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1. What are Mutual Funds? How do they work?

The concern for most investors is, ‘How do I know which instruments is best for me?’ Hence, for many investors, Mutual Funds mark the entry-point in to the stock market. For some, it is usually the last minute investment into tax-saving Mutual Funds. And, for some, it is the idea of their money being professionally managed by an expert Fund Manager for very little money.

A Mutual Fund (MF) is a collection of different type of assets. For investors with limited knowledge of investing, time or skill to do research, Mutual Funds become an entry-point to the stock market. Mutual Funds have become popular because of their built-in diversification, professional management and simplicity of buying-selling MF units. Post demonetisation, investments in Mutual Funds in India have sky-rocketed—Rs. 2.4 lac Cr inflows into Mutual Funds in 2017! Of this, Rs 1.5 lac Cr. were invested in Equity Mutual Fund schemes. It is more than Mutual Funds cumulative investments of Rs 1.1 lac Cr. in equity during 2000-2016!

Let’s understand how do Mutual Funds work:

  1. Many Investors, individually, invest money into a Mutual Fund scheme.
  2. A professional investor (i.e.the Fund Manager) invests this money into stocks and bonds of individual companies, thereby creating its Portfolio.
  3. Investors are allotted shares of the Mutual Fund Scheme (known as MF units) for their invested amount. (Price of an MF unit is denoted by the net asset value or NAV).
  4. As individual company stocks/bonds grow in value, Mutual Fund’s NAV increases.
  5. Investors sell these Mutual Fund units (through a process known as redemption) and benefit from their investments.

Types of Mutual Funds:

Mutual Fund Schemes have different types based on the type of assets they manage,

Equity Funds: These Mutual Funds invest majority (>70%) of their corpus (investor’s money pooled together) in stocks, with an objective of capital growth. Different Fund Managers invest in different stocks based on their outlook on those companies’ future. These are suited for investors with an Aggressive risk profile and a long-term horizon (usually more than 5 years). These Mutual Funds include

  1. Large cap Funds: Invest mainly in Large cap stocks (market cap of >20,000 Cr.).
  2. Mid and Small cap Funds: Invest mainly in Mid cap (market cap of 5,000-20,000 Cr) and Small cap (market cap of
  3. Multi-cap Funds: Invest in stocks across Large, Mid & Small market cap.
  4. Sector Funds: Invest in stocks from a specific sector. E.g. Healthcare Fund will only invest in healthcare/pharma stocks.
  5. Index Funds: Mimic a particular index such as the Sensex or Nifty. The portfolio of such a Fund will have the same stocks and in the same proportion as the index. NAVs of such schemes would rise or fall in line with the rise or fall in the index, though not by exactly the same percentage.
  6. Tax-saving or ELSS funds: Tax saving Funds are similar to Multi cap Mutual Funds. They offer tax rebates in addition to capital appreciation. However, unlike other Mutual Funds, they have a lock-in period of 3 years i.e. one cannot sell the Fund before 3 years from the investment date.

Debt Funds: These Mutual Funds invest mainly in Debt instruments like bonds. These include,

  1. Gilt Funds: Invest in Government securities with different maturities. E.g. A long-term Gilt Fund holds government bonds from 15 to 30 years. Since, the investment is in Government bonds, these funds carry almost zero default risk, but high interest rate risk. In fact, longer the maturity, higher the interest rate sensitivity. A Gilt Fund Manager actively manages the portfolio based on his/her outlook on the interest rate. The returns can also be volatile, and therefore, these are suitable for investors with moderate risk profile.
  2. Income Funds: Invest in Government securities and Corporate bonds & debentures, across varying maturities. An Income Fund Manager employs a mixed strategy of buying and selling bonds based on interest rate outlook, and holding the bonds to maturity. As a result, Income Funds can earn good returns in different interest rate scenarios. These Funds too are sensitive to interest rate movements, albeit less than gilt funds, and are suitable for Investors with Moderate to high risk profile.
  3. Liquid Funds: Aim to provide easy liquidity. Therefore, they invest in highly liquid money-market instruments (treasury bills, certificate of deposits, commercial paper, and term deposits) with maturities of 91 days or less. These Funds are less volatile and provide higher returns than a savings bank account. They provide a good option to investors to park their surplus idle cash in a low-risk instrument and also get higher returns than a bank account.
  4. Short-term Debt Funds: Invest in money-market instruments, with 2-3 years’ maturities. The Fund Manager usually holds bonds to maturity for accrual income. Suitable for investors with conservative risk profile, looking for stable income.
  5. Credit-opportunities Funds: Invest in Corporate bonds & debentures of 2-3 years’ maturities. However, the credit rating of these instruments is lower than that in Short-term Debt Funds. This allows investors to earn slightly higher returns. As the bonds are still held to maturity, interest rate risk is very low. Suitable for investors with a moderate risk profile.
  6. Monthly Income Plans (MIP): MIPs, investing majority (75-80%) of their portfolio in fixed income securities and the remaining (20-25%) in equities. The debt investments provide the fund with stable returns; and the equity portion allows the MIP to higher returns than regular Debt Funds. However, this also makes MIPs riskier than regular Debt Funds.
  7. Fixed Maturity Plans (FMPs): Close-ended schemes with a fixed tenure (similar to a bank FD, where investor’s money will be locked in for the said period). The FMP Fund Manager invests in fixed income securities with maturities matching scheme tenure. This also reduces re-investment risk. As a result, the returns of these schemes are stable (and higher than bank FDs), making them suitable for investors with conservative risk profile and looking for a tax advantage.

Balanced Funds: Own both stocks and bonds with a steady proportion, usually ~ 60% in stocks and 40% in bonds. Their downside is cost. One can buy a Short-term Debt Fund and an Equity Fund with less cost, and still achieve a ‘balanced’ portfolio.

Investing in Mutual Funds is made easy, however, understanding ‘What Mutual Fund investment entails may be a daunting task. E.g. Regular plan or Direct plan, Growth option or Dividend option, Dividend reinvestment or Pay-out etc. Hence, we have created a rundown on these important terms. Read the next article to ‘Familiarise yourself with different terminologies related to Mutual Funds.’

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This post first appeared on Principles Of Value Investing, please read the originial post: here

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1. What are Mutual Funds? How do they work?


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