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What are mutual funds and how do you make money from a mutual fund?

Many of us have questions What is Mutual Fund ? How does Mutual Fund Work?

Before investing money in Mutual fund, let us understand What is Mutual Fund?

Mutual Fund in simple words is a pool of money collected from the people which will be reinvested in Equities, Bonds, Government Securities, Money Market Instruments.

The money collected by the mutual fund is invested and managed by a professional Fund Manager based on the scheme’s investment objective. You will be issued with “Units” as against your investment at the prevailing NAV(Net Asset Value).

How a Mutual Funds are Ideal for Investors?

  1. Investors who have lack knowledge or skill/experience of investing in stock markets directly.
  2. Investors who want to grow their wealth, but do not have time to research the stock market.
  3. Investors who can invest only small amounts.

Why Invest in Mutual Funds?

Why Mutual Fund? Why can’t we directly invest our money in Equity, Bonds, Commercial papers?

Let me give example, Think that you have a fever. What will you do? Will you take medicine on your own or will you consult a Doctor? You will consult the Doctor, right? Likewise, investment in the share market can be done if you have expertise and experience. Otherwise, you may lose your investment money. So, an Experienced Fund manager will handle your funds and give you the returns earned thereby reducing the risk of losing money.

Mutual Fund

What is expense ratio?

Mutual Fund charges to its investors the management fees and operating costs of the fund.1 to 3% of your investment amount collected will be taken as the service charges. This is called as Expense Ratio.

How to calculate the Expense Ratio?

The total expenses of the fund dividend by the schemes value of assets under management (AUM).

Types of Mutual Funds

Equity Mutual Fund :

Out of many schemes of Mutual Fund, an equity fund is one of them which predominantly invests in equity stocks. Amount collected by this fund will be invested directly into the equity market. Since the exposure to the equity market is higher in this category, the risk-reward ratio to your investment is also high.

Equity Fund is suitable for those who do not posses a large amount of capital and not well-versed in investment in stock market directly. Small individual investors with small capital can invest in an Equity Fund thereby reducing their risk through diversified investment portfolio by Mutual Fund. Collecting small investors capital allows Mutual Fund diversify their investment more effectively.

Equity Mutual Fund Scheme is further classified as below. Each category has its own level of market risk.

Large Cap Equity Funds  This Fund invest a large portion of their capital in companies with large market capitalization. Hence this is called large-cap funds. This Fund offers a stable and feasible returns over a period of time. In stock market, Large cap stocks tend to be less volatile and risky when compared to mid-cap and small-cap stocks

Mid-Cap Equity Funds  Mid-Cap fund invest in stocks of companies with medium sized market capitalization which will be riskier than Large-cap stocks. But, this scheme may perform well considering investment in still developing and having good growth potential companies.

Small Cap Funds As name suggests, this Fund invest their corpus in companies with small sized market capitalization. Investment in small cap companies expose the Fund house for higher risk when compared to Large-cap and Mid-cap funds. Generally small-cap companies are upcoming companies hence, these stocks are more tend to be volatile in the stock market.

Multi Cap Equity Funds or Diversified Equity Funds invests in stocks of companies across the stock market regardless of size and sector. Mutual Fund unitholder gets the benefit of diversified investment made across the different sectors and different market capitalization companies. Diversified investment among different sector also reduces the risk factor.

Thematic Equity Funds: Invests in specific sectors stocks such as IT sector, Banking sector, Auto Sector, Pharma Sector, etc., The risk-reward ratio of Thematic Equity Fund directly depends on the performance of the respective sectors Companies.

What is Market capitalization?

Market Capitalization is calculated by multiplying a company’s outstanding shares by its stock price per share.

 

Equity Linked Savings Scheme (ELSS):

Investment in ELSS is beneficial for tax deductions under Section 80C of the Income Tax Act. Maximum Investment can be made up to Rs.1.5 lakh.

Equity-Linked Savings Scheme (ELSS) is an equity mutual fund investment that invests at least 80 per cent of its assets in equity and equity-related instruments. ELSS can be open-ended or close ended. The amount you invest in ELSS is deducted from your taxable income, which helps you lower the amount of income tax you are liable to pay. Investments in ELSS are subject to a three-year lock-in period.

Investing in equity mutual funds comes at a slightly higher risk as compared to debt mutual funds, but they also give your money a chance to earn higher returns.

Risk Factors with investment in Equities

  • Since the Equity-linked scheme’s objective is to invest in equity and equity-related instruments which offer high risk for your principal. Hence, understand your level of risk-taking before investing in an equity scheme.
  • Due to volatility, price of equities also fluctuates on a daily basis which in turn effect the NAV of the scheme
  • Sensational news or any corporate event of any sector, will impact the price of shares of that sector.

Debt Mutual Fund :

In the Debt scheme, the investment will be made on debt instruments like Government bonds, Treasury bills, Commercial papers, and certificates of deposits, etc., Your exposure to risk-reward is low in the case of debt mutual fund investment.

Risk involved in investment of Debt Mutual Fund

In case of issuers inability to pay interest to principal amount on due date

Debt Securities are subject to the risk of an issuer’s inability to meet principal and interest payments on the obligation (Credit Risk) on the due date(s). Also subject to price volatility, interest rate sensitivity, market perception of the creditworthiness of the issuer, and general market liquidity (Market Risk).

