Beginner’s Guide to Mutual Funds

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You may have heard about mutual funds, through television campaigns, print advertisements, friends etc. and may be wondering what mutual funds are and whether they are a good investment product or not.

In this article, we’ll try to understand the basics of mutual funds and the various types of mutual funds.

What is a mutual fund?

Mutual funds are investment schemes that pool money from investors, to invest in various securities. The returns from these securities are then passed on to the investors. There are two ways to invest in mutual funds viz., Systematic Investment Plans (SIP), and Lump sum investments.

  • The SIP route can help you invest systematically in mutual funds, at your chosen frequency. You can invest in a half-yearly, quarterly, monthly, weekly, or daily through SIP. You can change the SIP amount, or alsocease the SIP half-way, without penalty.
  • You can even invest in mutual funds through lump sum.

What are the types of mutual funds?

Mutual funds offer a plethora of schemes according to one’s risk profile. For example, risk-averse investors can choose debt-heavy mutual funds. Similarly, investors with a higher appetite for risk can choose equity-heavy funds. For investors willing to take amoderate risk, there are balanced funds, which are a combination of equities and fixed income securities.

On the basis of invested securities, mutual funds can be divided into the following three broad categories:

  • Equity-based funds

These funds invest heavily in equities. They are high-return, high-risk investments. However, an equity-based mutual fund investment is for long-term goals. This is because stock markets may witness short-term volatility. Yet, in the long-run, markets march forward. You can invest in ELSS (Equity Linked Savings Scheme), a type of equity-based mutual fund, to save taxes, up to Rs.1.5 Lakh.

ELSS has the lowest lock-in period compared to other tax-saving instruments. This can help you divide Rs.1.5 Lakh tax-saving investment into 12 or more parts (through SIP). With ELSS, you can also combine your tax-saving goal, with other long-term financial goals, such as retirement planning, child education goals etc. The value of your fund depends on your NAV (Net Asset Value). The NAV of mutual funds is the value of every share in your mutual fund.

Index funds are another type of equity-based mutual funds. These funds mirror benchmark indices, SENSEX and the Nifty. Therefore, if you are looking for high long-term returns, you can choose equity-based mutual funds.

Equity-based funds require you to study the markets. However, you can also seek financial advice from experts. A professionally managed equity-based mutual fund can give you returns over and above inflation, in the long-run.

  • Debt-based funds

Let’s consider, you plan on purchasing an expensive piece of jewellery next year. You wish to get good returns on your investment but not willing to take the risk. Debt-based funds can help you achieve such goals, with minimum risk on your investment. You can also invest in debt-based mutual funds to balance your risk and returns. These funds are low-risk funds.

You can invest in these funds if you are looking for good short-term returns. Ultra-short mutual funds, liquid funds, debt funds, fixed maturity plans (FMPs) etc. are some debt-based mutual funds that can help meet your short-term financial goals.

Liquid funds are debt-based mutual funds that can help you build a substantial emergency corpus. These funds don’t have a lock-in period and can give you short-term returns over and above inflation. These funds can even be an alternative to your savings bank account. 

Similarly, if you are comfortable locking-in your money for your short-term goals, you can invest in either ultra-short debt funds, FMPs, or debt funds. By investing in FMPs, you can receive benefits such as double indexation.

  • Balanced funds

If you are looking for an automatic diversification in your portfolio, you can opt for balanced funds. Balanced funds, or hybrid funds, help diversify your risk and returns.

Balanced mutual funds invest in a mixed basket of fixed income and stocks. Here, stocks can help you maximise your returns, while fixed income securities can minimise your risk. Therefore, you receive the combined benefit of lower risk and higher yields. You can invest in balanced funds for your medium-term goals liketravelling the world, buying a new car, renovating your house etc.

Balanced funds can further be divided into the following three types:

  • Equity-heavy balanced funds

Equity-heavy balanced funds invest around 60-80% in equity-based assets, and the remaining in fixed income securities. They are less risky than mere equity-based mutual funds.

These funds are also suitable for investors looking to balance their risk along with the high-return equity proportion. They are also known as aggressive hybrid funds since they invest heavily in equities.

  • Debt-heavy balanced funds

If you are seeking a higher return with a low-risk investment, you can consider debt-heavy balanced funds. These funds invest around 60-80% in debt-based assets, and the remaining in stocks. The equity component of your fund can help balance your return from your debt component.  They are also called conservative hybrid funds since they lean more towards debt-based assets.

  • Balanced hybrid funds

Here, you can choose your own risk-return combination. You can hold a fairproportion of fixed income and equities in your fund.

Mutual funds are professionally managed, helping you invest in a disciplined manner through SIP. It can also inculcate the habit of savings and regular investing. With the abundance of schemes available, mutual funds have something to offer for every risk appetite.

Mutual Funds as an Investment Option

As mutual funds are managed by professionals who invest in Stock Markets, the returns usually tend to be higher than fixed income sources like PPF, FD etc. However, as these funds are invested in stock markets – the returns earned are not stable and keep varying every year.

There is no guarantee of the returns which are generated from mutual funds and in some cases the returns may be negative as well in the short run. However, in the long run – the returns generated from mutual funds are usually higher than other type of investment products.

Karan is CA by Qualification with the rare distinction of being awarded All India Rank 22. He is also the founder of this website and is an expert in helping people save Taxes legally. He can be reached by booking an appointment for Tax Advisory Service.