A mutual fund is a pool of money deposited by thousands of investors, collected by a mutual fund company, commonly known as a fund house. The fund house then uses the pooled money to buy stocks, bonds, commodities, etc. Each fund house has various schemes. For example, a scheme can be stocks-oriented, bond-oriented, or commodities-oriented, or it can be combined. The decision to buy the underlying securities depends on the nature of the scheme. The purchased products are called holdings or portfolios of that particular fund. Like every class has a class teacher, every scheme has a manager called a fund manager. The fund manager is an experienced professional, and his/her job is to make investment decisions to generate profit from investments. This profit is then shared with the investors as returns. The investors get returns in proportion to the money they have invested.
An investor can start his investment journey in mutual funds by depositing money in one go. This is called a lump sum investment. The other way is by investing regularly – every month, every quarter, etc. This method is called a Systematic Investment Plan (SIP) or SIP. An investor can start investments with as little as ₹100 per month in SIP mode, so it’s easy on the pocket. After the investment, all investors are allotted units. The number of units depends on the amount of the investment. Each unit has a value called Net Asset Value or NAV. A simplified explanation of the NAV is that it is the market value of the total holdings of the scheme divided by the total number of units issued. NAV is calculated on a daily basis, as the market value of holdings changes daily.
An investor may not know which stocks to buy, when to buy stocks, or when to buy bonds, so he may make a wrong decision and incur losses. But, in mutual funds, a professional fund manager with several years of experience makes decisions.
There are several benefits to investing in mutual funds via an SIP. A striking feature of SIPs is the power of compounding. In simple words, compounding helps investors get a return on both the initial and continuing investments. Over a long period of time, this can result in substantial wealth creation with a small initial investment. Another important feature of SIPs is rupee-cost averaging. This helps average the cost per unit of investment over time. When market prices are high, the investor gets fewer units, but the same investment fetches more units when the prices fall. This, in the long run, lowers overall investment costs.
In most mutual funds, an investor can easily withdraw money in an emergency. The withdrawal process is called redemption. The units held by an investor are normally encashed at the NAV of the day of application if the application is submitted by 2.30 pm. The withdrawal amount gets credited to the investor’s account within one, two or three days depending on the type of funds. This makes mutual fund investments highly liquid. Some mutual funds have a longer redemption period – you will know which ones these are when you sign up to buy the fund.
An investor has to pay taxes on profit or capital gains made in mutual fund transactions. There are two types of capital gains taxes on mutual fund profits – short-term capital gains tax or STCG and long-term capital gains tax or LTCG. The tax rate depends on the type of mutual fund and the duration of the investment period.
Let us understand this with a simple example. Imagine three friends having ₹150 each to invest. Instead of buying one stock each, friends decide to pool their money. Now they have ₹450. One of the friends understood the nuances of the market and was entrusted with investing the pooled money. He bought 5 shares of Company A (₹50 each) and 2 bonds (₹100 each). The friend who invested money on behalf of two others is like the fund manager of a mutual fund scheme. The mix of investments – shares of Company A and 2 bonds – is the portfolio or the holdings. Since the portfolio has stocks and bonds, it helps reduce risk by not keeping all the eggs in one basket. Three days after the investment, the stock price of A rises to ₹60, while there is no change in bond price. Thus, the total value of holdings goes up to ₹500. There are three friends, so the total number of units becomes 3. The NAV on the day, thus, is 500/3 = ₹166 nearly. This is a simplified example of how NAV is calculated.
Let us now look at the benefits of investing in mutual funds:
- Diversification: Spreading money across various assets lowers risk
- Experts make investment decisions
- Funds cater to different risk levels and financial goals
- Even small investors can create wealth with small investments
- High liquidity
- Low-cost investment
- For SIPs, the Power of compounding and Rupee cost averaging
Mutual funds can be a powerful tool for wealth creation with small, regular investments over a long period of time. However, mutual fund investments also carry market-related risks like all market-related investments. Therefore, investing only in schemes aligned with your financial goals and risk appetite is important. If one is not confident about choosing the right mutual fund schemes, he can get advice from a SEBI-registered investment advisor.
1. Can I invest in mutual funds without a Demat account?
Yes, you can. A demat account is only mandatory for investing in equities. While you don’t need them for mutual funds, however, they allow you to track all your investments in one place, efficiently make transactions, and guarantee security.
2. What is the minimum investment threshold for mutual funds?
While the minimum investment threshold for mutual funds may vary across schemes, one can usually start investing in them via an SIP of as little as ₹100 to ₹500 per month, depending on fund house and scheme, making them accessible to beginner and seasoned investors alike.
3. Can I pause my SIP if I am unable to pay for it for a few months?
Yes, most fund managers allow you to pause or stop your SIP without penalties and restart it when you’re ready. However, this may vary across funds. It is therefore always prudent to go through all fund-related documents carefully.
4. Are mutual funds a safe investment?
While mutual funds are less prone to volatility than investment instruments such as equities, their performance is still market-linked. Returns, therefore, depend on market conditions and the type of fund one chooses to invest in.
5. What types of mutual funds can I invest in?
Mutual funds in India are broadly classified into the following, based on asset classes:
Equity funds: These invest primarily in the shares of companies listed on the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE), aiming for long-term capital appreciation.
Debt funds: These invest in government and corporate bonds, and other fixed‑income instruments such as certificates of deposit and commercial papers. They are more suited to investors looking for capital preservation, with stable, albeit slightly lower returns.
Hybrid funds: These funds invest in a combination of equity and debt instruments. They are suited to investors looking to balance capital appreciation in the long run with capital preservation and a stable income in the short run.
6. What are the costs associated with investing in mutual funds?
A few costs one must factor in while investing in mutual funds are transaction fees for redeeming or purchasing units in a given mutual fund, expense ratios, and exit loads. The former refers to a percentage of one’s total investment charged as management fees, and the latter refers to the cost one incurs if they choose to dilute their investment in the fund before a certain period.
7. What are the key factors to consider when investing in a mutual fund?
To make an informed investment decision regarding mutual funds, consider how well a fund aligns with your financial goals, investment horizon, and risk appetite, in addition to associated costs, unit price, lock-in periods if any (and subsequently, liquidity), the expertise of the fund manager, and past performance.
8. What is the difference between open-ended and close-ended mutual funds?
Open-ended funds allow investors to buy or sell units at any time, whereas units in close-ended funds can be bought only during the new fund offer (NFO) subscription period. These units can then be sold on stock exchanges after the fund’s specified lock-in period is over.
