What are mutual funds and how do they work?
What are mutual funds and how do they work?
There are several new investors who keep saying they are new to mutual funds world and want to know more about mutual funds. This article is for those who are new to investment world and want to know abou the basics of mutual funds and how do they work?
What are mutual funds?
Mutual funds pool money from investors and invest in stocks, government securities, corporate deposits etc., Investment by mutual fund schemes are done based on the investment objective specified in the prospectus.
Who promotes these mutual fund schemes?
There are several mutual fund houses which promotes the mutual fund schemes. Some of the main mutual fund houses are HDFC Asset Management company, ICICI Asset Management company, Birla Asset Management company, Axis Asset Management company etc., These mutual fund houses promotes several categories of mutual fund schemes and they work based on the objectives specified in the prospectus.
How many types of mutual funds do we have?
Mutual funds are categorized into two segments.
Close ended: Mutual fund schemes which invests only for specific period and closed at the end of the period are close ended mutual funds. Generally some of the debt mutual funds come with this close ended option of say 370 days or 3 years. After this period, the investment amount along with returns would be paid back to the investor.
Open ended: Unlike close ended mutual funds, there is another category which is exactly opposite to that. Mutual funds schemes which continue forever and there is no closure period are called open ended schemes. Means you can invest in these schemes for long term of say 10 or 15 years.
What are the different categories of Mutual funds?
There are different categories of mutual funds which an investor can invest depending on the risk appetite and tenure.
1) Large cap mutual fund: These mutual fund schemes invest up to 65% in Crisil rated large cap stocks. Large cap stocks are those where market capitalization in the stock exchange is very high. These large cap stocks perform well and offer high liquidity.
Suitable for: Large cap mutual funds are best suitable for moderate risk investors who want to invest for long term of 8 to 10 years and more and grow their wealth. The returns would range between 11% to 15% per annum depending upon the period of investment.
Not suitable for: These are not suitable for low risk investors and to investors who want quick returns on their investments.
2) Mid-cap/Small-cap mutual funds: These mutual funds invest majorly in mid-cap or small-cap stocks. Mid-cap (Medium capitalization) stocks are those which have high potential to grow in future. Similarly, small-cap stocks are those which are small in size, but have potential to grow and become mid-caps.
Suitable for: These mutual funds are best suitable for high risk investors who want to invest for 5 to 10 years and multiply their money. The returns would range between 12% to 16% per annum depending upon the period of investment and the performance of the mutual fund scheme.
Not suitable for: These are not suitable for Low risk investors or moderate risk investors who want to create their wealth with blue chip stocks.
3) Diversified mutual funds: These are top mutual fund schemes which invest in various stocks across sectors. Since these invest across sectors, even if a particular sector is not performing, the fund performance may not impact much. If you want to create wealth, you should invest majority of your mutual fund investments in diversified mutual funds. The returns vary between 13% to 16% per annum depending upon the fund performance and the period of investment.
Suitable for: If you want to create wealth, but do not want to stick to one sector or only in large cap sector, you should invest in these mutual fund schemes. These are moderate risk investment options.
4) Sector based mutual funds: There are mutual fund schemes which invest in a specific sector like Banking, FMCG, Pharma and Technology stocks. Since these mutual fund schemes invest in specific sector, these are high risk as the performance of mutual fund scheme depends on the sector growth. I personally felt that banking and Technology sectors are somewhat volatile. However FMCG and Pharma sector are ever green and keep growing. Mutual fund schemes which invest in specific sector like FMCG or Pharma has provided annual returns of 25% to 33% per annum in the last 5 years.
Suitable for: If you are high risk taker and want to double/triple your money in 3-5 years you can invest in these mutual fund schemes. However, if such sector based funds can underperform and can give negative returns too. Sometimes, you may lose your capital itself.
Not suitable for: Low risk or moderate risk investors can stay away from such sector based mutual funds.
