Mutual Funds: Common Types and Terminologies

In the world of investing, mutual funds have emerged as a popular choice for both seasoned and beginner investors. Mutual funds pool money from multiple investors to create a professionally managed portfolio.

However, navigating the world of mutual funds can be overwhelming without a clear understanding of the common types and terminologies associated with them. This article aims to provide an insightful introduction to mutual funds, its common types, and a few basic terminologies.

What are Mutual Funds?

Mutual funds are professionally managed investment vehicles that pool money from multiple investors. They invest this pooled money in a diversified portfolio of stocks, bonds, or other securities. Investors buy units/shares in the mutual fund. A unit represents proportional ownership. Experienced professionals manage the funds and make investment decisions on behalf of the investors. 

This professional management allows investors to benefit from the expertise of seasoned professionals. The Securities and Exchange Board of India (SEBI) regulates the mutual funds industry in India. Mutual funds offer a convenient and cost-effective way for individuals to invest in the financial markets.

Investors can choose from various types of mutual funds, each with specific investment objectives. These types include equity funds, debt funds, liquid funds, balanced funds, index funds, funds of funds, ELSS funds, etc. Investors can easily buy or sell mutual fund shares at the fund's net asset value.

Types of Mutual Funds

Equity Mutual Funds 

Equity Mutual Funds (EMFs) generate returns by investing in stocks of publicly listed companies across market capitalisations (large-cap, mid-cap, and small-cap). They typically generate better returns than fixed deposits (FD) or debt-based funds. EMFs can be theme based, such as emerging markets, dividend yield, energy funds, tax-saving, etc. It can also be sector-based, such as financial services, automobiles, and fast-moving consumer goods (FMCG). The profits and losses generated from EMFs depend solely on the performance of the shares included in them.

Debt Mutual Funds

These funds invest in fixed-income securities such as corporate bonds, treasury bills, commercial papers, and government securities. Such debt instruments have a pre-determined maturity date and interest rate that the buyer can earn at maturity. It can be a preferred choice for passive investors with a low-risk appetite. However, movements in interest rates pose a risk to debt fund investors.

[Interest rate risk is the risk of loss from changing interest rates.]

Liquid Funds

Liquid Funds invest in short-term fixed-income instruments that invest in securities having a maturity of up to 91 days. These funds carry the lowest interest-rate risk in the debt funds category. Liquid funds are an alternative to depositing your money in a savings bank account as it offers better returns.

Index Funds

An Index Mutual Fund tracks a stock market index, such as NSE’s NIFTY50. The fund manager invests in a portfolio of stocks that constitutes an index. Index funds are passively managed funds and have exposure to the constituent securities of an index in the same proportion. It aims to match the returns offered by the underlying index. If you prefer predictable returns, Index funds will be a good choice. 

Balanced Funds

Balanced Funds (aka Hybrid Funds) invest in a mix of equity and debt segments in specific ratios. Fund managers keep changing the allocation/ratio based on market risks. These funds often provide the best risk-reward balance and help to maximise the return on investment (RoI).

Fund of Funds

Fund of funds (FoFs) is a type of mutual fund that utilises the money pooled from its clients to invest in various other types of mutual funds available in the market. Thus, the returns of an FoF depend on the performance of the target fund. For example, FOF is used to invest in international funds, a fund that invests in an overseas fund.

Tax Saving Funds (ELSS)

An Equity-Linked Savings Scheme (ELSS) mutual fund helps in saving taxes. It provides the dual advantage of wealth creation and tax saving under Section 80C of the Income Tax Act. By investing in ELSS mutual funds, you can claim a tax exemption of up to ₹1.50 lakh from your annual taxable income. However, ELSS would only be effective under the old regime of taxation.

How do Mutual Funds Work?

1. Creation of the Fund

An asset management company establishes a fund with a specific investment objective, such as growth, income, or a combination of both.

2. New Fund Offer (NFO)

The fund launches an NFO, where it offers units of the fund to investors for subscription. Each unit represents proportional ownership in the fund's assets. The funds collected during this period are pooled together with investments from other investors.

