Mutual funds are becoming increasingly popular as a starting point for investors. In addition, many people are familiar with mutual funds as a result of various campaigns and investor education initiatives.

According to a recent Computer Age Management Services (CAMS) report, young people increasingly choose to invest in mutual funds. So, if you’re a new investor looking to learn the fundamentals of mutual funds, this article will help.

What is a mutual fund?

Mutual funds are pools of investor money. Fund managers invest this money in various financial instruments, including stocks, bonds, gold, government securities, and other asset classes.

These are managed by experienced financial professionals known as fund managers, who allocate money to various asset classes based on the fund’s objectives. These fund managers are also responsible for making decisions about when and where to invest.

How do mutual funds work?

Before we get into the details of how a mutual fund works, you should first understand what NAV is. The NAV is the price at which you can buy or redeem your mutual fund investments.

Here is a quick example. Suppose you invest Rs 1,000 in a mutual fund scheme with a NAV of Rs 10. Then you will be allocated 100 units of the fund.

Remember that the NAV of a mutual fund fluctuates on a daily basis depending on the fund’s underlying assets. If a fund’s underlying asset performs well, the NAV will increase, and vice versa.

So, based on the preceding example, if your mutual fund’s NAV rises to Rs 20, your 100 units will be worth Rs 2,000 (100 units x Rs 20). If you redeem your units, you will receive Rs 2,000 in exchange for your initial investment of Rs 1000.

Historically, equity markets have provided a net positive return that outperformed inflation, resulting in true wealth compounding. Although fixed deposits (FDs) are still very popular, even the best FD cannot compete with mutual funds. Mutual funds have been able to generate returns ranging from 12 to 15% over the last 10-20 years.

So, if you invest in an equity mutual fund and stay invested for a long time, you can multiply your money several times and thus accumulate wealth.

What are the categories of mutual funds?

Mutual funds can be classified based on a variety of criteria. For example, depending on whether a fund is managed by a manager, it can be divided into two broad categories.

Actively managed funds

These funds are overseen by an experienced fund manager. These managers are experts in market analysis and research. They create a strategy for these funds that allows them to outperform the returns of a specific index.

Passively managed funds

These funds are not overseen by a fund manager. Instead, they are intended to follow an index. Sub-categories include Exchange Traded Funds (ETFs), Index Funds, and even Funds of Funds (FoFs).

Similarly, mutual funds can be classified into two types based on entry and exit restrictions.

These funds invest approximately 65% of their assets in various stocks. While these funds can provide higher returns, they also carry more risk. There are several types of equity mutual funds

Open-ended funds allow you to sell and buy units at any time.

Closed-ended funds allow for unit purchases only during their initial launch. When these mutual funds mature, you will be able to withdraw the amount invested.

Mutual funds can also be classified according to their investment objectives and underlying securities. Let’s look at each type of fund.

Equity mutual funds

1. Large-cap funds invest approximately 80% of their assets in large-cap stocks.

2. Mid-cap funds invest approximately 65% of their assets in mid-cap stocks.

3. Small-cap funds invest approximately 65% of their assets in small-cap stocks.

4. Equity Linked Saving Schemes (ELSS) are tax-saving equity mutual funds that invest approximately 80% of their assets in stocks. ELSS schemes have a three-year lock-in period from the date you invest. With your ELSS investments, you can enjoy tax benefits under Section 80C of the Income Tax Act.

5. Multi-cap funds have freedom in investment in different market cap companies. These invest at least 75% of their assets in stocks.

6. Index funds track a specific index and invest in companies within that index. For example, if you invest in an index fund that tracks the Sensex, your money will be allocated to the same companies as the Sensex, in the same proportion. These funds aim to closely replicate the returns of their underlying indices. Unlike other funds, these funds’ operating costs and portfolio turnover are relatively low.

7. International mutual funds invest in companies listed in other countries’ indices. It adds geographical diversity to your portfolio.

Debt mutual funds

Debt mutual funds are low risk funds. These are not affected by market ups and downs. Because these mutual funds invest in fixed income securities such as government bonds, debentures etc. Debt mutual funds can be categorised into several types:

1. Liquid funds invest in treasury bills, commercial papers and certificate of deposits with maturity less than 91 days. Thus, these funds invest in highly liquid securities. Liquid funds can be used for making your emergency funds. But sometimes these funds react sharply in response to changes in interest rates by US Federal Reserve or Reserve Bank of India or similar entities. Overall these are less riskier than equity funds.

2. Short-duration mutual funds invest in a mix of government and private corporate bonds.

3. Overnight funds invest in securities maturing within a day or assets that mature within a day.

4. Hybrid mutual funds invest in combination of debt and equity securities. These are good for investors, as these funds automatically take care of asset allocation between debt and equity. One can invest as per their risk profile in these funds. While equity component of fund provides capital appreciation. Debt component protect down side during bear market. There are various types of hybrid funds:

4.1 Aggressive hybrid funds invest more than 65% of their assets in equity and rest in debt.

4.2 Conservative hybrid funds invest more than 75% of their asset in debt securities and remaining in equity. These have low consistent returns.

4.3 Balanced advantage funds: These are best of both worlds. These keep a balance between equity and debt by adjusting asset allocation as per market situations, minimizing risk while maximising gains.

Commonly used mutual fund terms

Net Asset Value (NAV) is price of one unit of particular mutual fund. It is derived by dividing total fund’s portfolio value by total units.

Asset Management Company (AMC) receives investment from individual investors and invest them in variety of asset classes, depending upon type pf mutual fund.
Assets Under Management (AUM) is the total market value of all the assets, including bonds, securities, and stocks, managed by a fund house on behalf of its investors.

New Fund Offer (NFO) is a subscription offer made by AMC at the time of launching a new fund.
Exchange Traded Fund (ETF)  are such mutual fund scheme that tracks the performance of its underlying index such as Nifty50, BSE30, NSE500 etc.
Registrar and Transfer Agents (RTA) helps mutual fund companies in maintaining their records. These also help investors for providing references of their investments.

Systematic Investment Plan (SIP) are such plans that allow investors to invest a fixed sum on a regular basis at a fixed period.
Systematic Transfer Plan (STP) are such plans that allow investors to transfer funds from one mutual fund scheme to another on a regular basis.  

Systematic Withdrawal Plan (SWP) are such plans that allows investors to withdraw a fixed sum at regular intervals.