In recent years, awareness about mutual funds and the equity market has increased. There has been a transition in investor behavior. Initially, investors sought traditional low-risk but moderate-return investment instruments. They are now open to investing in solutions that provide new, moderate or high-risk, and good returns.
What are mutual funds, and how do they work?
Mutual funds are investment programmes funded by shareholders that trade in diversified holdings and are professionally managed. Mutual funds are defined as pools of money collected from investors. These pools of money are used to invest in different stocks, bonds, and other securities. These investments are managed by professionals or expert investors in the field, known as fund managers.
When investing in a mutual fund, you have to weigh your options. Different mutual funds are available with varying objectives, risk factors, credibility, and rates of return. It all depends on your investment goal, and fund selection is subjective.
Once you have selected a mutual fund that you want to invest in, you can invest in it by filling out the relevant forms online or offline. Once you have done that, you can transfer whatever amount you are willing to invest.
Your investment amount will be pooled with that of the other investors. This fund is accumulated by all the investors and managed by the fund manager. The fund manager invests the money in different stocks, bonds, etc. The fund manager does this after carefully observing, studying, and analysing the market.
You can apply for redemption when you are ready to redeem your amount. The redemption can be done online or offline, and the amount will be deposited in your bank account.
What are the types of mutual funds and their benefits?
Mutual funds are classified based on four factors.
- Investment objectives: Why are you investing in the fund? The goal of the investment determines the type of fund.
- Investment period: Is it a long-term or short-term fund? You can invest for a few days or even a few decades.
- Returns: The returns from the fund often depend on the risk you are willing to take.
- Benchmark: Some mutual funds invest in companies with a certain valuation. This is called a benchmark.
Various other factors determine mutual fund returns and payouts. All these factors are determined by the Security Exchange Board of India (SEBI). SEBI and the National Institute of Securities Markets (NISM) regulate mutual funds. Based on the factors mentioned above, there are different types of mutual funds. However, they are mainly classified into four categories.
Equity mutual funds
These types of funds are mainly invested in equity or stocks. These are further classified based on the size of the company they invest in (small/medium/large-cap funds), or they can be classified based on the objective or strategy (income-oriented, aggressive, value, etc.) Usually, it is a blend of both. Equity funds are of the following types:
- Large Cap: These firms invest 80% of their funds in stocks of firms ranked 1–100 by their market capitalization, also known as “large-cap stocks.”
- Mid Cap: These firms invest 65% of their funds in stocks of firms ranked 101 to 250 by their market capitalization, also known as mid-cap stocks.
- Small Cap: These firms invest 65% of their funds in stocks of firms ranked above 250 by their market capitalization, also known as mid-cap stocks.
Also referred to as fixed-income funds, these mutual funds invest in bonds or debt instruments. The interest on these investments becomes the return for the mutual funds. These bonds are subject to interest rate risks.
These are mutual funds that invest in stocks that are part of a market index. For example, Nifty50. depends on the performance of the share prices of the top 50 companies on the NSE. As the name suggests, it largely depends on the volatility of the market index. These funds are usually in higher demand as they require lower management fees from investors and there is less research for analysts to do.
Hybrid or balanced funds
As the name suggests, these funds invest in a mixed bag of stocks, bonds, shares, money market instruments, etc. These funds reduce the risk by investing in different options. Hybrid funds have a few subcategories:
- Equity-oriented: These funds invest 65% of their funds in equity and the rest in debt instruments.
- Debt-oriented: These funds invest 60% of the funds in debt instruments and the rest in equity.
- Arbitrage funds: They mostly invest in stocks. They profit from the differences in buying and selling a company’s stock at the same time.
- Solution-oriented: These funds are tailored to certain objectives. These are the funds planned for specific life goals, such as retirement.
What are the benefits of investing in mutual funds?
- Managed by Professionals: The funds are managed by experts in their fields, backed by research analysts who carefully monitor the markets.
- Diversification: When you invest in stocks directly, you are at a greater risk. When you invest in mutual funds, they are diversified. Therefore, you are putting your eggs in different baskets.
- Liquidity: Even though mutual funds have lock-in periods, they are liquid. You can buy or sell units at NAV.
- Tax benefits: If you invest in ELSS funds, you can qualify for tax benefits under Section 80C of the 1961 IT Act.
- Risk factor: You can choose funds as per your comfort level with risk. If you are willing to take a higher risk with your investments, you can invest in high-risk funds.
- Objectives: You can choose funds according to your objectives. Therefore, you can plan your retirement or your child’s marriage and invest accordingly.
- Variety: There are many options to choose from. You can find mutual funds based on your risk appetite, investment amount, goal, and many other selection factors simply because there is a lot of variety.
As you can see, investing in mutual funds is beneficial for various reasons. It is profitable not just in the short run but also in the long run. You do not have to do research because the analysis is performed by experts. All you have to do is be sure of the objectives and funds you choose.