Mutual Funds

(Aastha Sao, BCP/23/23)

What is Mutual Funds?

A mutual fund is a type of investment vehicle that pools money from multiple investors to
invest in a diversified portfolio of securities such as stocks, bonds, money market
instruments, or other assets.

Key Features of Mutual Funds:

1. Professional Management-

Managed by skilled fund managers who analyze markets and make investment decisions
to achieve the fund's objectives.

2. Diversification-

Investments are spread across a variety of assets (e.g., stocks, bonds, etc.), reducing the
risk of significant losses from one security.

3. Liquidity-

Most mutual funds allow investors to buy or redeem their units at any time (except in
closed-end funds), providing ease of access to funds.

4. Variety of Options-

Includes equity funds, debt funds, hybrid funds, money market funds, index funds,
sectoral funds, etc., catering to different risk tolerances and goals.

5. Affordability-

Mutual funds allow small investments, making them accessible to beginners. Investors
can start with as low as ₹500 through SIP (Systematic Investment Plan).
6. Regulated by SEBI (India)-

In India, mutual funds are regulated by the Securities and Exchange Board of India
(SEBI), ensuring transparency and investor protection.

7. Cost Efficiency-

Offers benefits of a diversified portfolio and professional management at a relatively low

cost through shared expenses.

8. Flexibility-

Investors can choose funds based on their financial goals, such as growth, income, or tax
savings.

9. Tax Efficiency-

Some mutual funds, like ELSS (Equity Linked Savings Scheme), offer tax benefits under
Section 80C of the Income Tax Act.

10. Risk-

Mutual funds carry market risks, and returns are not guaranteed. However, risk levels
depend on the type of fund (e.g., equity funds are riskier than debt funds).

Purpose of Mutual Funds:

1. Wealth Creation-

To enable long-term growth by investing in equity or hybrid funds, helping investors

build wealth over time.

2. Income Generation-

Provide regular income through dividends or interest payments by investing in debt

funds or income-focused mutual funds.

3. Risk Management-

Reduce investment risks by diversifying across various asset classes, industries, and
geographies.

4. Accessibility to Professional Management-

Offer access to experienced fund managers who use research and market expertise to
make investment decisions on behalf of investors.

5. Convenience and Affordability-

Make investing accessible even to those with small amounts of capital, with options like
SIPs (Systematic Investment Plans).

6. Tax Savings-

Help investors save taxes through schemes like ELSS (Equity-Linked Savings Scheme)
under Section 80C of the Income Tax Act.

7. Liquidity-

Allow investors to easily buy and sell their investments, offering quick access to money
when needed.

8. Retirement Planning-

Provide options to save systematically and grow wealth for retirement through long-
term investment plans.

9. Education or Major Life Goals-

Serve as a tool to fund children’s education, buying a home, or other significant life
expenses through tailored investments.

10. Market Participation Without Expertise-

Enable individuals to participate in equity or debt markets without requiring in-depth

knowledge or time for analysis.

Types of Mutual Funds:

Mutual funds are categorized based on their investment objectives, asset classes, and
structure. Here are the main types of mutual funds:

1. Based on Asset Class-

Equity Funds: Invest primarily in stocks and aim for capital appreciation. Subtypes
include:
 Large-cap funds
Mid-cap funds
Small-cap funds
Sectoral or thematic funds
Debt Funds: Invest in fixed-income instruments like bonds, government securities,
and money market instruments. Subtypes include:
Liquid funds
Corporate bond funds
Gilt funds
Hybrid Funds: Combine equity and debt investments for balanced growth and
stability. Subtypes include:
Aggressive hybrid funds
Conservative hybrid funds
Arbitrage funds

2. Based on Investment Objective-

Growth Funds: Focus on long-term capital appreciation.

Income Funds: Aim to provide regular income through dividends or interest.
Tax-Saving Funds (ELSS): Provide tax benefits under Section 80C of the Income
Tax Act.
Index Funds: Track the performance of a specific stock market index (e.g., S&P 500,
Nifty 50).

3. Based on Structure-

Open-Ended Funds: Allow investors to enter and exit at any time.

Closed-Ended Funds: Have a fixed maturity period, and investments can only be
redeemed at maturity.
Interval Funds: Combine features of open and closed-ended funds, allowing
redemption at specific intervals.

4. Based on Risk-

Low-Risk Funds: Include debt funds and money market funds.

Moderate-Risk Funds: Include hybrid funds.
High-Risk Funds: Include equity funds and sector-specific funds.