5) International or Global Mutual funds: These mutual funds schemes invest across the globe or in specific countries or in specific sectors of various countries. Every individual should invest a small portion in such global mutual funds so that economy growth in other countries can be encashed and increase your wealth.
6) Debt mutual funds: If you have low risk appetite and do not want to participate in stocks, then you should consider investing in debt mutual funds. Debt mutual funds are those which invest in fixed income securities, Govt. securities, and corporate deposits etc., Debt mutual funds provide higher returns compared to bank fixed deposits.
Suitable for: If you are low risk investor and want higher returns than bank fixed deposits, you should opt for Debt mutual funds. The returns would vary between 9% to 11% per annum depending upon the fund performance and investment horizon.
Not suitable for: If you are risk taker and want higher returns, then do not invest these mutual fund schemes.
7) ELSS Mutual funds: ELSS Mutual funds are those which provide tax benefit under section 80C. These mutual funds invest majority in tax exempted Govt securities and a portion in stocks. These ELSS schemes have 3 years lock-in period and you cannot redeem your mutual fund units.
Suitable for: Investors who want to earn higher returns along with tax benefit under section 80C can invest in ELSS mutual funds. The returns vary between 9% to 13% per annum based on fund performance.
8) Index mutual funds: These mutual fund schemes invest in a particular index stocks. The performance of such index mutual funds directly depends on the index of which the fund is tracking. E.g. if the mutual fund scheme is tracking SENSEX stocks and if SENSEX is down, such index mutual fund returns also would be down and if SENSEX is up, the returns also would be up. There are index funds which track, SENSEX or NIFTY or Bankex etc.
Suitable for: If you want to invest in SENSEX or NIFTY stocks, but do not directly want to invest in stocks, can opt for Index mutual funds.
9) Balanced Mutual funds: If you are moderate or low risk investors, but want to take advantage of investment in stocks, then you should invest in balanced mutual funds. Balanced mutual funds invest 80% of their investments in fixed income securities or debt instruments and a small portion in stocks. Means, your investment would be safe and only a small portion has risk. The returns from balanced mutual funds range between 9% to 13% per annum depending on fund performance and period of investment.
Suitable for: If you want to participate in equity in small portion and have low risk appetite, you can invest in balanced mutual funds. Investors, who got bored by investing in bank FD’s where the returns are low, can also invest in these mutual fund schemes to get higher returns.
10) MIP mutual funds: Monthly income plan (MIP) mutual funds are those whose aim is to provide regular dividends. The regular dividends can be monthly, but they are not guaranteed like bank FD.
Suitable for: If you want regular income higher than bank FD, but willing to take little risk, you can invest in MIP mutual funds. The returns range between 8% to 10% per annum.
11) Gold ETF / Gold Mutual funds: Investments in gold can also be done through Gold ETF’s or Gold Mutual funds. Gold ETF’s are those where an investor can invest in gold through electronic form. You can buy Gold ETF’s as low as 1 gram value. On the other hand Gold Mutual funds invest in companies that deal with Gold manufacturing, distribution etc. Gold has been giving consistence returns of 18% to 24% per annum in the last 8 to 10 years. However recently gold prices have corrected. The correction may long for some more time.
12) Capital protection funds: These mutual funds schemes aim is to protect capital and provide good returns. However they have not become famous, as investors are looking for good returns and not just capital protection. The returns from these funds are ranging between 4% to 8% per annum in the last few years.
13) RGESS Mutual funds: Rajiv Gandhi Equity Saving Schemes Mutual funds are aimed to provide tax benefit to investors who have not opened the demat account earlier and not participated in direct equity investments. These RGESS Mutual funds have just been launched in Feb/Mar-2013 and the performance of these funds needs to be watched in the next 1-2 years.
Conclusion: Thought there are several mutual fund schemes, an investor need to select the mutual funds based on risk appetite and tenure.
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What are mutual funds and how do they work