These days, any proper investment plan tends to include a plan to invest in mutual funds too. While investing in a mutual fund is a good idea, it more often that not, leaves potential investors scratching their heads about what this whole mutual fund thing is all about. Mutual funds are incredibly simple to understand. The basics of the mutual fund is that you invest money in a fund along with load of other people. The company that offers the fund then invests the money and you get the returns.
How mutual funds work is by collecting money from lots of investors and then investing that money in stocks and bonds. The idea behind the mutual fund is to invest in a balanced way so as to mitigate the risk associated with investments as much as possible. Being an investment that is made in the markets, there is an inherent risk that comes with this investment and investors must be prepared for the possibility of a loss.
The fund, especially an open ended fund, can be judged by checking the NAV or the net asset value. The NAV, when multiplied by the units in the fund, is what will determine the amount that the investor will get when they make a withdrawal. It must however be remembered that the NAV is NOT an indication of the quality of the fund and should not be the only criteria used to judge the mutual fund.
Types of mutual funds
There are two broad types of mutual funds available in India. They are the open ended and closed ended mutual funds.
Open ended mutual funds are those where investors can indulge in the buying and seeling of units at any time. There are no maturity periods or investment periods for these funds. They can also be further classified in 4 types, which are:
Money Market/ Liquid
Debt or income mutual funds are those where investments are made in bonds and treasury bills. Money invested in such a fund can be put into monthly income plans, short term plans, flexible maturity plans, etc. These investments offer a very low risk factor and low returns and are ideal for those who are looking for a safer environment for their money to grow in.
Money market or liquid mutual funds are those where investments are made in treasury bills and fixed income securities among other instruments like short term bank certificates of deposits. The purpose of these funds is to provide investors with liquidity hence they come with short maturity periods of about 90 days.
Equity or growth mutual funds are those where the investors money is invested in equity stocks with the idea of either generating an income or capital gains. Sometimes they can be investments made with the purpose of generating both gains and income.
Balance funds, as the name suggests, invest the money in a balanced way between fixed income securities and equity funds so as to provide investors with the opportunity to invest aggressively but with caution.
Closed ended mutual funds
Closed ended mutual funds are those where the fund comes with a fixed maturity period and also alows for investments to take place only in the innitial stages of the fund. It has two types, the capital protection fund and the fixed maturity plans fund.
Fixed Maturity Plans
The capital protection mutual fund invest in both fixed income securities and equity plans but the investment in equity is marginal since the aim of the scheme is to safeguard the principal while still getting returns.
These plans, unlike most other plans, may come with the lowest charges for the scheme because they are not managed actively like other funds. In a fixed maturity plan, the investment is made mostly in debt instruments that mature along the same timeline as this fund since it comes with a fixed maturity period.
Sometimes you will notice that a mutual fund will only allow investment at specific periods. It does not allow investment at any time but it still allows investments to happen much later into the schemes duration too. This is so because the interval mutual funds operate as a combination of both open and close ended funds where investments can be made at specific intervals.
Advantages of Mutual Fund
There are several advantages to mutual funds. Some of these are:
- Since the investments are actually by experts, investors are not required to have an expert understanding of the markets and how they function.
- The investment in a mutual fund can be done in a lump sum or in instalments.
- Investments made in tax saver mutual funds are exempt from tax under section 80C.
- Investors can chose the risk level from low, medium and high risk funds based on their appetite for risk.
- Risks are mitigated by investment the money in different stocks and bonds.
- Mutual funds that don't have lock in periods can offer liquidity when needed.
- There is no need for large sums of money to begin investing in mutual funds.
- Invests can also be made in SIPs, (systematic investment plans) where a specific amount can be paid towards the mutual fund every month.
Disadvantages of Mutual Funds
The main disadvantage that a mutual fund may have is that, unlike fixed deposits or other such investments, there is a factor of risk involved. While fixed deposits provide steady and safe growth, the growth in a mutual fund depends on the market performance and can provide returns or even cause the investor to incur a loss.
How to invest in Mutual Funds
The very first step to investing in mutual funds is to figure out if the investment will be done in a lump sum or through SIPs. Once that is sorted, you will need to figure out your appetite for risk. Generally the high risk funds will also provide the highest returns but if you are not looking for high return rather, lower returns in a safer environment then you can go in for a medium or low risk mutual fund.