures like absolute return or annual return to understand performance. A mutual fund calculator helps make this easier. You enter the amount invested, the time period, and the expected rate. It gives an estimate of possible returns.

In reality, returns come from two sources. One is the price movement of the fund. The other can be payouts like dividends, depending on the plan. Since markets change, returns also change. That is why it helps to focus on longer periods instead of short-term results.

Types of Mutual Funds

A. Based on the Fund Structure:

1. Open-Ended Mutual Funds: These funds allow investors to buy or sell units at any time directly from the fund house. They do not have a fixed maturity date and continually issue and redeem units based on investor demand. Open-ended funds provide high liquidity and flexibility for investors.
2. Closed-Ended Mutual Funds: Closed-ended funds have a fixed lock-in period, and their units are typically bought and sold on stock exchanges like shares. These funds have a limited number of units issued during their initial offering, and after that, investors can only buy or sell units through secondary market transactions. Closed-ended funds may trade at a premium or discount to their Net Asset Value (NAV).

B. Based on Asset Allocation:

1. Equity Mutual Funds: These funds primarily invest in stocks or equities, offering the potential for higher returns but also higher risk. They are suitable for long-term investors aiming for capital appreciation.
2. Debt Mutual Funds: Debt funds invest primarily in fixed-income securities like government and corporate bonds. They are considered lower risk compared to equity funds and are suitable for investors looking for a stable income with lower volatility.
3. Hybrid or Balanced Mutual Funds: These funds invest in a mix of both equities and debt instruments. They aim to provide a balance between capital appreciation and income generation, making them suitable for investors with a moderate risk appetite.
4. Money Market or Liquid Mutual Funds: Money market funds invest in highly liquid, short-term debt instruments like Treasury Bills and commercial paper. They offer high liquidity and stability, making them suitable for parking surplus funds or short-term goals.
5. Sectoral and Thematic Mutual Funds: These funds focus on specific sectors or themes, such as technology, healthcare, or infrastructure. They are more specialised and carry sector-specific risks.
6. Index Mutual Funds: These funds aim to replicate the performance of a specific stock market index, providing investors with diversified exposure to the market. They are passively managed and typically have lower expense ratios.
7. Solution-Oriented Mutual Funds: These funds are designed to meet specific financial goals like retirement or children's education. They have a predefined investment horizon and asset allocation strategy to align with the goal.

Modes of Mutual Fund Investment 

Investors can invest in mutual funds in two popular ways.

Lumpsum

When you make a single large payment to the mutual fund, the units get allocated to you based on the day’s NAV value. For instance, if the fund’s NAV on the day is at ₹50, you’ll be allotted 200 units for a lump sum investment of ₹10,000.

SIP

In SIP, you make regular investments in the fund. These are small fixed instalments paid every month, and the units are allocated based on that day's NAV value. A Systematic Investment Plan encourages regular investment practices and eliminates any need to time the market.

How To Invest in Mutual Funds?

There are 3 common ways to invest in mutual funds.

●        Through the Mutual Fund Company (AMC) Website: You can invest directly with the Asset Management Company (AMC) by registering on their website. While this allows you to invest in "Direct Plans," it can be inefficient if you want to manage a diverse portfolio across multiple fund houses, as you would need separate logins and accounts for each.

●        Through Banks: Many banks allow you to invest in funds via their net banking or mobile apps. However, banks often act as distributors and may only offer a limited selection of schemes. Furthermore, they typically offer "Regular Plans," which include distributor commissions that may impact your long-term returns.

●        Through Angel One: Angel One is a renowned brokerage house offering a seamless, unified platform to manage all your investments in one place. We provide advanced screeners, expert-curated portfolios, and in-depth reports to help you find mutual funds that align with your financial goals and risk profile.

Documents Required to Invest in Mutual Funds:

To invest in mutual funds, you typically need the following documents:

●        KYC (Know Your Customer) Documents: These include identity proof and address proof (Aadhaar card, Passport, Driving License, or Voter ID). Note that utility bills are no longer accepted for primary address proof. You will also need a digital photograph and may be required to complete a Video-KYC (In-Person Verification).

