Mutual Funds: An Introduction, Types and Benefits

Last Updated on Jan 6, 2023 by Gayathri Ravi

For an individual investor investing directly in debt and equity securities seems to be an uphill task. They neither have the resources nor the expertise required to undertake security analysis. The next best alternative is indirectly investing in the market through mutual funds. However, as the word mutual funds pop up, one’s mind is flooded with questions – what are mutual funds, how do mutual funds operate and what kinds of mutual funds are available in the market and more. 

Before investing in mutual funds, it is of utmost importance for an investor to understand their modus operandi, characteristics and how one can benefit from investing in them. This article aims to provide a better understanding of mutual funds as an investment and tries to answer the above-mentioned questions.

Meaning of mutual fund 

The term mutual fund is an amalgamation of two words, ‘mutual’ and ‘fund’. Mutual refers to common investments, and Fund means a pool of money. 

A mutual fund is a financial intermediary made up of a pool of money contributed by several investors with a common investment goal. It invests the reservoir of funds in various investment opportunities such as equity, bonds, government securities and other financial assets to achieve the common financial objective.

Professional firms manage them called Asset Management Company (AMC), which are recognised by the Securities Exchange Board of India (SEBI). AMC employs professional investment managers, also referred to as Fund Managers, who manage the portfolio on a day-to-day basis on behalf of the investors.

An investor who subscribes to a mutual fund is issued units in proportion to the amount invested and is referred to as a unit holder.

Source: Unit Trust of India (amfiindia.com)

Now that we know what mutual funds are, let’s understand the mechanism of how they operate.

Process of mutual fund operations 

The following figure shows the process of a mutual fund:

• At inception, a mutual fund scheme is launched with a certain financial objective by AMC.

• Interested investors with the same investment objectives come together and pool their savings, forming a corpus.

• The corpus is managed by Fund Managers who invest these funds in various financial instruments per the scheme’s objectives.

• Subsequently, units are issued to the investors in proportion to the amount of capital contributed. Therefore, the investors do not have any direct claim over the shares, bonds and other financial securities purchased and owned by the mutual fund.

• Return on a mutual fund primarily arise from a change in the value of investments, distributed among the unit holders. 

What is NAV?

Just like equity shares trading on a stock exchange have a market price, Net  Asset Value (NAV) is the fair market value of a fund’s assets.

The NAV is the combined market value of all the securities in the fund’s portfolio net of all the expenses, charges and liabilities.

NAV= Value of Securities – Liabilities/ No. of units outstanding 

NAV of a fund simply tells us how much each unit of the fund is worth. It is the amount each unit holder would receive per unit if the fund is closed.

Since the market value of securities changes every day, the NAV of the scheme changes on a daily basis.

To understand the concept clearly, let us look at the following example:

ABC Mutual Fund collected Rs. 50,00,000 by issuing 5,00,000 units of Rs. 10 each. The amount collected was invested by the fund manager in different securities whose market value at present is Rs. 56,00,000 and the fund has a liability of Rs. 4,00,000 in respect of costs and expenses. NAV per unit of the fund would be:

NAV = Value of Assets – Liabilities/ No. of Units outstanding

       = 56,00,000 – Rs. 4,00,000 / 5,00,000

       = Rs. 10.4 per unit

So, if an investor owns 1000 units of the scheme, then the value of the investment would be at Rs. 10,400 (1000*10.4).

Systematic Investment Plan (SIP)

For a novice investor, investing in a mutual fund might sound complicated and onerous. However, it’s quite the contrary. Investment can simply be made in two ways, 

1. Lumpsum, i.e., a one-time payment made to the fund, or
2. Systematic Investment Plan (SIP).

Let’s understand SIP in a little more detail.

SIP is a tool that enables investors to invest a small amount regularly in a mutual fund scheme. It is best suited for those who either lack large sums for investments or are reluctant to commit large sums in one go.

A pre-specified amount is invested at a pre-specified interval, such as Rs. 1000 monthly. One must clearly understand SIP is not a mutual fund but rather a method of investing in a mutual fund.

Simply put, through SIP, investors can systematically save and invest in a mutual fund.

Types of mutual fund schemes 

There are a variety of schemes offered by mutual funds which invest in a wide range of securities to cater for the diverse clientele and investor needs. These schemes can be classified based on their investment objectives, sectors, market capitalisation, the underlying investment portfolio, liquidity, maturity of the securities and many more.

Some of the schemes are explained below:

Based on liquidity

• Open-ended mutual fund – The investor can enter or exit the scheme during the life of the open-ended mutual fund by purchasing or selling the units respectively from the Fund at the NAV.
  The scheme offers units for sale without specifying any maturity period and redemption duration, i.e., no lock-in period exists. A key feature of such funds is the liquidity the fund provides to the investor.
• Close-ended mutual fund – On the other hand, under closed ended mutual fund schemes, the redemption period is specified, i.e., it has a fixed maturity date. Under a close-ended scheme, an investor can invest when the scheme is opened for subscription at the time of inception.
  Such funds do not provide liquidity. Rather, they are traded and listed on the stock exchange like equity stocks. Thus, providing an exit option before maturity.

