How Do Mutual Funds Work: A Beginner’s Guide!

How do mutual funds work - feature image

This article explains how mutual funds work. It also elaborates on types of mutual funds with examples and discusses ideal mutual fund portfolio creation based on crucial factors.

Table of Contents

Introduction to The Concept of Mutual Funds

Since you are reading this blog,  I am sure you are interested in learning about the secrets of wealth creation. If so, this article will satisfy you and enrich your understanding of this crucial investment option and path to substantial wealth creation.

So, without any ado, let’s dive in and explore the road to financial success with an elaborate discussion on mutual funds.

What are Mutual Funds?

Mutual funds are a significant investment instrument, offering a diversified and managed approach to wealth creation. They represent a pool of funds collected from various investors with a common financial goal, managed by professionals with expertise in navigating the complexities of financial markets.

How do mutual funds work

At its core, a mutual fund is a financial instrument where funds from multiple investors are aggregated and invested in various securities, such as stocks, bonds, and money market instruments—expert fund managers employed by asset management companies (AMCs).

In the Indian markets, the Securities and Exchange Board of India (SEBI) regulates AMCs to ensure transparency and safeguard investor interests. To know more about safety aspect of mutual funds read my blog titled – Is Mutual Fund Safe Avenue for Investment?

Rather than risking the adventure of self-investing in the equity markets or picking the debt instruments for safer investment, mutual funds provide investors with a relatively low-risk and more organized channel for putting money into the stock and debt markets under expert guidance and assistance.

How do Mutual Funds Work?

Let’s delve into the workings of mutual funds using examples of a hypothetical individual investor, Mr. A, and an imaginary institutional investor, B.

Example of Mr. A – Individual Investor:

Mr. A, a salaried individual, wants to invest in the Indian stock market but is cautious about the risks involved. He decided to explore mutual funds as an investment avenue. After researching various funds, Mr. A chose an equity mutual fund managed by a reputed asset management company (AMC). He invests Rs. 50,000 in this fund.

Here’s how the mutual fund works for Mr. A:

Investment Process:

Mr. A submits his investment amount to the mutual fund through an online platform or a registered distributor.

The fund collects money from Mr. A and other investors, aggregating their contributions.

Professional Management:

The fund manager of the chosen mutual fund, appointed by the AMC, invests Mr. A’s and other investors’ funds.

The fund manager conducts market research, analyzes stocks, and strategically invests the pooled funds into various stocks that align with the fund’s investment objective, which, in this case, is growth-oriented.

Risk Mitigation and Diversification:

As Mr. A is risk-averse, the fund manager ensures diversification by investing in various sectors and companies, thus reducing the impact of adverse events on a particular stock or sector.

Returns and NAV:

The fund’s performance directly impacts Mr. A’s investment returns. As the value of the underlying stocks fluctuates, so does the mutual fund’s Net Asset Value (NAV).

If the stocks perform well, the NAV increases, potentially resulting in higher returns for Mr. A. Conversely, poor performance might lead to a decrease in NAV and lower returns.

Example of Institutional Investor B:

Institutional investors are institutions like pension funds, insurance companies, or banks, often dealing with reasonably higher sums of money. Assume Institutional Investor B is a pension fund managing employee retirement savings.

How do mutual funds work - Institutional Investor

Investment Process:

Institutional Investor B allocates a significant sum, say Rs—fifty million, into a debt mutual fund focusing on fixed-income securities to ensure steady returns.

Fund Management:

The fund manager, appointed by the AMC managing the debt fund, oversees the investment of Institutional Investor B’s funds.

They strategically invest in government securities, corporate bonds, or other fixed-income instruments to generate regular income while preserving capital.

Scale and Impact:

Institutional Investor B’s substantial investment significantly impacts the fund’s overall size. The larger pool of funds allows the fund manager to negotiate better terms, access different investment options, and potentially lower expenses for all investors in the fund.

Returns and NAV:

Like Mr. A’s scenario, the performance of the underlying assets determines the institutional investor’s return on investment. Positive performance increases NAV, resulting in higher returns for the institution and its beneficiaries.

Mr. A and Institutional Investor B benefit from professional management, diversification, and the scale mutual funds offer. However, their investment sizes, risk appetites, and investment objectives vary, showcasing the versatility of mutual funds in catering to different types of investors in the Indian market.

