Understanding Mutual Funds

Skill level : Beginner

🤔 Mutual funds, Sahi hai ?

Many new investors start with SIPs (Systematic Investment Plan) in mutual funds but not many have grasped the concept of what's cooking behind the scenes. You must know what an SIP is, you may even have started one already, but do you fully understand the concept of mutual funds themselves?

Understanding Mutual Funds - All you need to know

This blog will familiarize you with mutual funds – what they are, how they work, how many do you need and which ones to choose

What is a Mutual Fund ?

Mutual fund is an investment strategy where an Asset Management Company creates a fund, multiple investors pool in their money to invest in a diversified portfolio of securities like stocks, bonds e.t.c of various companies. The money of the investors is handled by the Fund Manager.

Think of mutual funds like a pie. When you purchase a share in a mutual fund you essentially own a slice of the pie, meaning you have a stake in a small fraction of all investments in that fund.

How do they work ?

In mutual funds, Instead of picking and buying individual stocks yourself, you buy units or shares of the mutual fund, you not only leave the tedious work up to the fund manager, but you also gain part ownership of the investments of that fund

These funds are professionally managed by financial experts, i.e. the fund manager, who's primary job is to research and select the assets to invest in, and make decisions according to the goal of the fund (be it stability, growth, income, or tracking an index).

The price of each unit of a mutual fund is called the NAV (Net Asset Value), which is basically the net value of the fund divided by number of it's units.

For example, if a mutual fund has net value or AUM (Assets Under Management) of ₹100 crore, has expenses of ₹1 crore, and has 10 crore units held by investors, its NAV will be ₹9.9.

NAV is calculated daily at market close, so unlike stocks, mutual fund prices update only once a day. You can generally buy or sell mutual fund units at the NAV of that day.

In short, a mutual fund lets you invest indirectly in a broad range of assets with small amounts of money, while a professional handles the hard work of stock-picking or bond-picking for you. It’s a simple way to benefit from the growth of markets without needing to be a financial guru yourself.

Source : Fintrack.blog

Types of Mutual Funds

Confused between Debt or Equity, safety or growth? Don't worry because there’s something for every goal and every risk appetite. Understanding the different types of mutual funds will provide you with clarity to take an informed decision.

Equity Funds - The Growth Engine

These invest primarily in stocks or equities. Equity naturally comes with higher risk and volatility, but with potential for higher returns over the long term. Within equity funds, there are sub-types based on different objectives to achieve. Division is based on primarily 3 categories, including: 1. Capital Segment : E.g. Multicap, Largecap, Midcap, e.t.c 2. Investing Style : Value Investing, Focused Investing, e.t.c 3. Sector Themed : E.g. FMCG, Healthcare, Banking, e.t.c

Debt Funds - The Stability Pillars

These invest in fixed-income instruments like bonds, government securities, or corporate debt. Debt comes with generally lower risk compared to equity and steady, conservative returns. Debt funds are suitable for investors who prefer liquidity with a low risk appetite and short-term horizon. Examples include short-term bond funds, corporate bond funds, or liquid funds (which are like parking your money in very safe short-term instruments).

Hybrid Funds - The Balance

Hybrid mutual funds are a category of mutual funds that invest in a mix of equity, debt, and sometimes other assets like gold or REITs in a single scheme. The idea is to balance growth and stability where you get some long-term upside from equity and some protection and diversification from debt.

Index Funds - The Market Mirrors

These are funds that passively track a market index, e.g. Nifty 50, S&P 500 by investing in all the companies in that index, in the same proportions. The idea is not to beat the market but to be the market. Index funds usually have a lower expense ratio because there’s no active stock picking, rather it’s on autopilot tracking the index.

Benefits of Mutual Funds

Professional Management

Skilled fund managers actively manage the fund by selecting, reviewing, and adjusting investments based on market trends and the fund’s objectives, so that individual investors don’t have to spend time researching or analysing countless options themselves.

Built in diversification

A single fund can hold dozens or even hundreds of securities across sectors and market caps. This reduces the impact of one company or sector performing badly. Replicating the same is much harder if you buy individual stocks yourself.

Investor Convenience

Mutual funds simplify investing. Investors can choose from a wide variety of funds that match their risk comfort and financial goals, set up effortless regular contributions, and track progress anytime through user-friendly online platforms. These are relatively hassle free as the fund manager does all the research work and chooses the most suitable funds accordingly.