Based on investment objective

• Income fund – The prime objective of such funds is to provide safety of investment and a regular steady income to the investors. However, there is no guarantee of income.
  Income funds are also known as dividend schemes. These schemes invest primarily in income-bearing securities such as bonds, debentures, government securities etc. Such schemes are ideal for investors who seek regular intermediate cash flows. The returns of the investment and the associated risk are relatively lower than growth funds.
• Growth fund – The main objective of the growth fund is capital appreciation over the medium to long-term horizon. They primarily invest in growth-oriented assets such as equity shares. Historically, the risk associated with equity investment is high, and there is no assurance of returns. Returns associated with growth funds are higher than that of income funds.
  Such funds are suitable for investors with long-term investment horizons willing to take a certain degree of risk.
• Hybrid fund – Such a fund aims to provide capital appreciation and regular income to its investors. Income-cum-growth funds invest in a mix of debt instruments and equity securities. Such schemes are also referred to as balanced funds.

Costs and loads in mutual fund investment 

There are two types of costs associated with the mutual fund:

1. Operating expenses: Mutual funds incur costs for managing the investments on behalf of the investors. Funds incur operating expenses such as legal, advisory, administrative, and custodial fees. Such expenses are expressed as a percentage of total assets under the fund’s management.

Expense Ratio = Total Annual Operating Expenses/ Average Assets under Management

It is important to note operating expenses are not directly paid by the unit holders but rather are deducted from the NAV. As the unit holders bear the cost in terms of reduced NAV, the lower the expense ratio, the better it is.

2. Entry and exit loads:

In the case of an open-ended mutual fund, the load is borne by the investors, which is the difference between the NAV and the Purchase/Sale Price per unit. The investor bears load at the time of entry (purchase of units) or/and at the time of exit (sale of units).

• Entry load: Also referred to as Front-end Load, is the cost incurred when purchasing units from the fund.
  For example, for a face value of Rs. 100 per unit, an entry load of 2% is charged. This means an investor has to pay Rs. 102 to buy one unit from the fund. Thus, the price paid by the investor to purchase a unit would be NAV plus entry load.
• Exit load: It is a redemption fee charged by the fund at the time of repurchase of units from the investor. Also referred to as back-end load. Exit load usually reduces with longer holding periods.
  For example, for a face value of Rs. 100 per unit and an exit load of 2% is charged. Investors selling units back to the fund would get Rs. 98 per unit. At the time of redemption, the investor would get NAV minus exit load.

Some funds may charge both entry and exit loads or either of the two. It is important to incorporate the load factor in calculating return to unitholders. 

Benefits of investing in a mutual fund

• Portfolio diversification – Most mutual funds invest in a number of securities and across asset categories. Diversification reduces the risk of losses. Even if one or some securities in the portfolio decrease in value, it’s extremely rare for all securities to perform on similar lines, which may even increase in value. Investing in a mutual fund allows a small-scale investor to hold a diversified portfolio even with a small amount of investment.
• Professional management – Most individual investors incur losses while investing in the stock market due to a lack of knowledge and experience. Mutual funds are managed by experienced professional managers who thoroughly research and analyse the securities market before investing. Mutual fund investors benefit from the support of such skilled and qualified professionals at a nominal cost.
• Well-regulated – Working and operations of a mutual fund are regulated and supervised by SEBI under SEBI (Mutual Funds) Regulations, 1996. As per the guidelines of SEBI and the Association of Mutual Funds of India (AMFI), mutual funds are required to publish all the material facts and information, such as the NAV of the fund, investment avenues and associated risks, regularly. SEBI lays stringent rules and regulations to protect investors’ interests and maintain business transparency.
• Low transaction cost – Mutual funds being pooled funds have sizable funds for investment. Since the fund buys and sells securities in large quantities, it minimises the transaction cost. It further decreases as it spreads across a large number of unit holders resulting in a low cost per individual investor. Thus, on a per-unit basis the cost of managing the mutual fund is less than buying and selling securities individually.
• Affordability – Small investors don’t have sizable funds to invest in the securities market to build a diversified portfolio. SIP allows such investors to invest in small denominations, ranging from Rs. 500 to Rs. 1000 per month only. Hence, even without substantial funds, mutual funds make investing in the securities market affordable for small investors.

The bottom line

Mutual funds are ideal for ordinary investors who either lack large sums for investment or those who neither know to analyse the market nor want to grow their wealth. For a small investor, investment through a mutual fund is more convenient than directly investing in the stock market, which requires time, energy and skills.

Hence, for a common man who seeks to maximise their wealth, a mutual fund is a suitable investment instrument offering an opportunity to own a diversified portfolio, which is professionally managed at a nominal cost.