In the previous chapters we learnt about the power of long term investing, when should one start investing and what to expect.  In this part of the series, we learn about Mutual Fund investing and choosing the right fund 

All You Need to Know About Mutual Funds

Mutual funds have emerged as a go-to investment option for those who want to grow their wealth without diving into the complexities of the stock market. Managed by professional fund managers, mutual funds simplify the investment process by allowing individuals to pool their money and benefit from diversified portfolios. This article will walk you through the key aspects of mutual funds, using examples to illustrate how they work and how they can help you achieve your financial goals.

What is a Mutual Fund?

A mutual fund is a type of investment vehicle that collects money from many investors to invest in a diversified portfolio of stocks, bonds, or other securities. The pooled funds are managed by a professional fund manager who makes decisions on what assets to buy or sell to meet the fund's investment objectives.

Imagine you and 999 other investors each invest Rs 10,000 in a mutual fund. The total pooled amount is Rs 1 crore. The fund manager uses this Rs 1 crore to invest in a variety of stocks and bonds. Instead of owning individual stocks, you own units of the mutual fund, which represent your share of the overall investment.

How Does a Mutual Fund Work?

When you invest in a mutual fund, your money is combined with that of other investors, and the fund manager uses this large pool of money to buy securities. These investments can be in stocks, bonds, or other assets, depending on the fund's objectives. As the value of the investments grows, so does the value of the mutual fund's units.

Suppose you invest Rs 10,000 in a mutual fund when its Net Asset Value (NAV) is Rs 25 per unit. This means you receive 400 units (Rs 10,000 / Rs 25 = 400 units). After five years, if the NAV rises to Rs 50, your 400 units are now worth Rs 20,000 (400 units x Rs 50). This increase in NAV reflects the growth of your investment.

What is an NAV?

The Net Asset Value (NAV) is the per-unit price of a mutual fund. It is calculated by dividing the total value of the fund’s assets by the number of outstanding units. NAV fluctuates daily based on the market value of the fund's investments.

If a mutual fund has total assets worth Rs 100 crore and there are 10 crore units outstanding, the NAV would be Rs 10 (Rs 100 crore / 10 crore units). If the value of the fund's investments increases, so does the NAV, and vice versa.

Are Mutual Funds Safe?

Mutual funds are regulated by the Securities and Exchange Board of India (SEBI), ensuring that they operate within a strict legal framework designed to protect investors. Asset Management Companies (AMCs), which manage mutual funds, are required to be transparent about their operations and investment strategies.

A mutual fund invests in a diversified portfolio, which might include stocks from various sectors like technology, healthcare, and finance. This diversification reduces the risk of losing money if a particular sector underperforms. Moreover, SEBI mandates that AMCs also invest a portion of their own money in the funds they manage, aligning their interests with those of investors.

Minimum Investment and Liquidity

One of the key advantages of mutual funds is the low minimum investment requirement. Many mutual funds allow you to start investing with as little as Rs 500-1,000, making them accessible to a wide range of investors. Additionally, most mutual funds are highly liquid, meaning you can redeem your investment and receive the proceeds in your bank account within a few business days.

Consider an investor who has Rs 1,000 to invest. Buying individual stocks may not be feasible, as some stocks can be quite expensive (e.g., a single Reliance Industries share might cost over Rs 2,000). However, with Rs 1,000, the investor can buy units in a mutual fund, gaining exposure to a diversified portfolio of stocks.

Costs Associated with Mutual Funds

Investing in mutual funds comes with certain costs, primarily the expense ratio. The expense ratio is the annual fee charged by the AMC for managing the fund, which covers administrative costs, fund manager salaries, and distribution fees. The expense ratio is expressed as a percentage of the fund’s assets and is deducted from the fund’s returns.

If a mutual fund has an expense ratio of 1.5% and you have invested Rs 10,000, Rs 150 will be deducted annually to cover the fund's expenses. While this fee might seem small, it’s essential to consider it when evaluating the potential returns of a mutual fund, as a higher expense ratio can reduce your overall returns.

Types of Mutual Funds

Mutual funds come in various types, each designed to meet different investment objectives and risk tolerances. The three main categories are:

1. Equity Funds: These funds invest primarily in stocks and are suitable for investors looking for long-term capital appreciation. They carry a higher risk but also offer the potential for higher returns.

An equity mutual fund might invest in a mix of large-cap, mid-cap, and small-cap stocks, aiming to benefit from the growth potential of these companies.

2. Debt Funds: These funds invest in fixed-income securities like bonds and are ideal for conservative investors seeking regular income with lower risk.

A debt fund might invest in government bonds, corporate bonds, or money market instruments, providing more stable returns compared to equity funds.

3. Hybrid Funds: These funds invest in a combination of equities and debt, offering a balance between growth and income. They are often recommended for investors looking to reduce risk through diversification.

A hybrid fund might allocate 60% of its assets to equities and 40% to debt, providing exposure to the stock market while cushioning against volatility with fixed-income investments.

Choosing the Right Mutual Fund

Selecting the right mutual fund is crucial to achieving your financial goals. Here’s a simple two-step guide to help you make an informed decision:

Step 1: Select the Fund Category

- Aggressive Hybrid Funds: Suitable for first-time investors aiming for long-term wealth creation. These funds invest in both equities and debt, reducing the impact of market volatility.

If you’re new to investing and want to start with a relatively safer option, an aggressive hybrid fund can provide exposure to equities while cushioning potential losses with debt investments.

Tax-Saving Mutual Funds (ELSS): Ideal for those looking to save on taxes while growing their wealth. These funds invest in equities and offer tax deductions under Section 80C of the Income Tax Act.

If you invest Rs 1.5 lakh in an ELSS, you can claim this amount as a deduction from your taxable income, reducing your tax liability while potentially earning higher returns over time.

Flexi-Cap Funds: Best for experienced investors with a primary goal of wealth creation. These funds can invest in stocks across various market capitalizations, providing flexibility to the fund manager.

A Flexi-Cap fund might invest in a combination of large-cap companies like TCS, mid-cap companies like PI Industries, and small-cap companies like La Opala, offering diverse growth opportunities.

Step 2: Select the Right Fund within the Category

Choose funds with a strong track record of performance, a reasonable expense ratio, and consistent fund management. Avoid funds that have recently changed their fund manager, as this can affect future performance.

When comparing two funds within the same category, you might choose the one with a lower expense ratio and a more experienced fund manager, as this could lead to better long-term returns.

Mutual funds are an excellent option for individuals who want to invest in the stock market without the need for in-depth research or constant monitoring. With the help of professional fund managers, investors can benefit from a diversified portfolio and potentially higher returns. By understanding the basics and carefully selecting the right mutual fund, you can build a portfolio that aligns with your financial goals and risk tolerance. Whether you're a first-time investor or an experienced one, mutual funds offer a pathway to achieving your investment objectives with greater ease and efficiency.

In the last part of the series, we will learn how to choose the right fund, what factors to look at and track its progress and then conclude.