Disclaimer: This post is for absolute beginners. If you know what a Mutual Fund is and how it works, you can skip reading this. However, since it's going to be just a 5-7 minute read, you can skim through it in either case.
So, Mutual Funds are a hot topic these days. Yet, all that some people know about them is “Mutual Funds are subject to market risk. Please read the offer document carefully before investing.”
Let me clear out a few things here:
First off, what is a Mutual Fund?
A Mutual Fund is an investment instrument (or an investment product, since “instrument” is a technical term again), where you invest in a fund. This fund essentially pools in money from thousands of investors like you, and then invests in other investment products. Those products could be shares of companies, bonds, commodities like gold or any other products, depending on a lot of factors. We'll discuss bonds and other products in later posts; for now, just understand that a bond is also an investment product where people put money.
Now, like I said, a Mutual Fund is a product where you invest, which has in turn invested in other products. Each Mutual Fund is managed by an individual called a Fund Manager, who takes a call regarding which products (instruments) to invest in. This guy is the most important part of the entire Mutual Fund puzzle, because he’s the one whose actions will decide how the Mutual Fund will perform.
Now that you know what a Mutual Fund is, how do you invest in it? Well, each Mutual Fund has something called as NAV (Net Asset Value). Again, I’ll get into details of how an NAV is calculated, in later posts. But for now, you can understand that an NAV is the price for one unit of a Mutual Fund. For example, when you buy shares in the stock market, you buy one share for a particular price. Same way, when you buy a Mutual Fund, you buy one unit at a particular price called the NAV.
Let’s get into some more details. I promise you, I’ll try and keep this interesting.
While there are various classifications for a Mutual Fund, it essentially falls in 3 buckets, i.e, there are 3 types of Mutual Funds:
Equity Fund - Here, multiple investors pool in money (i.e, buy units of the fund), and the Fund Manager invests at least 65% of the money in Equity instruments, i.e shares of companies. These investments that the Fund Manager makes, are called Holdings. So if you see the holdings of say, Axis Bluechip Fund, you will see that it has invested in shares of companies like HDFC Bank, Bajaj Finance etc. An equity fund, therefore, invests in shares of companies. Now since a Mutual Fund invests in multiple companies, the risk of you losing your money gets diversified, as compared to investing in 1 or 2 companies in the stock market. That’s why, if you don’t understand stock markets, it is wise to invest in an Equity Mutual Fund.
Debt Fund - Here again, the idea is the same. You pool in money, and the Fund Manager invests most of the money in safer instruments like Bonds.
[Yes, we’ll cover the details of bonds in later posts; but for now, just understand that a bond is like an agreement made between a borrower and an investor. Bonds are issued by companies and can be purchased by individuals like us as well as corporate institutions. By buying a bond, the company gives us an interest for the duration of the bond, and then returns the capital on expiry of the bond]
Coming back, in a Debt Fund, the Fund Manager invests most of the money in instruments like Bonds, which have relatively low risk compared to shares. Therefore, Debt Funds are less risky compared to Equity Funds. But they obviously also give lower returns.
Hybrid Fund - I won’t spend too much time on this. Simply, these are funds where the Fund Manager invests money in both- debt instruments like bonds, and equity instruments like shares. Moderate risk, moderate returns. Simple.
Like I mentioned, each of the above category is further sub-categorized, but we won’t get into those details. The above are the 3 broad categories of Mutual Funds.
Another aspect I’d like to cover is that of an SIP.
When you invest in a Mutual Fund, you do it in 2 ways - either as a lumpsum investment, or in a monthly, systematic way, where your bank account gets debited on a given date every month and Mutual Fund units are purchased at the rate (NAV) of that particular day. The second way, is called a Systematic Investment Plan, or an SIP. It basically means that you systematically invest money in a Mutual Fund. You could invest in a debt fund, an equity fund or a hybrid fund. Do not get confused - An SIP is just a style of investment, not a type of Mutual Fund, like most people confuse it to be. For people who have a regular stream of income (like us, poor, salaried folks), an SIP is the best way to invest, because it brings in discipline in investing, by investing every month.
Another reason why an SIP is great, is because it averages out the price we pay for each unit. Since the stock market is volatile prices of shares keep fluctuating, the NAV of mutual funds (especially equity funds) also keeps fluctuating. It may cost Rs. 35 today and Rs. 32 six months later. So you don’t need to worry about whether you bought the units at a higher rate, because you’ll be buying it every month, so if the rates have been high on some months and low on some other months, you’ll eventually average it out, as you will have bought funds at all rates - high and low.
Now, the last thing I’d want to cover is how a Mutual Fund gives returns.
Although simple, here’s how it works:
The Fund Manager invests in any share, bond or any other instrument. Now, the value of shares and bonds keeps fluctuating. (Yes, bonds trade in the bond market, similar to shares, and their value keeps fluctuating based on demand and supply). The main motive of the fund manager is to invest in such shares or bonds whose prices rise. Once they do, the price per unit (or NAV) of the Mutual Fund also rises.
So say, for example, I purchased an equity fund “ABC” at an NAV of Rs. 30. Now, that fund has invested in HDFC Bank, ICICI Bank, TCS, Infosys and a few other companies. If after 12 months, the prices of all these shares have overall increased in the stock market, then the NAV of fund ABC will also increase. If this NAV becomes Rs. 36, that means that ABC has given me a return of Rs. 6 per unit in one year. This means that I have received a return of (36-30)/30*100 = 20% in one year.
So essentially, a Mutual Fund is as good as the instruments it has invested in. If it invests in good company shares and bonds, it gives good returns. If it invests in shady company shares/bonds, the returns will also be equally shady.
Well, that’s all for today folks! Hope this article has given you a starting point. You can now read and see Mutual Fund performance on websites like Money Control, ValueResearchOnline and MorningStar. Please note however, that this article will only enable you to read about funds on these websites. To invest, you’ll need to follow the newsletter regularly, receive more updates and use the strategies that we will suggest to invest.
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Hi Ankur, I follow your posts regularly and I must say they are extraordinarily helpful. I’ve been trying to make sense of investment concept since long. It’s because of people like you, I’m able to at least make sense of this world now.
Regarding this particular post, please if you can also cover in another post about the kind of profits fund managers and their companies make and how much profit do they actually share with individual investors like us. I believe one of the factors that influence volatility of the markets is the bulk investments that these funds pull out of and push into markets. So eventually, one likes better profits, one has no shortcut but to understand markets directly and invest directly.
I’m a huge fan of Zerodha company. Their smallcase product is super cool. Do you have any association with such companies?
Thank you again for making this world more accessible for seekers like us.