Types and Categories of Mutual Funds in India

The Indian mutual fund landscape is a vibrant tapestry woven with many investment opportunities, each catering to distinct financial goals and risk appetites. Understanding the types and categories of mutual funds is crucial for investors aiming to navigate this diverse market effectively. There are predominantly two broader categories of mutual funds in India: equity mutual funds and debt mutual funds. Let’s understand these segments of mutuals with their subcategories with examples.

Types of Equity Mutual Funds in India:

Equity mutual funds are undoubtedly the crown jewel of mutual fund investments. This category of mutual funds is the biggest wealth creator for investors, especially in the long run. With an example, let me explain various subcategories in the equity mutual funds and what they offer.

Equity mutual funds for wealth creation

1. Large Cap Funds:

These funds predominantly invest in the stocks of large, established enterprises with a track record of stable performance.

Examples include the HDFC Top 100 Fund and the ICICI Prudential Bluechip Fund.

Hypothetical Investor Example: Mr. and Mrs. Patel

The Patels, a retired couple, prefer stability and consistent returns. They opt for large-cap funds, such as HDFC Top 100 Fund. These funds invest in established companies with a proven track record, offering steady growth and lower volatility.

2. Mid Cap Funds:

Mid Cap funds focus on investing in stocks of companies with medium market capitalization, offering the potential for higher growth compared to large caps but with increased volatility.

Examples include the DSP Midcap Fund and Kotak Emerging Equity Scheme.

Hypothetical Investor Example: Ms. Gupta

Ms. Gupta, a mid-career professional seeking higher returns, invests in mid-cap funds like DSP Midcap Fund. These funds have the potential for substantial growth by investing in medium-sized companies, albeit with relatively higher risk.

3. Small Cap Funds:

These funds invest primarily in stocks of small-sized businesses with high growth potential but higher risk due to their volatile nature.

Examples are the SBI Small Cap Fund and the HDFC Small Cap Fund.

Hypothetical Investor Example: Mr. and Mrs. Rao

The Raos, a young couple with a risk appetite, opt for small-cap funds like the SBI Small Cap Fund. These funds focus on smaller companies with high growth potential, offering the prospect of significant returns along with higher volatility.

4. Multi Cap Funds:

Based on market conditions and opportunities, multi-cap funds can invest across market capitalizations – large, mid, and small-cap stocks.

Examples are the Parag Parikh Flexi Cap Fund and Motilal Oswal Multicap 35 Fund.

Hypothetical Investor Example: Ms. Khan

Ms. Khan prefers flexibility and diversification. She invests in multi-cap funds like Parag Parikh Flexi Cap Fund, offering exposure to various market caps with a long-term goal of wealth creation. She can accept a sizeable corpus if she stays invested for extended periods.

5. Flexi Cap Funds:

Flexi Cap funds, a recent addition to the SEBI regulations, offer flexibility in allocation across market caps without any specific mandate. These funds adjust their portfolios across large, mid, and small-cap stocks and may also put a portion of capital in the debt markets, depending upon market conditions. Fund managers can shift assignments based on market conditions and valuations.

Flexi Cap Funds

Examples are the Axis Flexi Cap Fund and Aditya Birla Sun Life Flexi Cap Fund.

Hypothetical Investor Example: Mr. and Mrs. Sharma

The Sharmas, a middle-aged couple seeking flexibility, choose flexi cap funds such as Axis Flexi Cap Fund. With no specific market cap mandate, these funds adapt to market changes, allowing fund managers to navigate uncertain market conditions and create wealth while reasonably safeguarding capital.

6.Sectoral and Thematic Funds:

Sectoral funds concentrate on sectors like technology, banking, or healthcare, offering exposure to a particular industry.

Thematic funds invest in themes such as ESG (Environmental, Social, and Governance), consumption, or disruptive technology.

Examples include ICICI Prudential Technology Fund and SBI Banking & Financial Services Fund.

Hypothetical Investor Example: Mr. Kapoor

Mr. Kapoor, an industry expert, invests in sectoral funds like ICICI Prudential Technology Fund. These funds concentrate on specific sectors or themes, leveraging Mr. Kapoor’s knowledge of technology for potential higher returns.

7. Dividend Yield Funds:

Dividend Yield funds aim to invest in stocks with a history of higher dividend payouts, targeting regular income for investors.