3. Portfolio Construction

Fund managers create a diversified portfolio by investing the pooled money in a variety of securities, such as stocks, bonds, or money market instruments. The specific asset allocation depends on the fund's investment strategy.

4. Net Asset Value (NAV)

The NAV represents the per-unit value of the mutual fund. is calculated by dividing the total value of the fund's assets by the number of units outstanding. The NAV is typically calculated at the end of each trading day.

5. Buying and Selling Units

Investors can buy or sell mutual fund units at the NAV price. When investors invest in the fund, they receive units at the current NAV. Similarly, when they sell units, they receive the current NAV value.

6. Expenses and Fees

Mutual funds charge fees and expenses to cover operating costs, including management fees, entry and exit loads, etc. These fees are typically expressed as an expense ratio and deducted from the fund's assets.

7. Distribution of Profits

Mutual funds may distribute profits to unit holders as dividends or capital gains. These distributions are typically made periodically, depending on the fund's policy.

8. Performance Monitoring

Investors can track the performance of their mutual fund investments through regular updates provided by the fund. Performance is measured by comparing the fund's returns against relevant benchmarks or indices.

9. Ongoing Management

Fund managers continuously monitor the fund's investments, making adjustments as needed to align with the fund's objectives or market conditions.

Common Terminologies in Mutual Funds

Asset Management Company 

An AMC is a company registered with the Securities and Exchange Board of India (SEBI) that handles a mutual fund’s asset management and investment decisions. The top AMCs in India include SBI Mutual Fund (MF), ICICI Prudential MF, HDFC Mutual Fund, Aditya Birla Sun Life MF, Nippon India MF, and Axis MF.

New Fund Offer (NFO)

Asset Management Companies launch New Fund Offers (NFOs) to issue units of their new mutual fund schemes. The Units are similar to shares issued by companies during an initial public offering (IPO). Through an NFO, investors can purchase units of a mutual fund at the subscription price. The offer price is usually ₹10 per unit. Funds are launched via NFOs for a limited time, following which they are traded in the market based on their corresponding net asset value.

Before applying to an NFO, make sure to review the past performance of the AMC and the fund manager. Also, ensure that the fund matches your investment strategy and risk appetite.

Net Asset Value

Net Asset Value, or NAV, is the price of each mutual fund unit. It is the weighted average value of the stocks and other assets in the scheme/portfolio. It is calculated by deducting the liabilities from the total asset value and dividing it by the number of shares. NAV is calculated at the end of each trading day.

NAV is not an indicator of the future prospects of a scheme. Moreover, a mutual fund with a lower NAV does not mean it is not performing well when compared to a fund with a higher NAV.

Open-Ended and Closed-Ended Funds

Open-Ended Funds are mutual funds whose units are open for purchase and redemption at any time. There are no limits on the duration and amount a person can invest. All transactions of such fund units are done at the prevailing NAVs. Open-ended funds are ideal for those who want liquidity in their investments, as they are not bound to any maturity period.

Closed-Ended Funds are funds where investors can purchase units only during the initial offer period (NFO). The units can be redeemed at the specified maturity date.

Interval funds are a cross between open-ended and close-ended funds. It allows transactions at specific periods. Investors can choose to purchase or redeem their units when a trading window opens.  

Expense Ratio

The expense ratio is the annual maintenance charge levied by mutual funds to finance their expenses. It includes the annual operating costs, including management fees, allocation charges, and advertising costs of the fund.

Entry Load and Exit Load

Entry Load is the amount payable by an investor while joining a mutual fund. Recent SEBI regulations have removed the entry load from the calculations of the total expense ratio of a mutual fund.

Exit load is the amount payable when an investor chooses to withdraw from a mutual fund. This charge is payable on the total investment of an individual, usually standing at 1%. It serves as a tool to discourage people from withdrawing funds from a mutual fund and encourages them to stay invested for the long term.