●        PAN (Permanent Account Number) Card: This is mandatory for all mutual fund investments in India and must be linked to your Aadhaar.

●        Bank Account Details: You need a bank account for transactions. A cancelled cheque with your name printed on it or a recent bank statement is usually required to verify your bank details and IFSC code.

●        SIP Mandate (NACH/e-Mandate): If you are starting an SIP, you must register a digital mandate to authorise your bank to automate periodic payments.

●        Nomination: Under current regulations, you must either nominate a person to receive your units or formally sign an 'Opt-out' declaration if you choose not to name a nominee.

●        FATCA/CRS Declaration: All investors are now required to provide a self-certification regarding their tax residency status.

●        Declaration of Status (For NRIs): Non-resident Indian investors must provide their overseas address proof, passport copy, and ensure the investment is made through an NRE or NRO account.

Terms Used in Mutual Funds

As a beginner, it is difficult to understand the terminology of mutual funds. Here are the 10 most commonly used terms in mutual funds:

Term	Description
NAV (Net Asset Value)	Per-unit market value of a mutual fund scheme, calculated at the end of every business day.
AMC (Asset Management Company)	The fund house is responsible for managing the mutual fund scheme's investments and operations.
AUM (Assets Under Management)	The total market value of all assets managed by a specific mutual fund scheme at a given point in time.
Expense Ratio	Annual fee charged by the mutual fund to cover management and operational costs. A lower expense ratio generally leads to higher net returns for the investor. expressed as a percentage of Assets Under Management (AUM).
Load	A fee charged to investors specifically when selling (redeeming) mutual fund units before a certain period. Note: Entry loads (charges while buying) were abolished by SEBI and are no longer applicable in India.
SIP (Systematic Investment Plan)	An investment plan allowing regular fixed-amount investments at periodic intervals to benefit from rupee cost averaging
IDCW	Stands for Income Distribution cum Capital Withdrawal. This is the official term for what was previously known as the 'Dividend' option in India.
Diversification	Spreading investments across different asset classes or securities to mitigate the impact of a single underperforming asset.
Benchmark	A standard market index (like the Nifty 50 or Sensex) is used as a point of reference to evaluate a fund's performance.
Asset Allocation	Strategy of distributing investments across various asset classes to achieve specific financial goals while managing risk.

Mutual Fund Functions

To comprehend the inner workings of mutual funds, it is crucial to delve into their operational mechanisms:

●        New Fund Offer (NFO) Launch: Asset Management Companies (AMCs) initiate mutual fund schemes through NFOs. They disclose the scheme's investment objective and strategy before its launch, allowing potential investors to assess their investment decisions. NFO units are typically offered at a face value of ₹10.

●        Pooling of Funds: Following the NFO launch, fund houses collect capital from interested investors. This pooled money is used to purchase various assets like stocks, bonds, and money market instruments. Even individuals who missed the NFO can invest in the fund once it becomes open for continuous subscription (for open-ended funds).

●        Investment in Securities: The fund's strategy guides the fund manager in allocating the pooled funds. Professional fund management provides in-depth research to select securities and investment avenues that aim to yield optimal returns for unit holders.

○        For example, a Short-Duration Debt Fund focuses on investing in fixed-income securities with a Macaulay duration of one to three years, offering a balance of stability and returns compared to long-term debt funds.

●        Distribution of Returns: As mutual funds generate returns via dividends, interest, or capital gains, the profits can be either distributed among investors or reinvested within the scheme. Investors receive payouts if they opt for the Income Distribution Cum Capital Withdrawal (IDCW) option. Alternatively, selecting the Growth option allows gains to accumulate within the scheme to benefit from the power of compounding.

Features and Benefits of Investing in Mutual Funds

●        Diversification: Mutual funds offer instant diversification, spreading risk across different asset classes and reducing the impact of any single investment's performance on the overall portfolio.

●        Professional Management: Expert fund managers use their expertise and in-depth research to invest in promising opportunities that may be difficult for individual investors to track.

●        Liquidity: Most open-ended mutual funds offer high liquidity, making them suitable for various financial needs. Investors can redeem their units on any business day at the prevailing NAV.

