What Are Mutual Funds?
Mutual fund refers to a large pool of money invested in proportions, in the stock exchange by sound professional expert known as the finance manager.
Mutual funds are ideal for investors who either lack large sums for investment, or for those who do not have the time to research the market, yet want to grow their wealth. The money collected in mutual funds is invested by professional fund managers according to the scheme’s stated objective. In return, the fund house charges a small fee which is deducted from the investment. The fees charged by mutual funds are regulated and are subject to certain limits specified by the Securities and Exchange Board of India (SEBI).
Actively managed mutual funds refer to those funds which are actively and attentively managed and monitored by the financial experts, whereas, Passively managed mutual funds refer to those which have a set of predefined rules and regulations. Comparatively lesser fees are charged by these financial experts.
Mutual funds are started by the Asset Management companies. Investment of money is a complex decision, finding the right avenues, the rate of return, significant timeline are the major elements or factors which need to be taken into consideration.
Net Asset Value (NAV):
- NAV abbreviation stands for “Net Asset Value”. The performance of a specified mutual fund is denoted by its Net Asset Value (NAV). As shares have a market traded price, similarly, mutual funds are assigned a net asset value per unit. The NAV of mutual funds fluctuates daily depending on the performance of the underlying assets. It is required to be disclosed on a daily basis.
- The NAV per unit is the market value of securities of a particular mutual fund divided by the total number of units of the scheme on any specified date.
NET ASSET VALUE (NAV) = Fund Assets - Fund Liabilities / Total Number of Units
Mechanism of Mutual Funds:
Lets understand the way in which mutual funds work.
- NFO Issue: The first and foremost step is the issue of a New Fund Offer (NFO). The Asset Management Company starts the mutual fund by launching its NFO. The units in an NFO are generally priced at a nominal value of Rs.10.
- Finance: After the issue, the fund houses receive the funds from the investors to make further investments as stated in the scheme. Participation in the NFO is not mandatory, investors can still invest by purchasing the units.
- Investing Activity: The fund manager will now make investments as per the scheme’s strategy. This is the core element of the mutual funds, these investments will determine the future performance of the scheme. The finance manager has to do extensive research on its portfolio.
- Return of Funds: Mutual fund returns are subject to market risks. But in the long run it has the potential to reach great highs. Once the returns are generated they are either distributed among the investors or retained for further growth. Investors can take the decison of either IDCW (Income Distribution Cum Capital withdrawal) or the growth option. The IDCW option yield lower returns than the growth option, as one receives only a part of the profits made by the fund. The growth option provides with higher returns, as it gives the benefit of compounding effect of reinvesting the profits.
Parameters to look for before making an investment:
- Start as early as possible, the time duration or tenure of investment is more important than the amount.
- Understand the probable risk associated to investment and one’s personal risk appetite.
- Thoroughly check the portfolio of the fund, the trustworthiness of the company and the track record of the mutual fund manager.
- Lump sum method: The lumpsum method refers to the way of investment whereby, the investment is made at once. It is beneficial and profitable when the market is overly undervalued.
- SIP (Systematic Investment Plan Method): SIP abbreviation stands for Systematic Investment Plan, in this method a systematic investment of a specific amount is made every month for a number of years, when the prices of the units are high, less number of units are purchased whereas, when the prices of the units are less, number of units purchased are more, it is purchased at an average price. It gives the benefit of Rupee Cost Averaging. One must start an SIP when the market is saturated and at a high level.
Advantages of Mutual Funds:
- Diversification: Mutual funds help in the diversification of funds to various sources by putting the entire money in a single place.
- Expert Supervision and Management: Mutual funds are monitored and managed by financial experts which monitor and supervise the performance of the fund.
- Liquidity: Mutual funds provides with the advantage of liquidity of funds. In Economics, liquidity refers to something which can be easily converted into cash. One can redeem the mutual funds as and when required.
- Reduced Risk: Due to the factor of diversification the risk associated to investments is reduced significantly.
- Tax Advantage: There exist mutual funds which are primarily concerned with providing tax benefits and concession in regards to income Tax. By making investments in such particular mutual funds one can avail the facility of tax advantage.
- Low Operating Costs: The cost associated to operation of mutual funds is considerably low.
- Higher Returns: Mutual funds have a history of giving higher returns in comparison to any other financial instruments.
- Investor Protection: Mutual funds work within the framework of the stock exchanges or capital markets which are regulated by the Securities and Exchange Board of India (SEBI). SEBI protects and promotes the interest of the investors.
The biggest advantage of mutual funds in comparison to any other financial instrument is that it is already diversified. The probable risks associated are reduced due to the factor of diversification. Investment in mutual funds is affordable as the units are available at nominal net asset value (NAV).
Disadvantages of Mutual Funds:
- Exit Load: Mutual fund companies levy an exit load (charge) when the redemption is done within a specified period, for example, within one year from the date of such investment. This policy is laid down to refrain the investor from exiting the scheme too early, it will not only have a negative impact on the mutual fund’s performance but also lead to negative or less returns to the investor.
- Risk: The investment in mutual funds is linked to the stock exchange and investment in securities market are subject to market risks. One has to anticipate the losses, mere diversification does not give a complete hedging from the risks. For example, investment in equity mutual funds are subject to volatility due to the fluctuating market conditions.
