Mutual Fund is a vehicle that enables a collective group of individuals to:
a) Pool their investible surplus funds and collectively invest in instruments / assets for a common investment objective.
b) Optimize the knowledge and experience of a fund manager, a capacity that individually they may not have
c) Benefit from the economies of scale which size enables and is not available on an individual basis
Investing in a mutual fund is like an investment made by a collective. An individual as a single investor is likely to have lesser amount of money at disposal than say, a group of friends put together. Now, let’s assume that this group of individuals is a novice in investing and so the group turns over the pooled funds to an expert to make their money work for them. This is what a professional Asset Management Company does for mutual funds. The AMC invests the investors’ money on their behalf into various assets towards a common investment objective.
Hence, technically speaking, a mutual fund is an investment vehicle which pools investors’ money and invests the same for and on behalf of investors into stocks, bonds, money market instruments and other assets. The money is received by the AMC with a promise that it will be invested in a particular manner by professional managers (commonly known as fund managers). The fund managers are expected to honour this promise. The SEBI and the Board of Trustees ensure that this actually happens.
Typical classification of mutual fund schemes on various basis:
Tenor refers to the ‘time’. Mutual funds can be classified on the basis of time as under:
1. Open ended funds :
These funds are available for subscription throughout the year. These funds do not have a fixed maturity. Investors have the flexibility to buy or sell any part of their investment at any time, at the prevailing price (Net Asset Value – NAV) at that time.
2. Close Ended funds :
These funds begin with a fixed corpus and operate for a fixed duration. These funds are open for subscription only during a specified period. When the period terminates, investors can redeem their units at the prevailing NAV.
1. Diversified Equity Funds
These funds diversify the equity component of their Asset Under Management (AUM), across various sectors. Such funds avoid taking sectoral bets i.e. investing more of their assets towards a particular sector such as oil & gas, construction, metals etc. Thus, they use the diversification strategy to reduce their overall portfolio risk.
2. Sector Funds
These funds are expected to invest predominantly in a specific sector. For instance, a banking fund will invest only in banking stocks. Generally, such funds invest 65% of their total assets in a respective sector.
3. Index Funds
These funds seek to have a position which replicates the index, say BSE Sensex or NSE Nifty. They maintain an investment portfolio that replicates the composition of the chosen index, thus following a passive style of investing.
4. Exchange Traded Funds (ETFs)
These funds are open-ended funds which are traded on the exchange (BSE / NSE). These funds are benchmarked against the stock exchange index. For example, funds traded on the NSE are benchmarked against the Nifty. The Benchmark Nifty BeES is an example of an ETF which links to the stocks in the Nifty. Unlike an index fund where the units are traded at the day’s NAV, in ETFs (since they are traded on the exchange) the price keeps on changing during the trading hours of the exchange. If you as an investor want to buy or sell ETF units, you can do so by placing orders with your broker, who will in-turn offer a two-way real time quote at all times. The AMC does not offer sale and re-purchase for the units. Today, ETFs are available for pre-specified indices. We also have Gold ETFs. Silver ETFs are not yet available.
5. Fund of Funds (FOF)
These funds invest their money in other funds of the same mutual fund house or other mutual fund houses. They are not allowed to invest in any other FOF and they are not entitled to invest their assets other than in mutual fund schemes/funds, except to such an extent where the fund requires liquidity to meet its redemption requirements, as disclosed in the offer document of the FOF scheme.
6. Fixed Maturity Plan (FMP)
These funds are basically income/debt schemes like Bonds, Debentures and Money market instruments. They give a fixed return over a period of time. FMPs are similar to close ended schemes which are open only for a fixed period of time during the initial offer. However, unlike closed ended schemes where your money is locked for a particular period, FMPs give you an option to exit. Remember though, that this is subject to an exit load as per the funds regulations. FMPs, if listed on the exchange, provide you with an opportunity to liquidate by selling your units at the prevailing price on the exchange. FMPs are launched in the form of series, having different maturity profiles. The maturity period varies from 3 months to one year.
1. Country or Region Funds
These funds invest in securities (equity and/or debt) of a specific country or region with an underlying belief that the chosen country or region is expected to deliver superior performance, which in turn will be favourable for the securities of that country. The returns on country fund are affected not only by the performance of the market where they are invested, but also by changes in the currency exchange rates.
2. Offshore Funds
These funds mobilise money from investors for the purpose of investment within as well as outside their home country.
So we have seen that funds can be categorised based on tenor, investment philosophy, asset class, or geographic region. Now, let’s get down to simplifying some jargon with the help of a few definitions, before getting into understanding the nitty-gritty of investing in mutual funds.
SIP(Systematic Investment Plan)
SIP works on the principle of regular investments. It is like your recurring deposit where you put in a small amount every month. It allows you to invest in a MF by making smaller periodic investments (monthly or quarterly) in place of a heavy one-time investment i.e. SIP allows you to pay 10 periodic investments of Rs 500 each in place of a one-time investment of Rs 5,000 in an MF. Thus, you can invest in an MF without altering your other financial liabilities. It is imperative to understand the concept of rupee cost averaging and the power of compounding to better appreciate the working of SIPs.