What Is a Mutual Fund?

A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund's assets and attempt to produce capital gains or income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market cap of the fund—derived by the aggregating performance of the underlying investments.

How do Mutual Funds work?

Mutual funds are essentially a basket of many financial instruments that generate returns over a period of time. If an investor invests in a mutual fund scheme, s/he buys units of that scheme based on the Net Asset Value (NAV) of that fund on the day of transaction.

The fund manager invests the collected funds in various financial instruments, such as equity stocks, debt instruments, derivatives, arbitrage, etc. in order to generate returns for the portfolio holders. The total capital gains from these allocations gets added to the assets under management of the fund, on which the NAV of the fund depends.

The investors can redeem the fund units as per their convenience. The units are redeemed on the current NAV of the fund, which would have probably be substantially higher when compared to the NAV at which the units were bought. This increase highlights your total gains on the investment. If the NAV at the time of redemption is not much higher than at the time of investment, it is suggested to remain invested in the fund, and wait for the market sentiment to move in your favour.

Different types of mutual funds

Mutual funds offer one of the most comprehensive, easy and flexible ways to create a diversified portfolio of investments. There are different types of mutual funds that offer different options to suit investors diverse risk appetites. Let us understand the different types of mutual funds available currently in the market to help you make an informed investment decision.

Broadly, any mutual fund will either invest in equities, debt or a mix of both. Further, they can be open-ended or close-ended mutual fund schemes.

Open-ended funds

In an open-ended mutual fund, an investor can invest or enter and redeem or exit at any point of time. It does not have a fixed maturity period.

Close-ended funds

Close-ended mutual funds have a fixed maturity date. An investor can only invest or enter in these types of schemes during the initial period known as the New Fund Offer or NFO period. His/her investment will automatically be redeemed on the maturity date. They are listed on stock exchange(s).

Let's take a look at the various types of equity and debt mutual funds available in India:

1. Equity or growth schemes

These are one of the most popular mutual fund schemes. They allow investors to participate in stock markets. Though categorized as high risk, these schemes also have a high return potential in the long run. They are ideal for investors in their prime earning stage, looking to build a portfolio that gives them superior returns over the long-term. Normally an equity fund or diversified equity fund as it is commonly called invests over a range of sectors to distribute the risk.

Equity funds can be further divided into three categories:

Sector-specific funds:

These are mutual funds that invest in a specific sector. These can be sectors like infrastructure, banking, mining, etc. or specific segments like mid-cap, small-cap or large-cap segments. They are suitable for investors having a high-risk appetite and have the potential to give high returns.

Index funds:

Index funds are ideal for investors who want to invest in equity mutual funds but at the same time don't want to depend on the fund manager. An index mutual fund follows the same strategy as the index it is based on.

For example, if an index fund follows the BSE Index as the replicating index and if it has a 20% weightage in let's say Stock A, then the index fund will also invest 20% of its assets in Stock A.

Index funds promise returns in line with the index they mirror. Further, they also limit the loss to the proportional loss of the index they follow, making them suitable for investors with a medium risk appetite.

Tax saving funds:

These funds offer tax benefits to investors. They invest in equities and are also called Equity Linked Saving Schemes (ELSS). These types of schemes have a 3-year lock-in period. The investments in the scheme are eligible for tax deduction u/s 80C of the Income-Tax Act, 1961.

2. Money market funds or liquid funds:

These funds invest in short-term debt instruments, looking to give a reasonable return to investors over a short period of time. These funds are suitable for investors with a low risk appetite who are looking at parking their surplus funds over a short-term. These are an alternative to putting money in a savings bank account.

3. Fixed income or debt mutual funds:

These funds invest a majority of the money in debt - fixed income i.e. fixed coupon bearing instruments like government securities, bonds, debentures, etc. They have a low-risk-low-return outlook and are ideal for investors with a low risk appetite looking at generating a steady income. However, they are subject to credit risk.

4. Balanced funds:

As the name suggests, these are mutual fund schemes that divide their investments between equity and debt. The allocation may keep changing based on market risks. They are more suitable for investors who are looking at a combination of moderate returns with comparatively low risk.

5. Hybrid / Monthly Income Plans (MIP):

These funds are similar to balanced funds but the proportion of equity assets is lesser compared to balanced funds. Hence, they are also called marginal equity funds. They are especially suitable for investors who are retired and want a regular income with comparatively low risk.

6. Gilt funds:

These funds invest only in government securities. They are preferred by investors who are risk averse and want no credit risk associated with their investment. However, they are subject to high interest rate risk.

What are the requirement in mutual fund?

Bank account details

In order to protect unit holder interest from fraudulent encasement of cheques, the current SEBI Regulations, has made it mandatory for investors to mention in their application/repurchase-redemption request, the bank name and account number of the unit holders .The AMC will not be responsible for any loss arising out of fraudulent encasement of cheques and or any delay /loss in transit. In the absence of these details, applications are liable for rejection.

Permanent Account Number (PAN)

Permanent Account Number (PAN) is necessary for transaction, according to the rules, every investor should have a Permanent Account Number (PAN), which is why it is now gaining grounds with NRIs too. Although, Non-Resident Indians are not required to provide a Permanent Account Number in their Mutual Funds, shares, stocks and other related investments till now, the Securities and Exchange Board of India has directed the depositories to make PAN compulsory for all demat accounts that are started off after April, 2003. After 30th September 2006 existing demat account holders will not be allowed to operate their accounts unless their PAN card is submitted.

The procedures for availing a PAN are quite simple but, for NRIs not having their own residences and / or residential proofs can be a bit discomforting. Hence, before the procedure of acquiring a PAN becomes rigid, NRI can choose an easier alternate by providing proof of residence of his representative assessee.

Such representative assesses can be resident parents, brothers, close relatives or even friends. Details regarding PAN are mentioned herein. An NRI can avail a PAN by making an application to the Income Tax office or Office of Unit Trust of India. An NRI is required to submit the following:

  • Copy of passport
  • Photograph
  • Copy of Visa in case of an Indian citizen
  • Details and photograph of representative assessee i.e. say, parents or brothers or even a friend’s details and
  • Proof of residence of representative assesses being any one of the documents be that telephone bill, electricity bill, ration card, bank statement or driving licence, showing the address of representative assesses

What are the risks involved?

Investment in Mutual Fund are subject to market risks. The following risks are mentioned below:

  • Mutual funds and securities are subject to market risks and there is no assurance and no guarantee that the objectives of the mutual fund will be achieved.
  • The NAV of the units issued under the scheme may go up or down depending on the factors and forces affecting capital markets.
  • Past performance of the Sponsor/AMC/Mutual fund does not indicate the future performance of the schemes of the Mutual Fund.
  • Investors in the scheme are not guaranteed of any assured /guaranteed returns.

Who can nominate?

Only individuals holding beneficiary accounts either singly or jointly can make nomination. Non-individuals including society, trust, body corporate, Karta of Hindu Undivided Family, holder of power of attorney cannot nominate.

Who can be a nominee?

Only an individual can be a nominee. A nominee shall not be a society, trust, body corporate, partnership firm, Karta of Hindu Undivided Family or a power of attorney holder.