Mutual Funds: Different Types and How Mutual Funds Work?
Mutual funds in India are investment materials managed by Asset Management Companies (AMC’s) of India to collect a pool of funds from corporates, Govt of India, Institutions, and retail investors. These funds are then invested over the securities such as equities, bonds, money markets, commodities like gold, etc.
This process is managed by Fund managers, or Portfolio managers, or Money Managers. First, fund managers select the asset to get maximum returns for the investors. Then, the fund manager will be provided with a team to look at the securities and analyze them as a team.
It’s the role of the Fund manager and their team to choose the asset classes to meet the goal of that fund as mentioned in its prospectus. Every fund focus on overperforming the indices (Nifty 50 and SENSEX) to provide the capital gain for their investors and keep them investing through SIP (Systematic Investment Plan) or Lumpsum.
As Mutual funds, SIP starts from Rs. 500 (in a few AMC’s) is the only option where even a daily wage citizen, a low-class retail investor, can invest in equities, bonds, etc. As the term represents “mutual,” benefits and pitfalls are equally shared by all the investors. In terms of AMC’s, there is no loss to them as they collect only expense ratios.
Our researched article on the best mutual funds to invest in India will provide you a fare idea on the strategy. This help to choose the fund that fits your investment goal.
How Mutual Funds Work?
The basic principle of how a mutual fund works is well illustrated in the above image.
- Investors select and fund, and start their investments.
- All funds from various investors are collected is pooled into mutual fund investment.
- The fund manager and the team manage this. First, they choose securities and build a portfolio to meet the goal of any fund.
- The investment thereby generates returns (performance), which XIRR calculates.
- Returns are passed back to the investor. AMC manages the complete process.
Asset Management Companies (AMC) are known as the mutual fund company that introduces a new scheme under NFO (New Fund Offer), as same as IPO (Initial Public Offering) in the stock market. The only difference is IPO is for a particular stock, whereas NFO is for a pool of securities (Stocks, Bonds).
This AMC of Mutual Funds Company picks a Fund Manager with rich experience and a proven track record of performing highly diversified mutual funds. Fund Manager’s team consists of,
- Analysts to help in market research and picking the stocks to build a portfolio.
- A Fund Accountant to calculate NAV of daily trade.
- Compliance Officers.
- An attorney to maintain government regulations.
Once the NFO is introduced, it is promoted for investments to increase the AUM (Asset Under Management) for the fund launched. For a particular period, the fund will be under NFO. In this period, an investor can purchase a mutual fund share known as NAV (Net Asset Value) for Rs. 10.
Finally, when the fund is for trade, the NAV increases as the portfolio (stocks, bonds, money market) performers for a day. The NAV is calculated and updated at the end of every trading day, and returns are calculated based on NAV movement.
On average, mutual funds hold 100+ securities, which denotes a highly diversified portfolio investment. Naturally, this lowers the risk of investment, only think you should consider is how to choose a good mutual fund? At the same time, you should have a basic understanding of calculating any fund’s risk ratios.
You can checkout our article on how mutual funds work in India.
What is NAV in Mutual Funds?
NAV is the market price of a single share of the mutual fund. It is the same as the price of an equity share. NAV is calculated by dividing the total value of the portfolio (Equities, Bonds, money, minus liabilities) by the total value of outstanding shares.
Outstanding shares are referred to as the number of stocks owned by shareholders, institutional investors, company officers, etc.
NAV (Net Asset Value) is not the same as the stock price. In the stock market, we invest in cheaper stocks looking for high returns in the future. This is not relatively the same with mutual funds’ NAV. The investments value and redemption value are mapped only by NAV.
This NAV value for any transaction (Buy or Sell) is calculated by the NAV value of the same day if the request is made before 1.30 pm (IST). If the transaction is made post 1.30 pm, the NAV of the next trading day is calculated.
A fund accountant who is a part of the Fund Manager’s team will calculate the NAV every day.
How Does Investors Earn Returns from Mutual Funds?
Investors can typically earn in four ways from mutual funds in India.
- Every mutual fund provides an option of Growth or Dividend Funds. In the case of the Dividend fund, investors will be payout with dividends from stocks and interest from bonds.
- In terms of Growth Funds, the dividend and the interest yields are accumulated to the NAV of the funds. This keeps the NAV of the Growth fund higher than the Dividend fund.
- Capital gain while mutual funds sell out the securities. Generally, the growth is passed on to the investors.
- When the mutual fund’s portfolio price increases, fund managers fail to sell them. The investor can sell the shares of mutual funds in the market to gain profits.
Types of Mutual Funds
There are multiple types of mutual funds available in India. There are categorized on the following parameters
- Based on Asset Class
- Structure of the Fund
- Investment Goals
- Special Category
- Risk Profile
According to the above segments, here are the following mutual fund types you can choose to invest in India.
Equity Mutual Funds
Equity Mutual funds are investing in a pool of securities, especially equities. Equity funds are classified into,
- Large-cap funds
- Mid-cap funds
- Small-cap funds
- Flexi funds
- Multi-cap funds, etc.
It is an alternative to investing in stocks, as these funds produce a return of 12% to 20% per annum.
