What are mutual funds?

To many people, mutual funds might seem like a complicated concept. People are familiar with the traditional methods of increasing wealth like Fixed deposits which are as simple as they sound. Mutual funds, on the other hand, might appear to be complicated but function on a very simple principle.

Definition of a mutual fund

A mutual fund is like a trust that pools money from different investors who share a mutual investment objective. This trust is managed by a professional fund manager. The manager uses these funds to invest in equities, stocks, and different money market instruments which help increase wealth. The income gained from this collective investment is then distributed amongst all the investors proportionately after deducting certain expenses.

Understand mutual funds with the help of an example

Imagine there is a box of 12 oranges which cost Rs.40. There are 4 friends, who want to buy this box but have only Rs.10 each. They decide to pool in their money and buy the box. Based on each of their contributions, they are entitled to get 3 oranges. Now try equating this example with mutual funds. The cost per unit is calculated simply by dividing the total amount of investment by the total number of shares/equities. Every investor is a part-owner of the fund and collectively they own the entire pool of money.

What is a Mutual Fund’s NAV?

Net Asset Value (NAV) is the price of the mutual fund which is essentially the combined market value of the securities, shares, and bonds held by a fund, after deducting all the expenses and charges. If you combine the market value of all the shares and securities in the fund and divide it by the total number of units from the fund, you'll arrive at the NAV per unit.

Who should invest in a mutual fund?

Ideally, anyone and everyone can invest in a mutual fund since the required investment amounts start as low as Rs.500 per month. For someone who is not averse to risk and wants to grow their wealth with a small sum of investment on a monthly basis, it can prove to be the perfect choice. Additionally, there are multiple product choices under mutual funds that cater to various objectives inclined with savings for example - education, marriage, retirement, etc. There are a myriad of options and schemes for people to pick and choose from.

Types of mutual funds

Broadly, mutual funds can be classified as open-ended and closed-ended funds. An open-ended mutual fund, as the name suggests has no bounds or restrictions, an investor can choose to enter or exit the fund at any given time. It is perpetual in nature and is available for subscription throughout the year, whereas a closed-ended mutual fund comes with a fixed maturity date and is open for subscription only during the initial offer period. An investor can redeem his/her investment on the maturity of the date.

The SEBI (Securities Exchange Board of India) has classified mutual funds under these four categories-

  • Equity Mutual Funds

    Funds where investment in made only in stocks or equity instruments

  • Debt Mutual Funds

    These funds have investment in fixed income instruments

  • Hybrid Mutual Funds

    These funds include investment in both debt and equity funds

  • Solution-oriented Mutual Funds

    Those funds which are designed to achieve a specific financial goal

Benefits of investing in mutual funds

Mutual funds come with various advantages. For starters, there's a fund manager who takes care of all your investments which can be a huge time-saver for you and comes with expertise.

It can be quite challenging to create a diversified portfolio for an investor with meagre sums but with mutual funds, each investor can stand to earn returns proportionate to his/her investments. Mutual funds are also diverse in nature in terms of investment portfolios. You're at a higher risk when you invest in a single security, but the more diverse your portfolio is, the lesser risk you are at

Before you go ahead and make an investment in mutual funds you must know that there are no guaranteed returns as they are heavily dependent on the market performance. There's also no assured capital protection, hence if you're considering investing in one, start with smaller investments and do your research accordingly.

However, as opposed to your traditional methods of savings and investment like investing in gold and FDs, mutual funds can help you multiply your wealth at a much faster rate. The better the market performance is, the better the returns are.