5. Other Types-

Money Market Funds: Invest in short-term debt instruments and provide high
liquidity.
International Funds: Invest in overseas markets or global securities.
 Thematic/Sector Funds: Focus on specific industries like IT, healthcare, or
infrastructure.
Fund of Funds: Invest in other mutual funds instead of directly in stocks or bonds.

Structure of a Mutual Fund:

1. Sponsor-

The entity responsible for setting up the mutual fund.

Acts as the promoter of the fund and obtains necessary regulatory approvals.

2. Trustee-

Acts as a custodian of investors' interests and ensures the fund complies with regulations.

3. Asset Management Company (AMC)-

Professional fund management team responsible for making investment decisions and
managing the portfolio.

4. Custodian-

Handles the safekeeping of securities and ensures transactions are settled correctly.

5. Registrar and Transfer Agent (RTA)-

Manages records of investors, including unit issuance, redemptions, and distributions.

6. Unit Holders-

Investors who pool their money into the fund in exchange for units.

How Mutual Funds Operate:

A mutual fund works by collecting funds from several investors and investing it in a
diversified portfolio of assets like stocks, bonds, or other securities. In detail, this is how it
works step-by-step:

1. Pooling of Funds-
- Investors pool money into the mutual fund by purchasing units.

- Units owned by each investor are in proportion to their investment.

2. Fund Management-

- A fund manager, professionally employed in the Asset Management Company (AMC),

accumulates funds.

Based on the strategy-investment of the fund, it can be for growth, income, or stability,
wherein the fund manager invests the money.

3. Diversified Investments-

- The gathered funds are diversified into various securities that include equity
instruments, bonds, and money market instruments to maintain diversification and
maximize the returns but in control of the risk.

- The type of securities differs according to the type to which the mutual fund belongs
(equity fund invests in stocks, and a debt fund in bonds).

4. Calculation of NAV-

- Net Asset Value (NAV) is the price per unit of a fund.

Formula:

NAV = Total Value of Fund's Assets - Liabilities Total Units Outstanding

- NAV changes every day based on the market performance.

5. Investor Returns-

- Investors accrue profits in two primary ways:

Dividends/Interest: If the revenues are from its investments.

Capital Gains: When the fund sells securities at a higher price.
The investor receives returns share/proportionate or reinvested in the fund.

6. Purchasing and Selling Units-

-Open-Ended Funds: Units can be bought or sold at NAV as on date. It can be bought
and sold at a particular date.

-Closed-Ended Funds: Units are bought during the NFO and units are sold only at
maturity.
7. Costs and Fees-

Mutual funds charge fees like:

- Expense Ratio: These fees cover fund management, administrative costs, etc.

- Exit Load: The fee charged if units are sold before the expiry of a period of time.

8. Regulation and Transparency-

Mutual funds are regulated (for instance by SEBI in India) for transparency, protection
of investors, and high ethical standards.

Investors receive a periodic report on a fund's performance through fact sheets and
reports.

Advantages of Mutual Funds:

1. Professional Management-

Managed by experienced fund managers who make investment decisions based on in-
depth research and market analysis.

Ideal for investors without expertise or time to manage their portfolios.

2. Diversification-

Invests across various asset classes, sectors, and geographies to spread risk.

Reduces the impact of poor performance from a single security or sector.

3. Accessibility and Affordability-

Investors can start with a small amount (e.g., ₹500 via SIP).

Suitable for both small and large investors.

4. Liquidity-

Open-ended funds allow investors to buy and sell units anytime, offering flexibility and
easy access to money.

Provides more liquidity compared to many other investment options like fixed deposits or
real estate.

5. Transparency-

Mutual funds are regulated by authorities like SEBI (in India) to ensure fair practices.

Regular updates on fund performance, portfolio holdings, and NAV are provided to
investors.

Disadvantages of Mutual Fund:

1. Management Fees and Expenses-

Mutual funds charge management fees (expense ratio) for professional management,
which can reduce overall returns. Additionally, some funds may charge entry or exit
loads.

2. No Control Over Investments-

Investors have no say in the fund's investment decisions or the assets chosen by the fund
manager.

3. Market Risk-

Mutual funds, especially equity funds, are subject to market risks, meaning the value of
the investment can fluctuate depending on market conditions.

4. Performance Uncertainty-

There’s no guarantee of positive returns. Past performance does not always predict
future success, and some funds may underperform relative to benchmarks.

5. Complexity in Fund Selection-

With numerous funds available, selecting the right one that aligns with an investor’s
goals, risk tolerance, and time horizon can be overwhelming.