Many individuals in India look up to mutual funds when searching for diversification in their portfolios and accessing professional management. High-return mutual funds are a great way to start an investment journey as it offers a reliable means of growing money in the long run.
Read this article where we explore what mutual funds are, the different types of mutual funds and how they work.
What is a Mutual Fund?
Mutual funds are an investment strategy that pools money from several investors to buy diversified stocks, debt instruments and other securities. These investments are managed by professional fund managers who base decisions on the fund’s investment objective as set out in its prospectus. The primary benefit of mutual funds to individual investors is that they can benefit from a diversified professionally managed portfolio.
How Do Mutual Funds Work?
Mutual funds work in a way that instead of purchasing individual stocks, an investor pools their money or even part of ownership into other entities’ assets. This money gets invested in different things like government bonds, company shares, and other assets by a professional manager. The manager decides where to invest based on what the investors want and how much risk they can handle. For example, if someone invests in company shares, the manager will put most of the money in stocks. If they prefer safer investments, like bonds, they’ll focus on those instead.
When investing in Mutual Funds, it simply means buying units of the fund. The price of each unit is called the Net Asset Value (NAV). The manager uses the money from all the investors to create a portfolio of investments. This portfolio is managed according to the goals of the fund, with the manager making decisions about what to buy and sell to help the investors make money.
By doing so an individual who invests, becomes an owner of a section of a diversified investment portfolio. This offers protection against the risk involved when relying only on one company’s stock or bond issues; it means they will not lose everything even if one sector collapses completely. The owner comes up with portfolios and decides on distributing money among branches, industries, bonds and shares.
Understanding The Earnings from Mutual Funds
Investors can earn returns from mutual funds in three primary ways:
- Dividend/Interest Income: Mutual funds distribute dividends from stocks and interest from bonds to investors. These can be reinvested or taken as income.
- Capital Gains Distributions: When the fund sells securities that have increased in value, the profits (capital gains) are distributed to investors.
- Capital Gains from Selling Shares: Investors can sell their mutual fund shares for a profit if the share price has increased.
Types of Mutual Funds
There are various types of mutual funds, each with specific investment objectives and strategies. Here are the main categories:
1. Stock Funds
Stock funds invest primarily in equities or stocks. They can be further categorised by the size of the companies they invest in (small-cap, mid-cap, large-cap) and their investment approach (growth, value, or blend).
- Growth Funds: Focus on companies with strong earnings and sales growth.
- Value Funds: Invest in stocks that aim for long-term appreciation.
- Blend Funds: Combine both growth and value stocks for a balanced risk-reward profile.
2. Bond Funds
Bond funds, also known as fixed-income funds, invest in government bonds, corporate bonds, and other debt instruments. They aim to provide regular income to investors through interest payments.
- Government Bond Funds: Invest in government securities, offering lower risk.
- Corporate Bond Funds: Invest in corporate debt, which may offer higher returns but with increased risk.
- High-Yield Bond Funds: Focus on high-risk, high-reward bonds, often referred to as “junk bonds.”
3. Money Market Funds
Money market funds invest in short-term, low-risk debt instruments like Treasury bills and commercial paper. They offer lower returns compared to other mutual funds but provide high liquidity and safety.
4. Index Funds
Index funds aim to replicate the performance of a specific market index. They are cost-effective and often outperform actively managed funds due to lower fees.
5. Hybrid Funds
Hybrid Funds, also called Mix of assets Funds, are a mix of both stocks and bonds. They’re similar to balanced funds, aiming to provide growth and stability in a single package
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International and Global Funds
- International Funds: Invest in assets located outside the investor’s home country.
- Global Funds: Can invest in assets worldwide, including the investor’s home country.
7. Sector and Thematic Funds
Sector funds focus on specific sectors of the economy, such as technology or healthcare. Thematic funds invest based on broader themes, like artificial intelligence or green technology.
8. Tax Saving Funds
Tax Saving Funds, also known as ELSS, provide tax benefits under Section 80C. These funds mainly invest in stocks and are a tax-efficient way to invest money.
9. Pension Funds
Pension Funds are designed to build up savings for retirement by investing in a variety of assets. They’re for people who want to ensure a stable financial future after they stop working.
Conclusion
Mutual funds provide a versatile and accessible investment option for individuals looking to diversify their portfolios and benefit from professional management. With various types available, investors can choose funds that align with their risk tolerance, investment goals, and time horizon.
Understanding how mutual funds work, the available types and the associated fees can help investors make informed decisions and optimise their investment strategies.
