The concept of a mutual fund was first introduced in the 18th century by a Dutch merchant named ‘Adriaan van Ketwich.’ He created a pool of money from multiple investors, which he used to invest in various stocks. This allowed small investors to pool their resources and gain access to a diversified portfolio that would have been difficult to achieve independently. The concept of mutual funds took off in the United States in the 1920s. A man named ‘Edward Jones’ created the first modern mutual fund. This fund allowed investors to buy shares in a portfolio of stocks. It quickly became a popular way for small investors to participate in the stock market. But how to invest in mutual funds? Read on, and you will know.
What Are Mutual Funds?
Mutual funds allow investors to spread their money across a diverse range of assets. This helps to reduce risk and increase returns.
Think of it like a big, delicious pizza you can enjoy with friends. Just like a pizza comprises different toppings, a mutual fund can comprise various assets — stocks, bonds, etc.
The performance of a mutual fund is measured using ‘Net Asset Value (NAV) per unit.’
The formula is,
NAV of a Mutual Fund = (Total Market Value of securities in a mutual fund scheme) / (Total number of units of the scheme).
If we take India as an example, the mutual fund assets crossed INR 30 Trillion in November’20. It is expected to grow at a CAGR of 21.5% by 2027.
Types of Mutual Funds
1. Equity mutual funds
Equity mutual funds are mutual funds that primarily invest in stocks or shares of companies listed on the stock market.
These funds allow investors to participate in the stock market and offer the potential for higher returns over the long term.
In India, equity mutual funds have historically provided good returns to investors, especially over the long term. For instance, the average returns for equity mutual funds in India between 2011 to 2021 have been around 12-13%. It is higher than traditional fixed deposits and savings accounts.
But, it is essential to note that the returns of equity mutual funds are subject to market volatility and can be risky.
2. Debt mutual funds
Debt mutual funds invest in fixed-income securities — government bonds, corporate bonds, money market instruments, and other debt securities.
These funds aim to provide investors with a regular income while preserving their capital. Debt mutual funds are relatively less risky than equity mutual funds as they invest in low-risk, fixed-income securities.
In India, debt mutual funds have historically provided decent returns to investors, especially during periods of high-interest rates. Between 2017 to 2021, India’s average returns for debt mutual funds have been around 7-8%.
There are various types of debt mutual funds, such as liquid, ultra-short-term, short-term, and long-term. They differ regarding the investment horizon, return potential, and risk levels.
3. Balanced mutual funds
Balanced mutual funds, or hybrid funds, invest in stocks and bonds.
These funds aim to provide investors with a diversified portfolio of investments that can offer both capital appreciation and regular income. These funds can also give the investors steady income through dividends and interest payments.
The average returns for balanced mutual funds in India have been around 10%.
4. Index mutual funds
Index mutual funds are mutual funds that aim to track the performance of a particular stock market index, such as the Nifty 50 or the BSE Sensex.
These funds invest in the same stocks and proportions as the underlying index, making them a passive investment option. Index mutual funds are a popular investment option for investors seeking to achieve market returns with low expenses.
The Nifty 50 index has delivered an annualized return of around 12% between 2011 and 2021. The BSE Sensex has shown an annualized return of about 11%.
Why Invest in Mutual Funds?
Investing in mutual funds can provide several benefits to investors.
Mutual funds allow investors to diversify their investments across multiple asset classes. This helps reduce the risk of any investment significantly impacting the overall portfolio.
2. Professional support
Mutual funds are managed by professional fund managers with experience in handling investments. This means investors can benefit from their skills without actively managing their assets.
3. Low minimum investment
Many mutual funds have low minimum investment requirements, making them accessible to many investors. Generally, the minimum investment amount in a mutual fund is INR 500.
Mutual funds are generally highly liquid. Investors can buy and sell their shares easily and quickly. This allows investors to access their money when they need it.
Investing in mutual funds is easy and convenient. Investors can buy and sell shares directly through their brokerage account.
6. Tax efficiency
Mutual funds can be tax-efficient because they are structured to minimize taxes on investment gains. For example, investors in a mutual fund may only be taxed on capital gains when they sell rather than every time the fund managers sell a stock or bond.
Risks of Investing in Mutual Funds
Investing in mutual funds can also come with certain risks.
1. Market risk
Mutual funds invest in stocks, bonds, and other securities. These assets are subject to market fluctuations. If the market experiences a downturn, the value of the mutual fund may decline.
2. Management risk
While mutual funds are handled by professional fund managers, they are still humans. There is a risk that they may make poor investment decisions. This could result in lower returns or even losses for investors.
3. Liquidity risk
Mutual funds are generally considered highly liquid. But there may be times when investors cannot sell their shares as quickly as they would like, especially during market stress.
4. Concentration risk
Some mutual funds may be heavily invested in a particular sector or industry. It can increase the risk of losses if that sector or industry experiences a downturn.
5. Credit risk
Mutual funds that invest in bonds or other debt securities are exposed to credit risk. It is the risk that the bond issuer may default on its payments.
6. Interest risk
Interest rate risk is the risk that changes in interest rates will affect the value of an investment, particularly in fixed-income securities such as bonds. As interest rates rise, the value of existing bonds decreases; as interest rates fall, the value of existing bonds increases.
7. Inflation risk
Suppose the mutual fund is not generating returns more than the inflation rate. In that case, inflation can erode the purchasing power of an investor’s capital over time.
Factors That Affect Mutual Fund Returns
Mutual fund returns can be affected by various factors.