What is Interest Rate Risk?

Interest rates move up or down based on the interest rate movement of the fixed-income securities. If interest rates rise, price of fixed securities fall and if interest rate drop, price of fixed securities will rise. This volatility affects the value of the scheme portfolio.

What is Credit risk in Mutual Fund?

If the Issuer defaults on the payment of interest or principal amount of fixed income securities, the scheme may not receive the amount due /expected. This results in a fall of the NAV of the scheme.

Hybrid Mutual Fund :

As the name suggests, this fund invests in both equity and debt. Balanced investment in equity and debt will bring you good returns with average risk

Solution-Oriented Fund:

Investment goals are different from person to person. This fund gives you the solution for your long-term plans like a retirement plan, Children’s Education or marriage plan, purchase of a house, and health plan, etc.

Other Fund:

Others funds are specific funds like. Sensex Fund, Nifty Index Fund. These Funds will invest your money on specific sector.

Liquid Fund:

A liquid fund basically a Debt Fund with low risk. Liquid Mutual Fund invests in Money Market Instruments includes commercial papers, commercial bills, treasury bills, Government securities having an unexpired maturity of up to one year, call or notice money, certificate of deposit, usance bills, and any other like instruments as specified by the Reserve Bank of India from time to time. A liquid scheme is ideal for investors who wish to park their surplus funds for short periods.

SCHEME STRUCTURE

Mutual Fund Schemes are structured as Open-ended scheme, Close-ended scheme and Interval Scheme.

• Open-ended schemes provides you the facility of anytime entry and exit on all business days at the prevailing NAV of the scheme.

• Close-ended schemes have a fixed maturity date. The units are issued at the time of the initial offer can be redeemed only on maturity.

• Interval schemes allow purchase and redemption during specified transaction periods (intervals).

Mutual funds also offer investment plans, such as Growth plans, bonus plans, and Dividend options. This can help the investor further plan their investment according to their needs.

Growth Plan

Investment with Growth Plan provides the investor capital appreciation of their invested amount. The surplus amount earned by the scheme is not distributed to the investors instead re-invested in the scheme to provide capital appreciation. Appreciation of your investment required in the growth plan is medium to long term horizon.

Income Plan

Income Fund aims to provide steady income to investors. The surplus amount earned will be distributed to the investor by way of the Income distribution. But again., there is no guarantee of the income distribution.

Bonus Plan

Bonus Plan offers bonus units to its investors in case of any surplus amount which can be distributed by the Mutual Fund.

Mutual Funds Investment Planning

Risk factors of Mutual Fund Investment

  • Mutual Fund Schemes does not give a guarantee on your investment
  • By investing in Mutual Fund units, you may undergo the risks of Mutual Fund facing such as settlement risk, liquidity risk, default risk on their investment which may also lead to loss of principal amount.
  • The volatility of price movement of Equity and bond markets will directly impact the NAV of the scheme. Changes in Government policies, changes in interest rates, taxation policies, Economic and political development will influence the equity, bond markets. This volatile movement will affect the value of an investment which may go up or down
  • Do not invest in a mutual fund based on its past performance. The best-performed Mutual Fund does not give a guarantee for future performance.
Mutual Funds Investment Planning

Investment guide for beginner in mutual Fund

  • Plan your Mutual fund investment according to your goals. You may choose the proper fund for investment based on your age, risk appetite, and your future plans.
  • Choose the right fund which suits your goal
  • Check for the Fund Manager’s experience and expertise, portfolio investment details, expense ratio, and AUM of the scheme.
  • Diversify your investment in different schemes and different mutual funds thereby reducing your risk
  • It is better to invest through SIP(Systematic Investment Plan) to get benefitted from the different unit prices. In the long run, you will be earning better due to the purchase of units with a different (average)price.

Before investing, look for details like;

  1. Entry load and exit load of the scheme
  2. Lock-in period if applicable
  3. Read the offer document carefully for investment details
  4. Take guidance from a financial advisor

In conclusion, we must say, Investment in Mutual Fund will bring you secondary income. It gives the liberty to invest as low as Rs.500/-. You Need not go to any broker for investing.

Read my blog post about How to earn money sitting at home in India. Also learn about investment in IPO.

Learn more about Mutual Fund with AMFI.

Understand the performance of Mutual Fund Houses here.

What is XIRR in Mutual funds?

The Extended Internal Rate of Return (XIRR)is calculated on returns earned on SIP investment in Mutual Fund.

What is CAGR in Mutual Funds?

Compounded Annual Growth Rate (CAGR) is compounded growth rate of the investments made in mutual Funds. CAGR also helps to measure average annual growth of mutual fund for specified period.

What is Absolute Return in Mutual Fund?

Absolute return is the return that the mutual fund has earned over a certain period of time. It can be a gain or loss on your investment.

What is Total Return in Mutual Fund?

Total Return Index (TRI)includes the dividend yield and capital gain accrued on your investment.

What is Price Return Index?

The Price Return Index (PRI)measues the rate of return on capital appreciation of the portfolio. The income generated by the assets in the portfolio, in the form of interest and dividends, is ignored.

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