Mutual funds are an integral part of the financial world, offering a smart and efficient way for investors to grow their wealth. In this article, we will discuss more about mutual funds, exploring their structure, types, benefits, and risks. Let’s embark on this journey to demystify mutual funds.
What Are Mutual Funds?
A Collaborative Investment Vehicle
Mutual funds are a brilliant financial innovation that brings together a diverse group of investors who share common investment objectives. These investors pool their money into a trust managed by a professional Fund Manager. The Fund Manager then strategically invests this collective capital in various assets, such as equities, bonds, money market instruments, and securities.
The Unit Concept
Consider the following example for better understanding the concept of a Mutual Fund Unit: Imagine you and three friends want to buy a box of 12 chocolates, but each of you only has ten.
Instead of missing out on the chocolates, you decide to pool your money, contributing ₹10 each. As a result, you collectively buy the box of chocolates. In the world of mutual funds, this ₹10 contribution from each friend equates to owning 3 units of the fund.
Calculating the Unit Cost
To calculate the cost per unit, divide the total investment by the number of units. For example, if a box of chocolates costs $40 and you possess 12 units (3 units each), the cost per unit is $3.33. Therefore, your initial investment of ₹10 would correspond to 3 units.
Ownership Through Units
This arrangement means that each friend becomes a unit holder in the box of chocolates. Similarly, in a wealth fund, every investor becomes a unit holder in the collective pool of assets, owning a portion of the overall portfolio.
Understanding Net Asset Value (NAV) of Mutual Funds
The Market Value Indicator
Just like stocks have their traded prices, mutual fund units have Net Asset Value per Unit, commonly known as NAV. The market value of all the units in a wealth fund scheme on a certain day is represented by NAV.It is calculated by dividing the total number of outstanding units in the scheme by the market value of the fund’s holdings, less liabilities, costs, and cumulative income.
Why Choose Mutual Funds?
These type of investments offer an attractive investment avenue for individuals with varying financial goals and risk appetites. Here are some reasons they make a great option:
Mutual funds are overseen by experienced fund managers who make investment decisions aligned with the scheme’s objectives. Their expertise and resources enable them to navigate the market effectively.
Investing in mutual funds, you can spread your risk across various asset classes, such as equity, debt, and gold. This diversification ensures that your investments are not solely dependent on one asset class’s performance.
Affordability and Convenience
Mutual funds are accessible to a wide range of investors due to their lower initial investment requirements. This affordability makes them a convenient choice for those looking to start investing.
Open-ended mutual funds offer high liquidity, allowing investors to redeem their units on any business day. Your bank account will normally be credited with the redemption amount within a few days, making it simple to access your money.
Mutual funds are cost-effective due to economies of scale. Their expense ratios are generally low, making them an attractive option for cost-conscious investors.
The Securities and Exchange Board of India (SEBI) regulates mutual funds in India, assuring investor protection, transparency, and fair valuation.
Investments in Equity Linked Savings Schemes (ELSS) can qualify for tax benefits under section 80C of the Income Tax Act, 1961, making mutual funds a tax-efficient choice for long-term investors.
Types of Mutual Fund Schemes
Open-Ended and Closed-Ended Funds
Open-ended mutual funds allow investors to subscribe and redeem units throughout the year. They have no fixed maturity date, providing flexibility for investors.
Closed-ended mutual funds have a specified tenor and a fixed maturity date. Investors can only redeem their units on maturity, and these units may be traded on stock exchanges.
Actively Managed and Passively Managed Funds
Actively Managed Funds
In actively managed mutual funds, the fund manager actively makes investment decisions, aiming to generate maximum returns and outperform the benchmark index.
Passively Managed Funds
Passively managed funds track a market index and do not involve active decision-making by the fund manager. They aim to replicate the benchmark index’s performance.
Understanding Total Expense Ratio (TER)
The Cost of Management
Total Expense Ratio (TER) represents the annual operating expenses of a mutual fund scheme as a percentage of its daily net assets. These expenses include administration, management, advertising, and more.
SEBI imposes limits on the TER that can be charged by Mutual Fund Asset Management Companies (AMCs). The TER varies based on the scheme’s Assets Under Management (AUM) and is designed to protect investors’ interests.
Mutual funds can charge up to 30 basis points (bps) more for new inflows from retail investors from tier-2 and tier-3 cities. This encourages investments from beyond the top 30 cities.
Importance of TER
TER directly influences a scheme’s Net Asset Value (NAV). Lower TER can lead to a higher NAV, which is an essential consideration when selecting a mutual fund scheme.
Risks Associated with Mutual Funds
Standard Risk Factors
Mutual funds do not guarantee assured returns and come with inherent risks, including trading volumes, settlement risk, liquidity risk, and the possibility of losing the principal amount.
The NAV of a mutual fund scheme can fluctuate due to changes in interest rates, currency exchange rates, government policies, and market volatility. Future returns are not ensured by past execution.
Risks in Equity Investments
Investing in shares entails risks such as potential principle loss and price volatility. Liquidity risk can also limit the sale of equities in certain circumstances. Risks in Debt Securities and Money Market Instruments. Obligation protections are vulnerable to credit risk, financing cost hazard, and market liquidity risk. Changes in loan fees can influence the worth of these protections.
Mutual funds offer a wealth-building opportunity for investors, providing professional management, risk diversification, affordability, and regulatory oversight. Understanding the types of mutual fund schemes and the impact of expenses on your investments is crucial. Despite the fact that they offer a variety of advantages, it is important to recognize the risks and choose investments carefully.
As you begin your investment journey, keep in mind to speak with financial professionals and take your financial objectives and risk tolerance into account. When utilized appropriately, mutual funds may be a great complement to your investing portfolio.
Disclaimer: The information in this “Stock Profile” blog post is for informational purposes only. It is not financial advice. Always consult a qualified expert before making investment decisions.