Goal based flexibility

There’s a fund type for every need, the flexibility allows you to align your investments with a specific goal. Goals based on a time horizon can be :

• Short-term parking (1 week - 1 year): Liquid or overnight debt funds.

• Medium-term growth (1-5 years): Balanced or conservative hybrid funds.

• Long-term growth (5+ years): Equity, flexi-cap, or index tracking funds.

How to Choose a Mutual Fund

There are thousands of mutual fund schemes out there, but you only need 2-3 Good ones. Confused about which ones to choose? Don’t worry, you can narrow it down by focusing on a few key factors:

Your Investment Goal and Horizon

Ask yourself these 2 questions : why and how long. Are you investing for a long-term goal like retirement in 20 years or your child’s education in 15 years? Or is this for a shorter-term need say, a house down payment in 3 years? Your goal timeline will influence the type of fund. Long-term goals can typically tolerate more risk, so equity funds might be suitable to seek higher growth over time. Whereas for Short-term goals, say a few months to a year, your risk taking capacity will be drastically lesser, such goals might be better served by debt funds which provide stable short term growth. For anything in between medium-term ~5-10 years, your risk appetite will depend on the goal you are chasing. For someone in their young years, who is chasing growth, equity funds allocated in midcap or smallcap may make sense because these funds tend to shine within this given time period. Whereas someone who is nearing retirement will tend to lean towards safety instead of aggressive growth, for them hybrid funds may make more sense for cushioning their portfolio.

Risk Appetite

To know your risk appetite, you must know your finances first. If the thought of your investment value fluctuating by double digit (%) in a month gives you heartburn, you might want to stick with more conservative funds like debt funds or balanced funds. On the other hand, if you can handle short-term ups and downs for the prospect of higher long-term gains, equity funds could be in your mix. Make sure you’re comfortable with the level of risk a fund carries. Never invest in something you don’t understand or can’t emotionally handle. 

This neither means that debt is risk free, nor that risk is equal in all equities.

Even in equities, risk depends on 2 main factors.

1. Sector associated risks : Some sectors are cyclical, i.e. they move up and down depending on various factors like economic conditions, raw material availability, demand swings e.t.c. Examples include Real Estate, Automobiles and IT.

   
   

   Whereas some sectors are evergreen, i.e. they have more or less steady demand through out the year and act as defensive sectors during market uncertainties. Examples include FMCG, Pharma and Precious Metals.

   
   

2. Capital Segments : Broadly divided into Largecap, Midcap and Smallcap, with risks ranged from low to high in descending order i.e Large to small.

Expense Ratio

All mutual funds come with a fee, which is charged by the fund house for managing your money. This is called the expense ratio, it is the annual fee expressed as a percentage of your investment in the fund. Your money is deducted yearly to pay for the fund’s operating expenses and management. This might not sound like much, but over long periods, high fees can eat into your returns. Many equity funds charge around 0.5-2% expense ratio, while index funds often charge less, around 0.1% to 0.5% or even lower because they’re passive.

Always check the expense ratio, a seemingly small difference (say 2% vs 1%) can significantly impact your wealth over decades.

Example: Investing ₹10,000 per month for 20 years at a 12 % assumed returns, a fund with a 1 % expense ratio grows to about ₹76 lakh, while the same fund with a 2 % expense ratio grows to roughly ₹68 lakh, a gap of nearly ₹8 lakh purely due to the higher expense ratio.

💎 Fintrack Tip: Always go for Direct plans in mutual funds instead of "Regular".

Performance Track Record

While past performance doesn’t guarantee future results, it’s still worth looking at how a fund has performed historically. Check the fund’s 5-year and 10-year returns (if available) and compare against its benchmark and peer funds. Consistent, stable performance is generally better than a fund that is #1 one year and at the bottom the next.

Also, consider the fund manager’s tenure, check whether the same manager been running the fund during those years of performance. A new manager means past results might not hold, because there's no fund without the fund manager. Past performance is just one of several criteria, not the only one.

Fund Strategy and Portfolio Fit

Finally, understand the fund’s basic strategy and make sure it fits with your overall plan. Is it investing in diversified stocks across different capital ranges? Is it focused on a certain sector or theme? Does it hold mostly government bonds or corporate bonds? Make sure there is minimal to no overlap within your funds.

For example, if you already have exposure to a certain sector, you might not want all your funds to be in that same sector. It’s good to diversify across funds too (but don’t overdo it – holding 10 identical equity funds isn’t diversification). Often 2-3 funds across different categories are all that you need.

