Mutual funds in simple words are the collection of money from a large number of investors in a single fund. Mutual Fund is a company that connects money from different investors and pools the money and later invests it into different types of securities like equity and debt. This pool of money is managed by a manager Or teams of managers. The combination of the securities in which mutual funds invest the money of investors is called a portfolio. You can invest in mutual funds in many ways depending on the need and budget.
Over the Period of time, returns are generated on the investment made and the same is shared among the investors. Return is shared post deduction of fees and related costs like taxes. Here, units are allotted based on the net asset value and NAV is calculated simply by dividing the total amount of investment by the number of units investors have.
Understand Mutual Fund with Example
For example, there is a candy box containing 250 candies and it costs 250 rupees. There are five friends and each one of them has 50 rupees. While the shopkeeper is not selling the candies openly, he is selling the box itself. So in this case, none of them can afford to buy the Candy box individually. So there is one option they collect 50 rupees each collectively and purchase the box.
After purchasing the box they will divide the candies as per their investment made. So here, the net asset value of 1 candy is equal to 250 / 250 = 1. Because 250 is the total amount invested and 250 is the number of candies available in the box. So now each one will have 50 candies and the amount invested is equal to 50 X 1 = 50 because of the number of units X net asset value.
So in this example, each friend is an investor and the Candy box is a portfolio.
Net asset value:
As shares are traded in the stock market at different prices, mutual fund units also have a Net Asset Value per unit. It is the total value of securities held by the fund house on the particular day/number of outstanding units in that scheme.
A mutual fund is best for:
- Investors who don’t have large money to invest
- Investors who do not have enough time to research the stocks
- Investors who don’t want to take risks by investing in the stock market directly
- Investors who want to grow their wealth in the long term
Types of mutual funds
Mutual Fund is divided into different types but mainly there are only two types of mutual funds:
- Based on the management of the fund
- Based on the entry or exit time of the fund
Based on the management
On the basis of the management, how the mutual fund is managed is divided into two types:
Active mutual funds
As the name suggests, here someone is appointed who will be actively managing the fund for the investors. Fund managers or teams of managers will take all the decisions on the behalf of investors like buying or selling stock. They will also be looking after the selection of portfolios For investors and if any changes to be made in that. Returns of active mutual funds get reduced because of the payment to be made to these professional teams of managers. Also, securities in the portfolio are frequently traded thereby, attracting more fees. That is the reason why maximum investors try to invest in passive Mutual Funds because they are cheap and safe as compared to active mutual funds.
Passive mutual funds
In Passive mutual funds, the role of the fund manager remains limited or negligible. This is the reason, passive mutual funds have less cost and fees as compared to active mutual funds because expenses to be paid to the fund manager are less.
Passive Mutual funds simply follow the market indices and index funds don’t need a professional person compared to active mutual funds because investment in the portfolio is not regularly traded. So it attracts Fewer taxes and fees hence making it cheap as compared to active mutual funds.
Based on entry exit time of the fund
Based on the time of entry and exit, Mutual Funds are divided into two categories:
Open-ended Mutual Funds
Investment in open-ended Mutual Funds is like depositing money in a savings bank. It means you can enter and exit the investment at any time as per your preferences. There is no fixed tenure or maturity date to keep your investment. This type of mutual fund is best for those investors who are not sure about their investment and may require money anytime.
Close-ended Mutual Fund
Investment in closed-ended Mutual Funds is like investing in fixed income instruments like fixed deposits. It means this type of mutual fund has fixed tenure and fixed maturity date and you cannot redeem your units or exit the investment before the maturity period. You cannot take entry or exit in the investment scheme Midway, and you have to remain invested throughout the period of the fund till the maturity date.
