Understanding Mutual Funds
Let us now understand in detail mutual funds, one of the finest and easiest financial products available in the market.
Mutual Funds are a financial product that is available for people who want to invest in different types of investment options but do not have the time or expertise to choose good company stocks by themselves.
As mentioned in an earlier blog (read understanding the basics of the stock market), a Mutual fund is a wonderful thing.
Suppose you and your 4 friends want to invest 1000 rs each in the stock market, but you are all not sure which share to buy for profit. So you all go to a person in your city who is an expert in the stock market. He tells give me your money and I will invest your money in stocks as per my expertise and all profits will go to you 5 people. He will just be investing on your behalf. So he takes your money and invests in the stock market on your behalf. This is what a mutual fund is.
A Mutual fund is basically when a lot of people give their money to an expert who invests that money in stocks as per his expertise. This expert is called a mutual fund manager.
Now 2 questions will arise:
- Can that person be trusted? Can he do fraud or run away with our money?
- Mutual funds are run by big financial institutions like HDFC, ICICI, SBI, etc. Fund managers are like employees of these banks who are experts in finance and stocks market having many years of experience. Just like you keep your money in the bank with the trust, similarly, you give your money in mutual funds to these banks who then assign that money to fund managers who will manage the investments of that money as per their own expertise. These managers work under these banks, not independently. So, if you trust these institutions, you can trust their fund managers too.
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2. What if the fund managers make wrong investments and our money is lost? He can also make wrong decisions or lose our money in the wrong stocks.
-Suppose you invested 1000 rs in a mutual fund. The fund manager then divided 1000 rs into 200 rs and purchased shares in 5 different small companies. Now suppose 2 of those companies start making a loss. The fund manager will take out your money from those 2 bad companies and invest in some other company that is performing well. Fund managers are experts in finances and they work on the stock market 24*7. Their duty is to manage the investments. So, it is possible that he might invest in a wrong stock, but he is constantly managing the money and keeping eye on the stock market. He will take your money out in case something bad happens. But this does not mean you will not lose your money ever in a mutual fund. If the stock market is down or the economy is down, even the best fund manager cannot help you recover your money.
The investments in mutual funds are not by 8-10 people but thousands of people and the money runs into thousands of crores in all mutual funds. These are trustworthy.
I guess the concept of a mutual fund is clear now.
Let us see the main types of mutual funds:
1) Large cap mutual funds- mutual funds where the money will be invested in large-cap companies only.
2) Small and mid-cap mutual funds- mutual funds where the money will be invested in small or medium cap companies.
3) Index mutual fund- It is a type of mutual fund in which the investment is done only in the Top companies of India. Out of all large-cap companies, only top companies are used for this investment. If you are investing in an index fund, you are basically investing in the future of the Indian economy and your money will grow at a minimum 10% rate. Nifty 50 and Sensex are examples of an index. Nifty50 is a group of 50 top companies listed on the National Stock Exchange. Sensex is top 30 companies listed on the Bombay stock exchange. Similarly, Nifty next 50 is a group of top 50-100 ranked group of companies. So, if you invest your money in a nifty next 50 index fund, your money will be invested only in the 50-100 ranked companies of India.
Now, if you want to grow your money nicely, as discussed earlier, we need to invest some amount in small and mid-cap companies too, for potential growth. So, the best way to invest in these small and mid-cap companies is through small and mid-cap mutual funds where your money is invested in these high-potential companies for growth. And if the companies start falling, the fund manager as per his expertise takes your money out and invests in some other company. You get the expert help of a fund manager and all his management and handling of the investments at a very nominal price of less than 1%. So suppose you invest ten thousand rs every month in a mutual fund, so the fund manager’s fees will be maybe 50 rs only.
FEES/ Expenses of investing in mutual funds: Important point to note is that mutual funds are managed by financial institutions and fund managers, so they are going to charge some fees from you for the service they offer. This service fee is called- Expense ratio. Always remember that the lower the expense ratio of a mutual fund, the better return you get on your money. Consider expense ratio as the commission you pay to your fund manager to manage your money.
Generally, index funds have the lowest expense ratio because in this fund, the fund manager will not have to do a lot of research to identify good companies. An Index fund invests your money in pre-designated top companies of the country, so the fund manager has to just put your money in those companies only, without much research, so the fees are also very low.
Other important types of mutual funds:
Flexi cap funds: Flexi fund mutual funds generally invest your money as per their own expertise and wish. They can invest some part of your money in big companies, some money in small companies, some money in gold etc. It is called a flexi cap fund as it means you give them the flexibility to decide which investment option is good and they have the freedom to invest your money as they find fit.
ELSS Tax saver fund: ELSS tax-saving mutual funds are funds where you will have to pay minimal income tax on the gains that you make from your investments. It comes with a lockin period of 3 years. So whatever money you put in it, will not be withdrawn before 3 years.
Other not-so-important mutual fund types:
Sectoral or thematic mutual funds: Sectoral or thematic mutual funds invests your money in a particular sector. For example, if you wish to invest your money in a financial sector because you think that in the next 10 years, the finance sector will grow a lot, so you can choose a finance sectoral mutual fund and your all money will be invested only in finance companies.
Liquid funds: Liquid funds are types of mutual funds where you can keep your money for a short duration. Suppose you have 1 lakh rs and you will need this money after 2 years to build your house. You should not keep this money in stocks or mutual funds as these are long-term investment plans. So you have the option of keeping this money in bank FD. Similarly, a liquid mutual fund is a type of mutual fund but it offers safety and security like a bank FD. The returns on a liquid fund are just a bit higher than fixed deposits and it also has better tax benefits than a bank fixed deposit. The money that you invest in a liquid fund is invested in government bonds and thus, is safe.
Keep in mind that a liquid fund is used to keep the money for a short duration of 1-4 years. It is mostly used to keep money safe. So, do not run after liquid funds which offer high returns. If you want high returns, it will also become risky. So if you need money in 1-4 years, it is better to keep your money either in a bank fixed deposit or a liquid fund offering not above 6% returns, as any liquid fund offering more interest means the investments from that liquid fund is done in some risky options too.
To be honest, if you have some money and you will need that money within the next 5 years, or if it is an emergency fund, do not worry about anything and just keep that money in a bank fixed deposit instead of liquid funds.
Mutual funds are investment options for a period of more than 5 years. Because that is the time it will take for your money to compound and start growing. The real growth will be visible only after 10 years.
Subhav Samarth
+91-9015661671.
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