💎 Fintrack Tip: It can be useful to start with a balanced approach – e.g., one broad-based equity fund, one debt fund, and perhaps an index fund – and then adjust as you learn more about your preferences.

Also, consider using tools like a SIP calculator (e.g., many investment websites have one) to plan your monthly investments towards a goal. This can show you how much to invest each month to potentially reach, say, ₹10 lakh in 5 years, based on assumed returns.

How to buy mutual funds

Buying of Mutual Fund can be done via your Bank, AMC, or online brokerage platforms.

Step 1: Complete KYC, Keep your PAN and Aadhar card handy.

Step 2: Select the fund of your choice.

Step 3: There are 2 options for mutual funds. Buy or SIP. To buy, just set the amount. In case of SIP, set amount, date and frequency i,e, monthly, weekly, e.t.c.

Step 4: Place your order and pay the amount. You can also set up bank mandates in case of SIP.

Step 5: Monitor your portfolio.

How to sell mutual funds

Step 1: Log in to your account.

Step 2: From your portfolio, select the fund and the units which you want to sell.

Step 3: To convert the units into value of money that you want to withdraw, simply divide your desired amount by the current NAV value.

Step 4: Confirm the transaction, the money usually hits your bank account in 1-2 Working days once you have placed the order to sell. Make sure to check the exit load of the fund before selling. Calculate the tax liability before redeeming the mutual fund. Selling mutual fund units at a profit will be capital gains tax which is currently 12.5% for LTCG (Long term i.e. 12+ months) and 20% for STCG (Short term i.e. within a year).

Common Questions asked about Mutual funds

Here are a few common questions that often make investors doubt or second guess their decisions.

Q. Do I need a lot of money to invest in mutual funds?

No, you don’t need lakhs of rupees to begin. In fact, you can start with very small amounts – often ₹500 or ₹1,000 per month in an SIP is enough to get going. Mutual funds are designed to be accessible, they have relatively low minimum investment requirements. So, don’t think mutual funds are only for wealthy folks, they’re about getting into the habit of investing regularly, more than anything.

Q. Do mutual funds guarantee returns?

This is a dangerous myth. Mutual funds do not guarantee returns, they are subject to market fluctuations. Unlike a fixed deposit that promises a fixed interest, a mutual fund’s return can vary. Equity funds can even give negative returns in bad years, and debt funds, while safer, are not risk-free either. Over long periods, good mutual funds tend to deliver solid returns, but you must be mentally prepared for ups and downs. Always do your research before you pick a fund, look at the holdings of the fund, it's past performance and the serving period of the fund manager

Q. Does top past performance mean future success? 

Many first-timers make the mistake of simply picking the fund that was #1 last year or has the highest 3-year return, assuming it will continue. The reality is that past performance is not a reliable predictor of future results. A fund could top the charts one year and underperform the next. Consistency and alignment with your goals matter more. It’s wiser to look at long-term track records and how the fund performed in both good and bad markets. Also, consider why a fund did well, was it due to one hot sector that might cool off or was it the actual skill of the fund manager? Don’t chase returns blindly, the fund’s strategy makes sense for you going forward.

💎 Fintrack Tip: A change in the fund manager can significantly alter the performance of the fund going forward, as performance is determined by the skill and strategy of the manager

Q. Do I need to have a demat account to invest in mutual funds?

No you don’t need a Demat account to invest in mutual funds. Unlike stocks which require a Demat, mutual funds can be bought directly from the fund company or through your bank. Having a brokerage or Demat account can make it convenient, but it’s not mandatory at all. Don’t let the lack of a Demat account stop you from exploring mutual funds.

Final Thoughts

Mutual funds are an excellent way to grow your wealth while managing risk through diversification. The key is to choose funds aligned with your goals and risk comfort, and to keep your expectations realistic. Do a bit of homework, start small if you need to, and invest regularly (SIPs are great for instilling discipline and averaging out market ups and downs).

Now if you’re ready to get started, a soft nudge — consider using an SIP calculator to map out a plan for your goals, or consult a financial advisor for personalized advice. Goal-based planning can also help figure out what you’re investing for, and that will guide your mutual fund choices.

Investing is a journey, not a race. Stay patient, keep learning and you’ll gradually build confidence as you travel along your journey.

~ Lakshya Sharma