What are mutual funds and how do they work?

A mutual fund is an investment vehicle that collects money from investors with common investment objectives and invests them in equities, bonds, money market instruments and other securities.

Mutual funds pool in the money of individual investors and create a diversified portfolio spread across different asset classes depending on the scheme’s investment objective. When you invest in a mutual fund scheme, you are allotted units which are similar to buying shares of a company. The price of a single unit is known as its Net Asset Value (NAV) and represents the combined market value of all the underlying securities held by the fund, net of all expenses, divided by the total number of units outstanding. The NAV is updated on a daily basis at the end of each trading day. Unit holders in a mutual fund scheme earn returns in the form of dividends and capital gains.

According to the guidelines issued by SEBI, mutual funds can be classified into the following categories:

1. Equity Schemes: These are mutual fund schemes that invest at least 65% of their total assets in equity and equity related instruments. Equity funds are a suitable choice for investors who are looking for an equity exposure in their portfolio but are not well-versed with the capital markets. Because of the numerous schemes available, equity funds are a practical investment for most investors.
• Equity funds can be categorized into large-cap, mid-cap and small-cap depending on the market capitalization of the stocks that the fund predominantly invests in. Multi-cap funds invest in stocks spread across different market capitalizations. Market capitalization of a company is calculated by multiplying the number of outstanding shares of the company by its current market price.
• Dividend yield funds invest in companies that pay high dividends.
• Equity schemes can also be classified based on the underlying investment strategy as value or contra funds.
• Sectoral funds invest solely in companies that operate in a particular sector like healthcare, real estate, etc.
• Equity linked Saving Schemes (ELSS) are mutual fund schemes that provide tax benefits but have a lock-in period of 3 years.
2. Debt Schemes :These are schemes that invest in fixed income instruments like corporate and government bonds, and other debt securities.Debt funds are an ideal investment vehicle for conservative investors who are looking for stable returns.
• Liquid and Money Market Funds invest in debt securities with a very short tenure and hence provide high liquidity.
• Debt schemes can further be categorized based on the Macaulay duration of the underlying debt securities. Macaulay duration is the weighted average time taken to fully recover both principal and interest payment of a bond. Debt funds can be classified into a number of categories ranging from Ultra-short Duration Fund (with a Macaulay duration of 3 to 6 months) to Long Duration Funds (with a Macaulay duration greater than 7 years). Furthermore, there are dynamic bonds that invest across different durations.
• Debt schemes can also be classified on the basis of the credit rating of the underlying security as Corporate Bond Fund (which invest in highest rated corporate bonds) and Credit Risk Fund (which invest in below highest rated corporate bonds).
• Gilt fund is a debt scheme which predominantly invests in government securities and hence, has no risk of default in repayment of loan or payment of interest.
• Floating rate funds predominantly invest in floating rate debt securities where the interest rate paid to the bond holders change with changes in the interest rate scenario.
3. Hybrid Schemes :These are mutual fund schemes that invest in both equity and debt, giving the investor the best of both worlds. Investing in equity provides the required growth to the portfolio, while debt investing protects from any downside risk.
• These range from Conservative Hybrid Fund that predominantly invests in debt to Aggressive Hybrid Funds that predominantly invest in equity.
• Dynamic Asset Allocation Fund change their allocation in equity and debt depending on the fund manager’s view of the market.
• Arbitrage Funds work by exploiting the price differential between cash and futures market.
4. Solution Oriented Schemes :: These are schemes that cater to the needs of long-term investors looking to fund children’s education or creating a retirement corpus. This is a new category of mutual fund schemes. Earlier they were treated as equity or balanced schemes. They have a lock-in period of 5 years which has been increased from the earlier 3-year lock-in period to keep the investors invested for a longer time.
5. Other Schemes:: This category includes Index Funds, Exchange Traded Funds (ETFs) and Fund of Funds (FOFs). Index and ETFs are passively managed mutual funds which aim to replicate the performance of a benchmark index by purchasing stocks in the same proportion as the index. FOFs is a scheme that invest in mutual funds rather than investing directly in an asset class.

Mid cap funds are ideal for investors who want capital appreciation and wealth building, and are ready to take a measured risk in companies that have a potentially high growth trajectory.

Mutual funds have been the investors’ preferred choice for a number of reasons.

• Diversification: By investing across asset classes and in a number of securities, mutual funds provide diversification benefits to its investors. Even if one security underperforms, the performance of the portfolio will not be hampered.
• Professional management: Mutual funds are managed by professional fund managers who have the required financial expertise and conduct in-depth research and analysis before taking investment decisions.
• Liquidity: You can redeem your units and receive your funds back from the mutual fund within 3-5 business days.
• Highly regulated: All mutual funds are required to register with SEBI before they start operations. They are also required to provide investors with all scheme information – daily NAVs, complete portfolio, expenses, etc. The mutual fund industry is highly regulated in order to safeguard the interests of individual investors.
• Affordability: Mutual funds provide an affordable platform to gain exposure to a number of securities and asset classes. Investors can take advantage of professional fund management and diversification by paying nominal fees which is levied as scheme expenses.