Mutual funds are investment vehicles that pool money from multiple investors and allocate it across a diversified portfolio of stocks, bonds, or other securities. These funds are managed by professional fund managers who make strategic investment decisions based on market research and financial analysis.
By investing in mutual funds, individuals gain access to a diversified portfolio without needing to actively manage it themselves. The fund's total value is divided into units or shares, and each investor owns a proportionate stake based on their contribution. Mutual funds are popular because they offer diversification, professional management, and liquidity, making them a preferred choice for both beginners and experienced investors.
Advantages of mutual funds
Professional management
Investors benefit from the expertise of full-time professional fund managers who analyse market trends, select securities, and optimise the portfolio to maximise returns while managing risk. This is especially useful for individuals who lack the time or knowledge to manage their investments.
Risk diversification
Instead of putting all their money into a single stock or bond, investors in mutual funds gain exposure to a broad range of securities. This diversification reduces the risk of significant losses from any single investment. If one stock underperforms, gains from other holdings in the fund can help balance the returns.
Affordability
Mutual funds allow investors to start with a small amount of money through systematic investment plans (SIPs). This makes it easier for people to invest regularly without requiring large capital upfront.
Liquidity
Most mutual funds, especially open-ended funds, allow investors to buy and sell their units on any business day. This makes it easy to access money when needed, unlike other long-term investments like fixed deposits or real estate.
Transparency
Mutual funds in India are regulated by the Securities and Exchange Board of India (SEBI), ensuring that investors' interests are protected. Regular disclosures and portfolio updates ensure transparency.
Tax benefits
Equity-linked savings schemes (ELSS) allow investors to claim tax deductions under Section 80C of the Income Tax Act, 1961, making them an attractive tax-saving option.
Disadvantages of mutual funds
Costs and fees
Mutual funds charge management fees, administrative expenses, and other costs that can reduce returns over time. These costs are measured by the expense ratio.
No control over investments
Investors do not have direct control over which securities the fund buys or sells. Fund managers make all investment decisions, which may not always align with individual investor preferences.
Fluctuating returns
Mutual funds are market-linked investments, meaning their value can rise or fall based on market conditions. Unlike fixed-income investments, they do not offer guaranteed returns.
Exit loads and lock-in periods
Some funds charge an exit load if investors redeem their units before a specified period. For example, ELSS funds have a mandatory three-year lock-in period.
Over-diversification
While diversification reduces risk, excessive diversification can limit potential returns. A fund that spreads its investments too thin may miss out on significant gains from high-performing stocks.
How mutual funds work
Mutual funds operate by pooling money from multiple investors and investing it in a portfolio of assets. Here’s how they function:
Pooling of funds
Investors contribute money to a mutual fund, which combines these funds to create a large capital pool.
Investment and management
A professional fund manager strategically invests this money in stocks, bonds, or other assets, aiming to generate returns while managing risks.
Net asset value (NAV)
The mutual fund’s NAV is calculated by dividing the total value of its assets by the number of outstanding units. This NAV determines the price at which investors buy or sell fund units.
Returns and income distribution
Mutual funds earn money through dividends, interest income, and capital appreciation. These profits are distributed to investors in the form of dividends or reinvested into the fund.
Buying and selling units
Investors can buy or sell mutual fund units at the prevailing NAV, ensuring liquidity and flexibility.
Key terms in mutual funds every investor should know
1. Net asset value (NAV)
NAV represents the per-unit price of a mutual fund. It is calculated as:
NAV=(TotalAssets–Liabilities)/TotalUnitsOutstandingNAV = (Total Assets – Liabilities) / Total Units Outstanding
Investors buy and sell fund units based on the NAV, which changes daily based on market movements.
2. Expense ratio
The expense ratio is the annual fee charged by a mutual fund to cover management, administration, and operational costs. A lower expense ratio means higher returns for investors.
3. Assets under management (AUM)
AUM refers to the total market value of all assets managed by a mutual fund. Higher AUM indicates a large investor base and trust in the fund’s performance.
4. Asset allocation
This refers to how a mutual fund distributes its investments across different asset classes like equities, debt, and gold to balance risk and returns.
5. Systematic investment plan (SIP)
SIP allows investors to invest a fixed amount in a mutual fund at regular intervals, promoting disciplined investing and reducing the impact of market volatility.
6. Systematic transfer plan (STP)
STP enables investors to transfer money systematically from one mutual fund scheme to another, usually from a debt fund to an equity fund, for better returns.
7. Systematic withdrawal plan (SWP)
SWP allows investors to withdraw a fixed amount from their mutual fund holdings at regular intervals, providing a steady income stream.
8. Entry load
A fee charged when an investor enters a mutual fund (mostly abolished in India).
9. Exit load
A fee charged if investors redeem their units within a certain period, discouraging premature withdrawals.
10. New fund offer (NFO)
NFO is the initial offering of a mutual fund when it is launched. Investors can buy units at a face value before the NAV is determined based on market performance.
Conclusion
Mutual funds offer a simple and efficient way to invest in the stock market, providing professional management, diversification, and liquidity. While they involve certain costs and risks, their advantages often outweigh the drawbacks, making them a preferred choice for both new and experienced investors. Understanding key terms helps investors make informed decisions and optimise their financial growth.
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