Advantages of Investing in Mutual Funds

A few advantages of investing in Mutual Funds are:

• Diversification: Mutual funds offer a diversified portfolio of investments, reducing the impact of individual stock or bond fluctuations.
• Professional Management: Experienced fund managers make investment decisions on behalf of investors, leveraging their expertise and research capabilities.
• Accessibility: Mutual funds provide easy access to a wide range of investment opportunities, even for small investors, with low minimum investment requirements.
• Liquidity: Investors can buy or sell mutual fund shares at the fund's net asset value on any business day, providing liquidity and flexibility.
• Transparency: Mutual funds disclose their holdings regularly, allowing investors to review the investments made on their behalf.
• Regulations: SEBI regulates the Mutual funds industry in India. SEBI ensures investor protection and adherence to investment guidelines.
• Convenience: Investors can rely on professional management, avoiding the need for extensive research and monitoring of individual securities.
• Choice of Investment Objectives: Mutual funds offer a variety of investment objectives, catering to different risk appetites and financial goals.
• Dividend Reinvestment: Many mutual funds offer the option to reinvest dividends automatically, compounding returns over time.

Risks and Challenges of Investing in Mutual Funds

A few of the risks and challenges of investing in Mutual Funds are:

• Market Risk: Mutual funds are subject to market fluctuations, and the value of investments can go up or down.
• Lack of Control: Investors have limited control over the specific securities chosen by the fund manager.
• Fees and Expenses: Mutual funds charge various fees, including entry and exit loads, which can impact overall returns.
• Underperformance: Despite professional management, mutual funds can underperform their benchmarks or other investment options.
• Over diversification: Some mutual funds may become overly diversified, diluting potential returns and making it harder to outperform the market.
• Style Drift: The fund manager might deviate from the stated investment strategy, leading to a mismatch with investor expectations.
• Market Timing Risk: If investors try to time their entry or exit from a mutual fund, they may miss out on potential gains or incur losses.

How to Choose the Right Mutual Fund?

Choosing the right mutual fund requires careful consideration of several factors. 

• Investment goals: Decide whether you seek growth, income, or a balanced approach.
• Risk tolerance: Understand how much risk you are comfortable with.
• Fund Performance: Look for consistent returns over time and compare against benchmarks. 
• Expense ratio: Lower expenses can positively impact your overall returns.
• Evaluate the fund manager: Assess their experience, track record, and investment philosophy.
• Diversification: Look for funds with a diversified portfolio to reduce risk.
• Read the prospectus: Understand the fund's investment strategy and potential risks.
• Minimum investment and fees: Consider if the fund's requirements align with your budget.
• Comparison with Benchmarks: Measure the fund's performance against relevant indices.
• Seek professional advice: Consult a financial advisor for guidance and expertise if needed.

What is NAV in Mutual Funds?

Net Asset Value, or NAV, is the price of each mutual fund unit. It is the weighted average value of the stocks and other assets in the scheme/portfolio. It is calculated by deducting the liabilities from the total asset value and dividing it by the number of shares. NAV is calculated at the end of each trading day.

NAV is not an indicator of the future prospects of a scheme. Moreover, a mutual fund with a lower NAV does not mean it is not performing well when compared to a fund with a higher NAV.

How to Invest in Mutual Funds?

You can invest in mutual funds online through a broker. A trading & demat account is not necessary to invest in mutual funds. However, it is useful if you have one. Platforms such as Zerodha Coin and Groww offer mutual funds. You can also set Systematic Investment Plans (SIPs) on these platforms.

What is Direct Mutual Fund & How to Buy Mutual Funds?

Direct mutual funds allow investors to purchase units from the mutual fund company directly.  This bypasses intermediaries like brokers or distributors. These funds do not charge any distribution or commission fees, resulting in lower expense ratios compared to regular mutual funds. With direct mutual funds, investors can potentially earn higher returns over time due to the lower expenses.

You can buy direct mutual funds through Zerodha Coin.

Which Mutual Funds Come Under Tax Benefits?

An Equity-Linked Savings Scheme (ELSS) mutual fund comes with tax benefits. It provides the dual advantage of wealth creation and tax saving under Section 80C of the Income Tax Act. By investing in ELSS mutual funds, you can claim a tax exemption of up to ₹1.50 lakh from your annual taxable income. However, ELSS would only be effective under the old regime of taxation.

We would like to remind our readers to invest in mutual funds only after thoroughly understanding the objectives, theme, expenses, and risks involved. Ensure that the strategy deployed by the fund manager aligns with your investment goals. HAPPY INVESTING!