UTI Dividend Yield Fund and Aditya Birla Sun Life Dividend Yield Plus Fund are examples.

Hypothetical Investor Example: Ms. Desai

Ms. Desai, a retiree seeking regular income, chooses dividend yield funds like UTI Dividend Yield Fund. These funds focus on stocks with a history of higher dividend payouts, providing consistent income.

8.Tax Saving Funds (ELSS):

Equity Linked Savings Schemes (ELSS) offer tax exemption under Section 80C of the Income Tax Act and potential wealth creation through equity investments.

Example: Axis Long Term Equity Fund, Aditya Birla Sun Life Tax Relief 96 Fund.

Hypothetical Investor Example: Mr. and Mrs. Reddy

The Reddys aim for tax-saving along with equity exposure. They invest in ELSS funds like Axis Long Term Equity Fund. The most significant advantage of this instrument is the tax benefit under Section 80C of the Income Tax Act while potentially generating wealth through equity investments. In case you are interested in reading about seven advantages of mutual funds for investor then check my detailed article on the topic.

9. Exchange Traded Funds (ETFs)

Exchange-traded funds (ETFs) serve as a distinctive category within the realm of funds, resembling mutual funds yet differing in their structure. Like mutual funds, ETFs pool investors’ money to purchase a diversified collection of assets. However, the primary divergence lies in their trading mechanism.

ETFs can be traded on any trading day, just like equity shares, allowing you to buy and sell them at market prices throughout the day. In contrast, fund managers price mutual funds at the end of each trading day.

This unique trading aspect and potential tax efficiency set ETFs apart. Delve into my comprehensive article to better understand the in-depth comparison of mutual funds vs. ETFs.

Types & Categories of Debt Mutual Funds in India

Debt mutual funds are investment vehicles primarily investing in fixed-income asset classes and securities like government and corporate bonds, treasury bills, debentures, and other debt instruments. They aim to provide stable returns while managing interest rate fluctuations and credit quality risks. Here are the various subcategories of debt mutual funds, along with examples and hypothetical investors for each:

1. Overnight Funds:

Definition: Overnight Funds invest in very short-term debt securities with a maturity of one day, focusing on very short-term instruments for investors seeking minimal risk.

Hypothetical Investor Example: Ms. Desai

Ms. Desai, a risk-averse investor, chooses overnight funds like Axis Overnight Fund. These funds provide ultra-safe investments with high liquidity, ideal for parking funds for a single day or very short periods.

2. Liquid Funds:

Definition: Liquid funds invest in very short-term instruments with a maturity of up to 91 days, offering high liquidity and minimal interest rate risk.

Liquid fund image

Hypothetical Investor Example: Mrs. Patel

Mrs. Patel, a retired individual, prioritizes safety and liquidity. She chooses liquid funds like HDFC Liquid Fund. These funds offer stability and quick access to funds, suitable for parking surplus cash or meeting short-term financial needs.

3. Ultra Short Duration Funds:

Definition: Ultra Short Duration Funds invest in debt and money market instruments with slightly longer maturities (3-6 months), aiming for higher returns than liquid funds with minimal interest rate risk.

Hypothetical Investor Example: Mr. and Mrs. Singh

The Singhs, a couple saving for a near-future goal, opt for ultra short-duration funds like ICICI Prudential Ultra Short Term Fund. These funds offer relatively higher returns while ensuring capital preservation and moderate risk exposure.

4. Short Duration Funds:

Definition: Short Duration Funds invest in debt securities for 1-3 years, aiming for moderate returns with slightly higher interest rate risk.

Hypothetical Investor Example: Mr. Gupta

Mr. Gupta, a mid-career professional, seeks stability with moderate returns. He chooses short-duration funds like Kotak Short-Term Fund. These funds offer a balance between returns and interest rate risk suitable for mid-term goals.

5. Medium Duration Funds:

Definition: Medium Duration Funds invest in debt securities for 3-4 years, targeting relatively higher returns with increased interest rate sensitivity.

Hypothetical Investor Example: Ms. Rao

Ms. Rao, planning for her child’s education in a few years, selects medium-duration funds like the Franklin India Income Opportunities Fund. Debt funds offer the potential for relatively higher returns than fixed-income investments while managing moderate interest rate risk.