1. Market conditions
Mutual fund returns are closely linked to market conditions. Factors such as economic growth, interest rates, and inflation can affect a fund’s performance. A bull market can lead to higher returns, while a bear market can lead to lower returns.
2. Investment strategy
3. Fund manager
The experience and skill of the fund manager can also affect the mutual fund returns. A good fund manager can identify opportunities in the market and make the right decisions to generate higher returns.
The expenses associated with a mutual fund, including management fees and other costs, can impact its returns.
5. Investor behavior
Investor behavior can also impact mutual fund returns. Investors who buy and sell frequently can incur higher transaction costs and reduce their overall returns.
Choosing the Suitable Mutual Fund Scheme
Below are some key factors that can help you make an informed decision.
1. Identify your investment goals
Before investing in a mutual fund, you must identify your investment goal, risk tolerance, and horizon. This will help you determine the type of mutual fund best suited for your needs.
Investment goals can include wealth creation, retirement planning, education, purchases like a car or house, and so on. The risk tolerance can be high, medium, or low. The time horizon can be short, medium, or long-term.
Generally, debt funds fall under the low-risk category, and equity funds fall under the high-risk category. The balanced and index funds fall in the middle of the spectrum.
Regarding time horizon, a shorter time frame goes well with debt mutual funds. Moreover, there are different types of debt instruments with varying time frames. An equity fund is a better option for a medium to longer time frame.
2. Consider fund performance
Look for mutual funds with a ‘consistent’ track record of performance over the long term. This can be evaluated by comparing the fund’s past performance and comparing it with its benchmark and peer group.
Also, read the scheme’s offer document to understand the following,
- Fund’s investment objective, asset allocation, and past performance.
- Fund’s investment strategy, portfolio composition, and risk factors.
3. Assess the fund manager
The fund manager’s experience, track record, and investment philosophy can significantly impact the fund’s performance. Therefore, it’s essential to research the fund manager’s background.
A well-diversified mutual fund can reduce risk and increase returns. Look for mutual funds that invest in a diversified portfolio of stocks, bonds, and other securities.
There are two approaches to reaching diversification in a mutual fund.
- Either you can straight away buy a balanced fund,
- Or you can buy equity and debt fund separately to maintain a balanced portfolio.
5. Expense ratio
Mutual funds charge a management fee and other expenses, affecting returns. Therefore, it’s vital to consider the mutual fund’s expense ratio before investing.
6. Check ratings
Independent rating agencies like Morningstar provide ratings to mutual funds based on their past performance, management quality, and other factors. Consider these ratings while selecting a mutual fund.
Understanding Mutual Fund Fees and Expenses
Mutual fund fees and expenses can be broken down into the following sections.
1. Expense ratio
This is the annual fee the mutual fund company charges for managing the fund. This includes administration expenses, management fees, and other costs. The expense ratio is a percentage of the fund’s NAV and can vary from fund to fund.
2. Exit load
Exit load is a fee charged when you sell units. This fee discourages frequent trading and protects long-term investors.
3. Securities Transaction Tax (STT)
STT is a tax charged on securities transactions, including buying and selling mutual fund units. The government sets the tax rate, and it is currently at 0.001% of the transaction value.
If you purchase mutual fund units through a broker or distributor, they may charge a brokerage fee for their services.
Mutual funds are a popular investment choice for people worldwide.
They allow investors to spread their money across a diverse range of assets like stocks, bonds, etc.,
But before investing in mutual funds, you must do some groundwork to identify your investment goal. It helps to determine the type of mutual fund best suited for your needs.
Afterward, you can research the fund and fund manager background to boil it down to the mutual fund you want to invest in. This approach will help to reduce risk and increase returns.
1. What are the advantages of investing in mutual funds?
The benefits of investing in mutual funds include the following.
- Professional Management
- Ease of access
- Potential for higher returns
Mutual funds also allow smaller investors to access a broad range of securities they might not be able to invest in otherwise.
2. What is a systematic investment plan (SIP)?
A systematic investment plan (SIP) is a method of investing in mutual funds. An investor invests a fixed amount of money at regular intervals, usually monthly.
SIPs help in disciplined investing and averaging out the cost of investments over a period of time. It is a popular investment method, especially in India.
3. What are the different types of mutual funds?
There are many types of mutual funds, as mentioned below.
- Equity funds invest in stocks
- Bond funds invest in bonds
- Money market funds invest in short-term debt securities
- Index funds track a particular market index like Nifty or Sensex
- Sector funds focus on a specific industry sector
- Balanced funds invest in both stocks and bonds
4. What are the risks of investing in mutual funds?
Investing in mutual funds carries several risks.
- Market risks can fluctuate the fund value with changes in the financial markets, leading to potential losses.
- Credit risk refers to the possibility that bond issuers default on their obligations.
- Inflation risk refers to the potential erosion of purchasing power due to rising prices.
- Liquidity risk relates to the possibility of being unable to sell mutual fund shares quickly enough.
5. How to choose the best mutual fund scheme?
To choose the best mutual fund scheme,
- Consider your investment goals, risk tolerance, investment horizon, and style.
- Look for a fund with a track record of consistent performance, low expenses, and a skilled fund manager.
- Check the fund’s investment objective, asset allocation, and past performance.
- Read the scheme’s offer document and understand the fund’s investment strategy, portfolio composition, and risk factors.
- Lastly, compare the fund’s performance against its benchmark and peer group.