Beginner’s Guide to Easily Understand Mutual Funds

what are mutual funds

What is a Mutual Fund?

Let’s say you and your friend decide to invest money together so that you can buy more and highly priced investments that you cannot do alone. You want to put in Rs 500 and your friend wants to put in Rs 300. You then open a bank account where you put in your Rs 500 and your friend puts in his Rs 300. This bank account is like a mutual fund.

This Rs 800 in the bank account is the size of the fund or the Assets Under Management or AUM. 

In order to keep track of how much you invested and share the profits, it is easier to issue units to each of you. Let’s say each unit is of Rs 10. This is called the face value of the unit. You get 50 units and your friend gets 30 units.

Now you and your friend don’t know much about investing. So you go to another friend who is an expert. He decides how this Rs 800 Rs of Assets Under Management will be invested. That expert is the asset management company or AMC that manages the fund through a fund manager.

For managing this fund, your expert friend or the AMC will charge a small fee called the Total Expense Ratio. Hence the amount available for investment is Rs 800 less the fee charged.

You tell your expert friend that you may want to remove the money at any time. Hence he must value the investments every day. Hence, the expert values the investment every day at the market price. The value of this investment less the expenses and charges is then divided by the number of units to arrive at the Net Asset Value (NAV) of each unit. This way you have the flexibility to sell some units back to the fund, called redemption, and get the right value for that.

When you redeem, the expert will sell a similar amount of investment in the market to pay you.

Why invest through Mutual Funds

There are many reasons for investing through a mutual fund.

  1. You can participate in shares of companies or invest in loans which have a high price and which you would not have been able to do on your own. You can now do it by pooling money with others.
  2. You can now have a professional money manager to manage your money for a fee that otherwise you would not have been able to afford on your own. By letting professionals manage your money you get more time for work and family, with lower stress.
  3. Mutual Funds also offer a cheap way to diversify your risk by investing in different types of debt and different types of equities.
  4. And Mutual Funds offer a systematic approach to investment where you can invest a fixed sum every month easily through an SIP*.
  5. Finally, Mutual Funds are quite transparent and well regulated.

What are the main types of mutual funds and schemes

Let’s continue with the example of you and your friend. Now if you both have pooled money to form this fund, let’s see where to invest this.

If it is invested in shares of companies listed on the share market, it is an equity fund.

If it is invested in loans taken by companies and the government, then it is a debt fund.

A mix of both is a hybrid fund, such as a balanced fund.

Now each of equity funds, debt funds, hybrid funds have several schemes under them. Think of schemes like playlists on a music app and the songs in the playlist are like individual investments. Just like playlists have themes – Dance, Chill,  so do mutual funds.

You can invest in a Large Cap Playlist – a Large Cap Fund. This is an equity fund investing in shares of some of India’s biggest companies. A Mid Cap Fund invests in shares of mid sized companies. A Corporate Bond Fund invests in loans and bonds issued by companies. A Banking & PSU Fund invests in loans through bonds issued by banks and government owned companies. Similarly, there are many other types or mutual fund schemes.

The schemes or types of mutual funds are classified and controlled by Securities and Exchange Board of India or SEBI.

What is the growth option and IDCW Option in Mutual Funds

Most Mutual Fund schemes have a Growth Option and an IDCW Option, which stands for Income Distribution cum Capital Withdrawal.

A Growth Option in Mutual Funds does not distribute its profits to the unit holders. It reinvests its profits back in the fund. The power of compounding comes into play here. When you need money you can redeem the units. You will pay tax on capital gains.

An IDCW Option, which was earlier simply called Dividend Option, distributes its profits to the unit holders. In the IDCW option, you will pay tax on income received by you from the fund at the tax rate applicable to you. Once profit is distributed, the NAV becomes lower to that extent. Hence, the NAV of the IDCW Option is always lower than the Growth Option of the same Mutual Fund scheme.

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