How to invest in Mutual Funds
There are different types by which you can invest in mutual funds and you can select any of them based on your needs and demands. Different ways to invest in mutual funds are:
Lump sum or one-time investment
As the name suggests, you can invest large amounts in one go. It is the best option for those investors who have funds in their hands or are going to receive them in the near future. If you do not know how to invest the amount you are going to receive, investing in a mutual fund through this mode is best for you. But lump sum investment has its own advantages and disadvantages and it depends only on the entry timing for your investment.
If you invested in good market times when the market was in an uptrend, your returns can be low but if you invested when the market was in a downtrend your investment Returns can be high. If you have invested in the upper market then you should stretch your holding period for the investment to mitigate the risk of low Returns.
This is the most popular method to invest in mutual funds because of its systematic transactions and affordability. It is the best plan to invest in mutual funds for the people who are receiving regular payments like salary. Since in India maximum people belong to this category of employees receiving monthly payouts, so Systematic Investment Plan (SIP) is best for them. This mode of investment is also best for the people who don’t have enough money to invest initially because here investment can be started with a minimum of five hundred rupees only.
You can start your investment by paying small amounts regularly like on a monthly basis. Your monthly Investments keep on adding to your capital and it will generate compound interest in the long term for you. In this mode also, units are allotted based on net asset value each month and get added to your portfolio.
The volatility of the market has less impact on this mode of investment because of its systematic process. Because you keep on investing in the market in both good and bad phases thereby averaging your Returns. Suppose your monthly investment is 1000 rupees in a scheme. For example, in the month of March, the net asset value of a unit was 100 rupees, so you will be allotted 10 units in the month of March. Now suppose in the month of April the net asset value of a unit increases to 20 rupees, so in this case, you will be allocated 50 units. So in the long run rupee cost averaging will generate magnificent Returns for you.
Systematic transfer plan (STP)
If you want to invest in mutual funds but don’t want to go for lump sum investment or SIP mode, then this mode of investment is best for you. In this scheme, the fund house will invest your money initially in the less risky funds and gradually and systematically they will transfer your investment to high-return schemes like equity.
Dividend reinvestment plan (DRIP)
The dividend is nothing but the process of sharing profit made by the company among its investors. If your mutual fund is investing in dividend stocks which are paying a regular dividend to their investors, you will be liable to receive the same from the mutual fund.
Now there are two options in front of you as an investor: either take out a dividend for your expenses or else reinvest this dividend into the scheme. By this, you can generate more returns on your investment by investing in the dividend. This mode of investment is best for those people who don’t want regular dividend payouts.
Dividend transfer plan (DTP)
The dividend transfer plan is the same as the dividend reinvestment plan with only one difference. In a Dividend transfer plan, you can change the class of securities while reinvesting your dividends. For example, if you are a risk avoider and you have invested in a debt scheme and receiving a regular dividend payout, then you have the option to invest this dividend into the equity class of securities. By investing the dividend in equity you can generate high returns while keeping your capital invested in a low-risk debt fund.
Systematic withdrawal plan (SWP)
It is not a method to invest in mutual funds but a withdrawal plan where you have an option to redeem or withdraw systematically. Managing your personal finance is all about how best you can take care of your money. This plan is best for those people who are going to receive large Corpus in the future like a retirement fund and don’t know how to manage that fund. If you don’t know how to invest that money after retirement, it will get used up in useless things and you will be left with no savings.
Here SWP plan comes to the rescue and it makes sure that you remain financially free post-retirement. You can decide the amount and the term at which you need that money like monthly or quarterly which is sufficient for you to meet your daily needs. The Remaining amount will remain invested and keep generating good returns for you, so you will not have to think about managing the fund.
The Bottom Lines:
It can be a great tool for you to invest in mutual funds to generate wealth in the long term. Here you can invest in mutual funds in many ways depending on your financial conditions and needs. The best part of this type of investment is that here you can start investing with as little as 500 Rs and investment is safe as the MF industry is closely monitored by SEBI. If you are reading this article and have not invested yet, this is the right time for you to start your investment journey.