●        Affordability: Mutual funds are affordable, allowing investors to start with as little as ₹100 or ₹500 via SIPs, while benefiting from economies of scale.

●        Transparency: AMCs are required to publish daily NAVs and monthly portfolio disclosures. This level of transparency enables investors to track exactly where their money is invested.

●        Regulatory Oversight: The Securities and Exchange Board of India (SEBI) ensures strict compliance with industry standards, offering investors a level of protection and confidence.

●        Flexibility: Mutual funds are available in various types, allowing investors to choose funds that align with their investment goals, risk appetite, and time horizons.

●        Power of Compounding: In the Growth option of mutual funds, gains are reinvested automatically, potentially boosting long-term wealth accumulation through compounding.

●        Tax Efficiency: Mutual funds can be structured to provide tax benefits. For example, investors can save tax up to ₹46,800 a year on investments up to ₹1.5 lakh under Section 80C by investing in ELSS mutual funds (applicable under the Old Tax Regime).

Disadvantages of Mutual Funds

By understanding the disadvantages along with the advantages of mutual funds, you’ll be able to make an informed decision.

●        Fluctuating returns: Those who prefer fixed returns on investment may feel disappointed by mutual funds' returns. Mutual funds don't offer fixed returns and may not appeal to risk-averse investors.

●        Less control: Unlike equity investments, you have less control over your portfolio in a mutual fund. In the case of mutual fund investing, all decisions related to the fund's holdings and investment strategies are made by the fund managers.

●        Fees and expenses: Mutual fund investments involve charges such as management fees, operating expenses, and sales loads. These costs can reduce the investor's net gains.

●        Diversification: Diversification is always cited as the major plus of mutual funds, but over-diversification can reduce your overall gains. The chance increases because you have less control over your portfolio.

●        Performance fluctuations: Mutual fund returns are subject to market volatility, economic conditions, and the skills of the fund manager. Poor investment decisions or adverse market conditions can result in periods of underperformance, potentially impacting an investor's returns.

●        Fund evaluation: Some investors can find it difficult to compare funds' performance, NAV etc. You may find mutual funds complex if you’re a completely new investor.

●        Exit load: The fund house will charge a fee when you redeem your units within a specific time frame. These fees are designed to discourage frequent withdrawals from the fund, but ultimately, they will limit your access to the fund.

●        Past performance: While evaluating the fund's past performance is a common decision-making factor, it is important to keep in mind that robust past performance doesn't guarantee future performance.

●        CAGR: The performance of the fund in comparison to the CAGR doesn’t tell investors about the risks or the method of investing involved.

●        Manager’s performance: The return on the fund depends on the experience and judgments of the fund manager.

●        Capital gain tax: Gains from the investment are subject to tax as per the capital gain tax rules and may result in an increased tax obligation for the investor.

Objectives of Mutual Fund

Mutual funds achieve the following objectives for the investor:

●        Diversification: Mutual funds offer instant diversification, which helps mitigate unsystematic risk and improve risk-adjusted returns by spreading capital across multiple securities and sectors.

●        Capital Appreciation: The primary purpose of many mutual fund schemes is long-term wealth creation and capital growth.

●        Risk Management: While mutual funds do not offer guaranteed "principal protection" (as all market investments carry risk), they provide professional oversight and disciplined strategies to manage and mitigate potential losses.

●        Tax Efficiency: Some mutual funds have the advantage of tax savings, specifically ELSS (Equity Linked Savings Scheme) under Section 80C of the Old Tax Regime. Note that ELSS comes with a mandatory three-year lock-in period, which makes it less liquid than other open-ended equity funds.

●        Regular Income: Certain funds aim to provide periodic payouts through the IDCW (Income Distribution cum Capital Withdrawal) option, making them suitable for investors seeking regular cash flow.

Conclusion

Mutual fund investment will work for you if you're patient and informed. It is not about quick gains. It is about letting your money grow with a variety of investments. There will be ups and downs along the way. That is part of the process. The trick is to make sure that the fund fits your objective and time frame. Then you know what to do. You focus on the long term and not the short term.

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