Fixed Income Funds
Fixed Income Funds are sub-divided into debt funds and money market funds. These funds invest in securities like government bonds, corporate bonds, Treasury bills, certificates of debentures, etc.
Investors choose fixed-income funds as an alternative to fixed deposits or post office savings schemes. Fixed Income funds meters low risk with an average return of 7%-9% per annum.
Hybrid/Balanced Funds
Investors prefer Hybrid or Balanced funds to balance the risk and reward. These funds invest in both equity and bonds on a 60:40 ratio. This fund has moderate risk and can yield a return between 10% to 12% per annum.
Index Funds
Index funds are the mutual funds that invest directly over the indices like Nifty 50, Sensex, Nifty Next 50, Nifty 100, etc. It is also known as passive funds. Index funds are among the best investment types as they are bet on the Indian Stock market indices.
Indicies like Sensex have produced nearly 13% CAGR for the last 37 years. The stats are the backbone for every financial planner to advise investing in Index funds. Generally, Index funds are moderate risk and provide 12% to 14% annually.
Sectoral Funds
Sectoral Funds invest in a particular sector like IT, Bank, FMCG, Automobile, etc. Fincareplan doesn’t advise investors to pour funds into sectoral funds as they are high-risk and speculative.
Diversification is good for risk appetite, yet diversifying investments in the same sector is also risky. These funds sometimes provide high returns, and sometimes high volatility.
Tax Saving Funds
Tax saving funds, generally known as ELSS (Equity Linked Savings Scheme). ELSS comes with a lock-in period for 3 years, i.e. investors can’t redeem any funds until 3 years of the initial investment made.
ELSS is widely chosen as a tax exemption up to 1.5 lakhs under section 80c. An example of ELSS or tax Saving fund is Axis Long Term Equity Fund.
What is Expense Ratio In Mutual Funds
There are two types of fees structure used by a mutual fund company. It is annual operating fees (Expense Ratio) and Shareholder Fee (Entry & Exit Load).
So, what is an expense ratio or annual operating fees? A percentage of AUM (Asset Under Management) is detected from investors and paid to Mutual Fund companies. This expense ratio covers the administrative expenses, payments for the Funds manager and Team, Marketing of the fund, and the profits.
How much does a mutual fund charge expense ratio? Nominally, the expense ratio starts from 0.1% to even 3%, depending on your chosen fund. Passive funds have low expense ratio than actively managed funds.
How does the expense ratio impacts the fund’s performance? Let us take an example.
An investor invests Rs. 10000 every month via SIP (Systematic Investment Plan) for 10 years.
Fund performed at a CAGR of 12% (without Considering Expense ratio). So, the actual return would be Rs. 23.23 lakhs.
Let’s assume the fund covers 1% as an expense ratio. Then the return will be Rs. 21.89 lakhs
In the case of an aggressive or growth fund that is actively managed, the expense ratio can be 3%. If so, the return will be Rs. 19.49 lakhs.
I hope you give an additional weightage in understanding the expense ratio of any fund before choosing.
What is AUM In Mutual Funds
AUM (Asset Under Management) is the total market value of the securities a mutual fund manages on behalf of investors. AUM is calculated by adding mutual fund holdings, bank deposits, and cash. Many mutual funds keep up to 20% of the fund in cash without investing in any securities, this is known as cash drag. This is used while investors redeem their funds.
Any fund holding higher AUM is an indicator for investors to choose them, as it denotes the strength of the AMC. In addition, AUM stands as one of the parameters for calculating the fund’s expense ratio (annual operating fee).
When AUM holds a high market value of securities, the expense ratio will be low. Similarly, when the AUM is low, the expense ratio will be increased.
Why is AUM a crucial factor in choosing a mutual fund?
Many mutual fund companies try to hold their securities (stocks, bonds) for a more extended period. As a result, these companies hold up to 20% of actual AUM (only market value of securities) as cash. This cash is used to deposit in investors’ accounts while they redeem.
In every mutual fund, the maximum shares are invested by Foreign institutions, domestic institutions, corporate companies, Government. As a result, retail investors have few holdings as a whole.
Let us consider a case where the stock market crashes down. This will spread the selling panic all over the market.
So, the foreign and domestic investors could redeem the holding to save their investment. But, in this scenario, 20% of cash liquid can’t fully the redemption value. So, Mutual funds companies are forced to sell their securities in the secondary market (in most cases low price). This could make a significant impact on the retail investor.
AUM with less than 1000 crores can result in a negative return in a short period. That’s the reason you should choose mutual funds holding AUM higher than 1000 crores
What is SIP in Mutual Funds?
There are two terms of investments allowed for every mutual fund investor. SIP and Lumpsum.
SIP (Systematic investment plan), also known as Dollar Cost Average, is like investing a specific amount on a particular date of every month. SIP has more benefits compared to lumpsum investments.
Why is SIP the best investment option?
When we analyze the markets having a history of 100+ years (S&P 500, Dow Jones) and 35+ years (Sensex), investors have only one takeaway. The market has volatility. It may fall or rise. But, in the long term, it provides you an unimaginable wealth.