- Finance: After the issue of NFO, the received funds need to be invested which is the core element of the mutual fund scheme, this primarily defines its performance. The finance manager has to do extensive research and take sound financial and investment decisions inorder to make good returns.
What Are Debt Mutual Funds?
Debt mutual funds are those funds which primarily invest in debt instruments such as bonds, debentures, certificates of deposits, etc.
This is a category of mutual fund that primarily invest in fixed-income securities, such as corporate and government bonds, treasury bills, and money market instruments. They are also known as income funds or bond funds. Investment in debt mutual funds is ideal for investors who are not willing to take up major risks but want safety of capital along with a stable return on their investment.
The mechanism of debt mutual funds is as such that they are designed in such a way so as to provide the investors with a regualr income, stable returns due to the stability of the assets they invest in, debt mutual funds are less volatile and less risky than other types of investments. These funds are a good option for investors who prefer lower risk in their investment strategies. Nevertheless, there are some risks associated with debt mutual funds, including:
- Liquidity Risk: The risk that the fund house won’t have enough liquidity to meet redemption requests.
- Credit Risk: The risk that the issuer will default on repaying the principal and interest.
- Interest Rate Fluctuation Risk: The risk that changing interest rates will affect the value of the securities.
Mechanism of Debt Mutual Funds?
Debt Funds function by investing in a diversified portfolio of fixed income securities, the mechanism is as follows:
- Diversification of Portfolio: Debt Funds spread investments across various debt instruments, reducing the risks associated with individual bonds.
- Expert Financial Management: Expert fund managers make accurate decisions by analysing the various financial aspects and take the investment decisions based on the market conditions and the fund’s objectives.
- Risk and Rewards: Debt Funds offer a predictable income stream as interest or dividends. The interest rates and credit quality of the underlying securities influence the returns.
- Liquidity: In economics, liquidity refers to something which can be easily converted into cash. Investors can buy or sell units in Debt Funds quickly, providing high liquidity.
How to Pick the Best Debt Fund?
When deciding on the ideal debt fund for your portfolio, monitoring the selection process effectively is necessary. Follow these tips to make the right choice:
- Align the fund choice with your investment duration. Liquid and ultra-short-term funds suit short-term goals (a year or less), while short-term bonds are suitable for 1-3 years. Medium-term objectives (3-5 years) benefit from corporate or dynamic bond investments.
- Reflect on your personal objectives. Whether it’s post-retirement income or liquidity needs. Ensure your chosen fund aligns with these goals to augment benefits.
- Although debt funds generally carry lower risk, they aren’t risk-free. Consider credit and interest-rate risks associated with the fund’s investments. Understanding these risks and the fund’s strategy aids in risk minimisation.
- Check a fund’s historical performance against prevailing market conditions. This insight helps anticipate future performance, especially in fluctuating interest rate environments.
- Given that debt funds usually offer lower returns, assess expense ratios. Go for funds with lower ratios to maximise your net returns, especially for long-term investments.
- Understand the tax implications based on the investment duration. Short-term capital gains (STCG) within three years are taxed at applicable income slab rates, while long-term capital gains (LTCG) after three years incur a fixed 20% tax with indexation benefits.
Type of Debt Mutual Funds:
Liquid Funds:
These refer to such funds which can easily and quickly be converted into cash. In economics, liquidity refers to something which can be easily converted into cash. This type of funds have a comparatively low risk and can be considered as an alternative to savings account.
They are prohibited to invest in risky assets, as specified by the SEBI rules and regulations. These standards make sure to limit credit risk in the liquid fund portfolio.
Guilt Fund:
Guilt funds are those which primarily make investments in government issued securites, it practically has zero risk as it is safe to invest money with the government. These funds have no risk of default of interest or principal amount but gets affected by interest rate fluctuation as the Government borrowing typically happens to be for a longer duration.
Fixed Maturity Plans (FMPs):
Fixed maturity plans are a type of debt mutual fund that invests the money in fixed income securities such as bonds, certificates of deposit, commercial papers, etc. They have a fixed maturity date, which means they lock in your money for a specified period of time, ranging from a few months to a few years. Fixed maturity plans are considered as an alternative to fixed deposit, as risk associated to these funds is less and the returns are better in comparison to fixed deposits.
Corporate Bond Fund:
These funds invest primarily in corporate bonds. Companies issue bonds for expansion, diversification, modernization and to meet expenses and finance other activities. The yield and risk are generally higher than government and most municipal bond funds. Potentially offer higher returns than government securities.
Dynamic Bond Funds :
Managed actively to adapt to the changing market conditions, they have the potential to offer higher returns. Here, the fund manager decides the investment portfolio’s duration.
DISCLAIMER:
Investment in securities market are subject to market risks, read all the related documents carefully before investing.
The information presented on this website is with the objective of imparting financial knowledge and for informational purposes only, not a substitute for any professional financial advise.
We have made sure to provide information with atmost accuracy. Regardless of anything, financial information imparted through this website should not be considered as an offer to make investment decisions.
You must consult a qualified financial advisor before making any actual investment.
