What is Mutual Fund|How to invest in Mutual Funds
Having joined the “Quora” community, for last few months I have been receiving many personalized questions on Mutual Fund investment. People are asking me the various questions on What is Mutual Fund|How to invest in Mutual Funds. Considering this, today I have decided to write a blog post on What is Mutual Fund|How to invest in Mutual Funds.
Definition of Mutual Fund
“A mutual fund is an investment scheme funded by investors for trading in diversified holdings being managed by professionals.”
A mutual fund is to be registered with SEBI before it starts collecting money from investors/ public. A mutual fund has to be established through the medium of a sponsor. The sponsor then forms a Trust under the Indian Trust Act and the instrument of trust shall be a deed.
The trust thereafter will form an Asset Management Company (AMC) to manage the affairs of the mutual fund and to operate the various schemes of mutual funds. An Asset Management Company or AMC is set up as a Limited Liability Company, having a minimum net worth of ₹10 Crores. The sponsors have to necessarily contribute at least 40% of the net worth of the AMC. The Trustee is the holder of the properties of the Mutual Fund in the trust for the benefit of the unit holders or investors.
An Asset Management Company pools investments from investors for investment in different instruments such as equity, debt and money market instruments. When profit arises in any scheme, after deducting the expenses of that scheme, it is returned back to the investors in the form of capital appreciation or dividend.
Types of mutual funds
Just to maintain this blog post on What is Mutual Fund|How to invest in Mutual Funds very simple,concise and precise, today I am just mentioning the names of various types of mutual funds like Equity Mutual Fund, Debt Mutual Fund, Large Cap Mutual Fund, Mid Cap Mutual Fund, Small Cap Mutual Fund, Hybrid Mutual Fund and Gilt Mutual Fund. A detailed blog post will be published later on elaborating all these types.
Do I need Mutual Funds?
Since there’s direct equity or other Government securities for investment, why should I need Mutual Funds. This question arises to millions of investors. But after going through this blog post, all doubts will be clear.
Investment is not so simple that just pick up some stocks and start investing randomly and wait for the market to make all your dreams come true. There may tons of factors to be considered for directly selecting a stock for investment.
Being a general investor it’s not possible for all to make the right stock selection process or right investment decision. Here, comes Mutual Funds handy. You are pretty sure that your money is being managed by professionals. They are far more knowledgeable and experienced than you. They know when to buy, what to buy, what to sell when to enter and when to exit. Basically, they know how to churn out the portfolio on behalf of the investors to earn maximum returns on the schemes.
The professional fund managers having years of experience with the help of market analyses and using strict standards can easily identify laggards and underperformers and keep them out of the portfolio to prevent the scheme a stagnant one. This is not possible for ordinary investors not only today but in the future as well.
Costs associated with Mutual Funds
The value of a Mutual fund is calculated as per the Net Asset Value (NAV), which is the value of the fund’s portfolio after deducting its expenses. This is calculated regularly by the AMC after each business closing day.
The AMC charges a little amount(Administrative fees) on the NAV of the mutual fund for meeting their operating costs such as their salaries, brokerage, commission, advertisement expenses and other costs from the investors. This expense is popularly known as Expense Ratio.
For example, if the expense ratio is 1.90% on a particular mutual fund scheme, this means if one invests Rs.100, Rs.98.10 only is being invested in the scheme. The balance amount of Rs.1.90 is being utilized for meeting fund’s operating costs. This is quite obvious and there is no harm in it. But the lower the expense ratio the lower is the cost of investment in mutual fund. Investors must go through scheme related documents to know about the expense ratio.
The popularity of mutual funds has remained always on the top due to its transparency and tremendous reporting standards, unlike insurance sectors.
How to invest in Mutual Funds
Now I will discuss on the second part of my today’s topic i.e. What is Mutual Fund|How to invest in Mutual Funds.
Asset allocation with the Risk profile
Before starting investment in mutual funds one should consider some important factors like goal setting or desired corpus, required time horizon, asset allocation, one’s risk profile, and portfolio mix. At the onset, an investor must set his goal i.e. how much money he requires and what is the time horizon for reaching that goal. I do strongly believe that mutual fund investment should be perceived as always linked to one’s goals or objectives. After setting up the desired corpus with justified time horizon now is the time for analyzing your risk profile. Risk profiling should be done based on one’s age. After determining risk profile like whether you are risk tolerant or risk averse there comes Asset Allocation.
Your funds will need to be divided into different asset classes to achieve the returns that you want. This is known as asset allocation. The ideal asset allocation strategy would help you to invest in a number of funds that are based on your risk profile. Your risk profile will also help determine the extent to which you should invest in each asset segment such as equity and debt. Once, asset allocation is done, you have to look for a right portfolio mix. One must consider a healthy mix of high-risk and low-risk components.
Thumb rule for portfolio mix
Generally, financial experts advocates for this rule of 100 minus your age. For example, if you are 30 years old, then 70%(100-30) of your investment should be in equity and balance 30% equals to your age should be in debt instruments. This will provide necessary risk management when any market downturn happens. This principle should be followed when you are young. But when you grow older, you should reduce your high-risk investment in equities gradually. Also, when you are getting closer to your goals say you need your money in a year or so, you should consider withdrawing your money from equity investments and park the corpus into a liquid fund.
Once you are done with asset allocation in terms of portfolio mix, now is the turn for fund selection. In this segment, one should carefully identify and compare funds based on their past performance and investment objective or philosophy. Also, you should go through shareholder reports and prospectus provided by the AMC to get all those details.
The next step is to determine the time horizon for meeting up your goals. The more money you need, the more risk you have to take for shorter time horizon. You can afford to take lower risks if you have set a short-term goal. On the other hand, if your goal is fairly long time, you can take more risks, as it will come down gradually with the passing time and goals coming nearer. Thus, I can say that time horizon enjoys an inverse relationship with risk. In general, the shorter the period of investment, the lower the risks that you should take, while a higher time frame will help you overcome downturns in case of high-risk instruments.
Final word on What is Mutual Fund|How to invest in Mutual Funds
The important benefits of mutual fund investment are that it is more liquid than other fixed-interest bearing instruments. It is more tax friendly and has the ability to deliver superlative returns in the long run. Currently, in India, there is no other tax saving instrument which provides tax benefits like mutual funds with a lock-in period of just only three years.
I hope I have done enough justice on What is Mutual Fund|How to invest in Mutual Funds. If you like this blog post kindly comment below in the comment section