You can’t predict a bear market or bull market. Everyone knows to invest the entire amount in the bear market. Unfortunately, when the market plunges, the panic in the market won’t allow a new investor to invest in the market.
In such unpredictable market behavior, SIP would be the required investment method.
- SIP helps to buy more units NAV while the market falls
- It helps to increase the value of your holding while the market grows.
So, it doesn’t need any maths fiction behind investing in SIP. Choose the monthly installment, choose and date and mutual fund, then start investing.
What is XIRR in Mutual Funds?
The returns of mutual funds are primarily measured by CAGR (Compounded Annual Growth Rate) and XIRR (Extended Internal Rate of Returns).
CAGR can’t be used as the meter to measure the ROI for mutual funds as there are multiple cash-flows. However, XIRR helps an investor calculate the ROI of any multiple cash-flow funds. CAGR can be used for Lumpsum’s investments, as single investment and single redemption are involved.
When you invest in SIP, there are multiple investments happen, and that’s why we say XIRR can be the better option to calculate your mutual fund ROI.
Advantages of Mutual Funds?
Many advantages keep many investors growing their wealth over a long period. Mutual funds are a primary source for middle-class people to achieve all their goals or shift their class to rich with vast corpus to live retirement life. Here are a few advantages that you should understand and stay as a long investor.
Diversification
Diversification is one of the reasons many salaried people invest in mutual funds. Every fund holds 2-3 asset classes and 100+ securities. Diversification is the only source for making a nominal return with low risk. You can’t focus on 100 company results, their fundamental analysis, etc.
It becomes a tedious process to pick such diversification in stocks over various sectors, that too on the amount you invest.
Highly liquidable and Easy to Access
As same as stocks, mutual funds are highly liquidable. Investors can buy and sell quickly on any trading day. Even assets like foreign company shares, or foreign mutual funds can be bought easily by funds of funds.
Professional Management
All funds are managed by a professional fund manager and a team of equity research analysts. This is the primary advantage of why you should invest in mutual funds. This professional team takes care of research, trading, managing portfolio, managing dividends, and interest rates.
Investors don’t have any time to research and built a portfolio. More than that the experience is what an investor needs. Finally, these professional team charges only a few percent as fees.
Freedom on Choosing Various plans
There are multiple plans like growth, dividend, direct, and regular funds. Every investor holds the freedom on choosing any of these plans according to their investment goals.
Also, mutual funds in India have various types like large-cap funds, small-cap funds, mid-cap funds, etc. So, investors get varieties of options.
Disadvantages of Mutual Funds?
There are a few disadvantages, yet they don’t have much impact compared to stock trading.
- Few funds have a relatively high expense ratio (up to 3%).
- You can’t make any decision on the portfolio of the funds. You either can’t advise AMC to buy or sell a stock.
- Unlike Shares, the amount redeemed is not transferred to the bank account on the same day. Therefore, it may take 2-3 working days.
- Unlike Fixed deposited, the returns from any mutual funds are not fixed or predictable.
- Cash Drag is another disadvantage, as a few portions of the total AUM are not invested.
- Mutual funds investments are also prone to taxation on returns (>1 Lakhs). But, tax is standard across any returns from investments in India.
In India, mutual funds are regulated and supervised by SEBI (Securities Exchange Board of India) to protect investors against the fraudulent. SEBI is the board that approves for new NFO in India.
RBI, Ministry of Finance, Companies Act also has a few roles in regulating the stock market and mutual funds in India.
Conclusion
- Mutual Funds are one of the investment materials in India that invest over the securities like shares of a company, Bonds, and money market.
- Mutual Funds allow small and retail investors to invest in stocks and bonds in a diversified way.
- As professional fund managers manage these funds, it eases out the time to analyze stocks or bonds for an Investor.
- Mutual Funds are classified into various types depending on the asset classes, risk profiles, investment goals, etc. Further, it facilitates different options like direct or regular, growth or dividend for any investor.
- Each share of funds is denoted as NAV. Every trade (sell or buy) is mapped by the movement of NAV, which is calculated by the fund accountant and updated by the end of every trading day.
- The Expense Ratio is the annual operational fees an AMC charge to its investors. The expense ratio can vary between 0.1% to 3% of the total AUM.
- AUM (Asset under management) is the total market value of the securities in the portfolio and the cash holdings.
- Mutual funds can benefit long-term investors to achieve their goals, and recommended mode of deposit is SIP.
Frequently Asked Questions (FAQ)
Can You Get Rich From Mutual funds?
Mutual funds are one of the investment options that help in building your wealth. Yet, it has risk profiles. As an investor, you can overcome the risk appetite by investing for a long term in a fund in SIP (Systematic Investment Plan) mode.
Are Mutual Funds a Good Investment?
Yes, definitely mutual funds are one of the good investments available in India. These investments can yield a decent return of 12% to 20% per annum with minimal risk compared to stocks, cryptocurrencies, etc. Mutual funds have more advantages on investment compared to disadvantages.
What are the 3 types of Mutual Funds?
There are more than 10+ types of mutual funds available in India. But, the top 3 types are equity mutual funds, Debt funds, Hybrid or Balanced Funds.