What is Mutual Funds? Types, Benefits and How to Invest
A mutual fund is a pool of money collected from many investors and managed by a professional Fund Manager. This article helps you understand different types of mutual funds, how they work, and different methods to invest in them.
Rahul Jaiswal11 Jul, 2024
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A mutual fund is a professionally managed investment tool that pools investors' money to invest in a diversified portfolio of stocks, bonds, or other securities. Fund managers manage mutual funds to provide investors with capital appreciation and/or regular income based on the fund's objectives.
How Do Mutual Funds Work?
Mutual funds operate using the Net Asset Value (NAV) concept, representing the price per unit at which investors can buy or redeem their investments. When you invest in a mutual fund, you receive units proportional to your investment amount based on the current NAV. For instance, if you invest ₹2,000 in a mutual fund with an NAV of ₹20, you would receive 100 units (₹2,000/₹20). The NAV fluctuates daily, reflecting the performance of the underlying assets in the fund. For example, if the mutual fund invests in stocks and the value of those stocks increases, the NAV will rise accordingly. If the NAV increases to ₹25, your 100 units will now be worth ₹2,500 (100 units x ₹25). This illustrates how the mutual fund's performance is directly linked to the value of its underlying assets. When you decide to redeem your mutual fund units, you will receive an amount based on the current NAV. Continuing with the previous example, redeeming your 100 units at an NAV of ₹25 would yield ₹2,500, resulting in a capital gain of ₹500 from your original investment of ₹2,000. However, since the NAV and the market value of the fund's portfolio can fluctuate daily, these gains are not guaranteed and could also result in losses. Capital gains from mutual funds are subject to taxation, known as capital gains tax, which is applied when you redeem your investment. The tax rate depends on how long you have held the investment, with different short-term and long-term capital gains rates. Short-term capital gains tax (STCG) and long-term capital gains tax (LTCG) are defined differently for mutual funds and can impact the net returns from your investment. Overall, mutual funds provide a way to diversify your investment across various securities managed by professional fund managers and offer the potential for capital appreciation. However, they also come with market risks and tax implications that investors must consider.Types of Mutual Funds
Mutual funds in India are classified based on the asset classes in which they are invested. Here are the main types:Equity Mutual Funds
- Invest primarily in stocks.
- Examples: Large-Cap Funds (invest in top 100 companies), Mid-Cap Funds (101st to 250th companies), Small-Cap Funds (251st and above), and Multi-Cap Funds (invest in large, mid, and small-cap stocks).
Debt Mutual Funds
Invest in fixed-income securities like bonds. Examples: Liquid Funds (up to 91 days), Corporate Bond Funds (high-rated debt papers), Overnight Funds (one business day), and Money Market Funds (up to one year).Hybrid Funds
Invest in a mix of equity, debt, and sometimes other assets like gold. Examples: Aggressive Hybrid Funds (65-80% equity), Dynamic Asset Allocation Funds (0-100% in equities or debt), and Multi-Asset Allocation Funds (invest in at least three asset classes).How to Invest in Mutual Funds?
Investing in mutual funds involves a few straightforward steps that make it accessible for beginners and experienced investors. Here are the steps investors follow to invest in mutual funds.- Understand Your Risk Profile: Start by assessing your risk tolerance and investment goals. This involves understanding how much risk you are willing and able to take.
- Asset Allocation: Divide your investment across asset classes such as equity and debt to balance risk and reward. This helps in spreading the risk.
- Select the Right Funds: Research and identify mutual funds that align with your risk profile and investment objectives. Consider checking the past performance of funds, fund managers, and the investment strategy of funds.
- Complete KYC: Before investing, complete the Know Your Customer (KYC) process. This involves submitting documents like your PAN card, proof of address, and a passport-sized photograph.
- Start Investing: Choose the investment mode—either a lump sum or through a Systematic Investment Plan (SIP). SIP allows you to invest small amounts regularly to spread out your investment costs over time for better affordability.
Methods to Invest in Mutual Funds
The different methods to invest in mutual funds are discussed below:- Through AMC Websites: Visit the official website of the Asset Management Company (AMC) to complete the application form and the e-KYC process online. You can then start investing directly in the mutual fund schemes.
- Using Mobile Apps: Many AMCs and third-party platforms offer mobile apps that allow you to invest in mutual funds easily. These apps enable you to manage your portfolio, buy or sell units, and track your investments.
- Through a Mutual Fund Distributor: Distributors provide financial advice and help you with the investment process. They offer a range of mutual fund schemes and assist you in selecting the right funds based on your profile.
- Via Registrars and Transfer Agents (RTAs): RTAs retain responsibiity to process mutual fund transactions on behalf of AMCs. You can invest in multiple mutual fund schemes serviced by the same RTA through their website or offices.
- Through Banks: Many banks offer wealth management services that include mutual fund investments. You can invest in mutual funds through your bank’s online platform or by visiting a branch.
Benefits of Investing in Mutual Funds
Investing in mutual funds offers several advantages that can help diversify your portfolio, manage risk, and achieve your financial goals. Here are some key benefits:- Risk Diversification: One of the primary benefits of mutual funds is risk diversification. By pooling money from various investors, mutual funds invest in various securities, including stocks, bonds, and other assets. This diversification reduces the impact of poor performance by a single security, spreading risk across different sectors and companies.
- Professional Management: Mutual funds are managed by professional fund managers with the expertise and experience to make informed investment decisions. These managers, supported by research teams, continuously monitor the market and adjust the fund's portfolio to meet its investment objectives, providing investors with the potential for better returns.
- Liquidity: Mutual funds offer high liquidity, allowing investors to redeem their units anytime. This flexibility is crucial during emergencies or when you need quick access to cash. While some funds may have a lock-in period, many mutual funds, especially open-ended ones, can be easily converted to cash.
- Smaller Capital Outlay: Mutual funds enable investors to start with relatively small amounts. You can begin investing with as little as ₹500 through a Systematic Investment Plan (SIP). This approach makes mutual funds accessible to a broader range of investors, allowing them to build a diversified portfolio without needing a large initial investment.
- Convenience and Simplicity: Investing in mutual funds is straightforward compared to direct stock market investments. Investors can open a mutual fund account through banks, financial institutions, or online platforms. After completing the KYC process, you can start investing easily, either online or via mobile apps, making it a convenient option for managing your investments.
- Variety of Products: Mutual funds offer various investment options to suit risk profiles and financial goals. Whether you seek capital appreciation through equity funds, regular income through debt funds, or a balanced approach with hybrid funds, there is a mutual fund product to meet your specific needs.
- Tax Benefits: Certain mutual funds, such as Equity Linked Savings Schemes (ELSS), offer tax benefits under Section 80C of the Income Tax Act. Additionally, long-term capital gains from equity funds are tax-exempt up to ₹1 lakh per financial year and gains above this threshold are taxed at a lower rate.
Mutual Funds FAQs
Are mutual funds safe?
Mutual funds carry market risks but are generally safer than investing in individual stocks due to diversification and professional management.
How do mutual funds work?
Mutual funds pool money from multiple investors to buy a diversified portfolio of stocks, bonds, or other securities managed by professional fund managers.
Who should invest in mutual funds?
Mutual funds are ideal for individuals seeking professional management and diversification and are suitable for novice and seasoned investors.
What are the costs associated with mutual funds?
Costs include expense ratios, management fees, and sometimes load charges. High fees can reduce overall returns, so reviewing these before investing is important.
Can I withdraw a mutual fund anytime?
Yes, investors can withdraw money from most mutual funds anytime unless they have a lock-in period.
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