What is a mutual fund?

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A mutual fund is a type of investment instrument consisting of stocks, bonds, and other securities. In mutual fund, the fund house collects money from small-small investors and invests it in securities.

Mutual fund

This way, mutual funds give small or individual investor an edge to invest in well diversified portfolio even with small amount. On the other side, fund house earn from managing your investments.

Definition of mutual fund.

A mutual fund is a type of investment vehicle that pools money from multiple small investors to invest in a diversified portfolio of stocks, bonds, or other securities which is managed by a professional fund manager. Investors buy shares in the mutual fund, and the value of those shares is determined by the performance of the underlying securities in the fund’s portfolio. It offers a good diversification and management, making them an accessible investment option for a wide range of investors with different financial goals and risk tolerances. Fund houses are also known as domestic institutional investors.

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Understand how it’s working with a real life scenario.

For example, take HDFC AMC as the fund house who manages many mutual funds under it and look it into its very basic HDFC Index Nifty 50 mutual fund. It consists of India’s top 50 listed companies and investing in all 50 companies will require huge capital which is not feasible for small investors. So fund house make a well diversified portfolio and breaks it down to fractions so that anyone with little fund can also invest.

Mutual funds

Here, HDFC AMC is an asset management company, which is also known as a fund house. HDFC Index Nifty 50 is a mutual fund scheme where an investor can begin his/her journey to securities market.

Benefits and risks of mutual funds.

Mutual funds offer diversification, professional management, accessibility, and a variety of options.

However, they carry risks like sudden market fluctuations, fund manager’s performance, fees, lack of control, and liquidity issues. Understanding your goals and risk tolerance is essential before investing, and seeking advice from a professional can help navigate these benefits and risks effectively.

Please do not take advice from a bank employee, in my own experience they are just fools. I have seen bankers selling such schemes for commissions. Good advice may cost you, but never ever misguide you.

Technical jargon used in mutual fund schemes.

Now let’s look into some terminologies used in such schemes.

1. Lump sum investment:

Just like it sounds, one time investment. Investors who just opt for large investment in a mutual fund scheme go with lump sum investment. Typically, seasoned investors who have access to funds and looks for an opportunity (example when market has fallen enough) in the securities market invest in lump sum.

2. Systematic Investment Plan (SIP):

Unlike lump sum in this method, an investor set a fixed amount to be invested monthly in a mutual fund scheme. Investors can also choose on which day the SIP amount should be debited from his savings account, which is set with a mandate and gets invested in a mutual funds.

People who do not track stock market or do not have time for it and have very less idea about it go with this SIP as they do not have to worry about ups and downs, on top of that they are regularly investing in it so they will average down everything and still earn handsome returns out of it in long run.

It is similar to installments, but you are investing for a bigger goal.

3. Risk factors (Risk-o-meters):

Every mutual fund is different, so they all have different risk factors too. Like equity mutual funds invest in direct stock markets so they are risky, bonds and debentures mutual funds are medium risky, and liquid mutual funds are way less risky. But do note that only higher risks can help you generate higher returns.

It is mandatory for mutual fund house to show this in their every scheme so that the risk-taker (investor) understand what level of risk he/she is taking to reach the set goals.

4. Net Asset Value (NAV):

It is the current value of a single unit of a mutual fund scheme.

5. Asset Under Management (AUM):

It means how much funds they have gathered from small investors and invested the same in scheme. Usually, strong AUM also shows credibility of a scheme.

6. Benchmark:

The Majority of mutual fund scheme follows a benchmark so that they can show some counting return. Like Nifty 50 Index have given around 12-15% annual return in last few years, so if you buy their index mutual fund that replicates the Nifty 50 Index you can estimate that this much return is possible.

You also get a chance to review whether they are able to beat the index or not. If not, then they are underperforming, and you should switch to some other fund house or scheme.

7. Entry load:

Some fund house has sales charges or loads, so they charge entry load. Usually, direct mutual funds do not have such entry load fees, and you should opt for those only.

8. Exit load:

Just like entry load, there are exit load too. You will pay some fee to fund house when you exit from their scheme. Most of the time, such fee is less than 1% and debited directly from the scheme.

9. Lock in:

There are some mutual fund schemes that lock you in from exiting from it. Like, ELSS tax saver funds, usually help you save tax by allowing you to stay for long run like 3 years. This way you eliminate the short and long term capital gain taxes which are charged when you sell it early. Do note that in India, you will be taxed differently based on how time you have held a fund before you sell it.

  • STCG – 15% for the short term capital gains when sell it within a year.
  • LTCG – 10% for the long term capital gains if they reach ₹1 lakh in a fiscal year.

Holding for long run is more lucrative as you get ₹1 lack of tax-free buffer for every additional years.

10. Total Expense Ratio (TER):

Total expense ratio is the annual maintenance charge levied by mutual funds to finance its expenses. Like – annual operating costs, including management fees, allocation charges, advertising costs, etc. So that will be charged from your investment amount directly.

For instance, HDFC Index Nifty 50 has TER of 0.20%, means when you invest ₹10,000 in the scheme then ₹20 will be deducted from it before investment. To make sure you don’t pay a huge fee, invest in direct mutual funds only, otherwise this fee could double just because you buy it indirectly from banks or an agent.

So this is the detailed introduction and definition of mutual fund with benefits and risks associated with it.

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