6. Long Duration Funds:

Definition: Long-duration funds invest in debt securities with a longer duration (more than seven years), aiming for higher returns but with higher sensitivity to interest rate changes.

Hypothetical Investor Example: Mr. and Mrs. Sharma

The Sharmas, a young couple planning for their retirement in the long term, choose long-duration funds like UTI Long Term Debt Fund. These funds offer the potential for significant returns but with increased exposure to interest rate fluctuations.

Understanding the diverse categories of debt mutual funds helps investors select instruments aligned with their investment horizon, risk tolerance, and financial goals.

Special Case of ULIPs

Finally, there are ULIPs or unit-linked insurance plans; although they are primarily an insurance instrument, they are quite similar to mutual funds. They invest considerable premiums into equity and debt markets through various market-related funds. Refer to my detailed article to learn more about unit-linked insurance plans(Ulips).

Considerations for an Ideal Mutual Fund Portfolio

Investing in mutual funds offers a gateway to diverse investment options, each catering to different risk appetites, investment horizons, and financial goals. An ideal mutual fund portfolio involves aligning these factors to build a robust investment strategy. Let’s explore how investors can create their perfect mutual fund portfolio with hypothetical examples.

How do mutual funds works - ideal portfolio

Understanding Risk Profiles:

Risk tolerance forms the bedrock of any investment strategy. Investors typically fall into different risk profiles:

Conservative: Prefers lower-risk investments with steady returns.

Moderate: Comfortable with average risk for potentially higher returns.

Aggressive: Willing to take on higher risks for the prospect of substantial returns.

Investment Horizon and Goals:

Investment horizon and financial goals determine the time frame for achieving investment objectives:

Short-term goals:  Goals achievable within 1-3 years, such as buying a car or a vacation.

Mid-term goals: Goals accomplishable in 3-7 years, like funding education or a down payment for a home.

Long-term goals: Goals that span over seven years, such as retirement planning or creating wealth for future generations.

Crafting the Ideal Portfolio:

  1. Conservative Investor – Short-term Goals:

Hypothetical Example: Mr. and Mrs. Patel

Objective: Saving for a home renovation in 2 years.

Ideal Portfolio: Focus on low-risk options like liquid funds (e.g., HDFC Liquid Fund) or ultra short-term funds (e.g., ICICI Prudential Ultra Short Term Fund) for capital preservation and liquidity.

  1. Moderate Investor – Mid-term Goals:

Hypothetical Example: Ms. Gupta

Objective: Planning for her child’s education in 5 years.

Ideal Portfolio: Blend short- and medium-duration funds (e.g., Kotak Short Term Fund, Franklin India Income Opportunities Fund) for balanced returns and manageable risk.

  1. Aggressive Investor – Long-term Goals:

Hypothetical Example: Mr. and Mrs. Sharma

Objective: Building a retirement corpus in 15 years.

Ideal Portfolio: Diversified mix including large-cap (e.g., HDFC Top 100 Fund), mid-cap (e.g., DSP Midcap Fund), and flexi-cap funds (e.g., Axis Flexi Cap Fund) for potentially high returns over the long term.

Considerations for All Profiles:

Diversification: Spread investments across various fund categories to mitigate risk.

Review and Rebalance: Regularly reassess the portfolio to align with changing goals and market conditions.

Expense Ratio and Fees: Opt for funds with reasonable expenses to maximize returns.

Building an ideal mutual fund portfolio involves balancing risk tolerance, investment horizon, and financial goals. Understanding these factors helps investors tailor their portfolios, ensuring a harmonious blend of funds to achieve their aspirations.

Conclusion:

The Indian mutual fund market offers a bucket of choices, each catering to diverse investment objectives and risk profiles. No matter the individual risk appetite and purpose, there is a mutual fund category to suit every investor, whether seeking growth, stability, tax benefits, or thematic exposure to their equity investments.

Understanding these varied options empowers investors to make informed decisions and construct a well-rounded investment portfolio aligned with their goals. By leveraging a diversified mix of mutual funds tailored to their unique profile, investors can confidently navigate the market, inching closer to their financial objectives.

Finally, it is crucial to mention that consulting with a financial advisor or expert can further refine and optimize your mutual fund portfolio to suit your needs.

 

 

 

 

 

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