Till now we have learned what are assets and the different asset classes. if you have not read that post, you can read about it here. In this post, we are going to learn about one of the important options available for investing in the market which can be easily used by any new investor for the ease of investing. These are known as mutual funds.
So let’s start by understanding what are mutual funds.
Mutual Funds
A mutual fund is an investment vehicle that pools money from multiple investors to purchase a portfolio of securities. When an individual buys shares in a mutual fund, they gain part-ownership of all the underlying assets the fund owns.
These funds are managed by professional money managers and provide investors with access to a wide mix of assets, such as stocks, bonds, and other securities. So instead of relying on their intelligence investors rely on the intelligence of the mutual fund manager for generating their returns.
The fund’s performance depends on how its collective assets are doing—when these assets increase in value, so does the NAV of the fund. Conversely, when the assets decrease in value, the NAV of the fund decreases.
Before going further we need to understand some of the common teminologies associated with mutual funds.
Net Asset Value (NAV):
It reflects the current and average value of the fund and it is calculated by subtracting liabilities from Assets and dividing this by the total number of outstanding units.
It is a useful metric in deciding how many units of the fund the investor will get by investing a certain amount in the fund. For example, if there are two funds, fund A whose NAV is 100, and another fund B whose NAV is 200, then if a person invests INR 10,000 in each, the person will get 100 units of fund A and 50 units of fund B.
Expense Ratio:
it is the fees the fund charges for managing the investors’ money. it represents all the management fees and operating costs of the fund. it is calculated by dividing the fund’s operating expenses by the average total currency value of all the assets in the fund.
Smaller funds tend to have higher expense ratios due to limited assets for covering costs. The risk associated with the assets in the funds also impacts its expense ratio.
For actively managed funds, the expense ratio can vary from 0.75% to 1.5%, whereas for passively managed funds this ratio can vary from 0.4% to 1%. A higher expense ratio can eat into investors’ profit, so investors need to caution against investing in funds with a high expense ratio.
CAGR Returns
This reflects the return the fund has generated on 1 year, 3-year, and 5-year basis. This can help investors to assess if they want to invest in that fund or not. However, the returns of the fund are not a major factor in deciding to invest in a fund or not.
Exit Load
It is a penalty that an investor has to pay for exiting the fund before the specified period. All funds do not have an exit load. it is done to discourage short-term trading.
Types of Mutual Funds:
There are four main types of mutual funds that cater to different investment needs:
Equity Funds (Stock Funds):
These funds pool money from investors to primarily invest in stocks of publicly traded companies. They offer higher growth potential but come with more volatility. Equity funds invest in stocks listed on major exchanges. By holding stocks from various companies, they offer diversification, which helps mitigate the risk of any single stock underperforming.
Based on the management of the fund, these funds can be divided into two types:
- Actively managed: In this, the fund managers actively research, analyze, and select stocks. These funds attempt to beat a benchmark, often an index in that market. The expense ratio of these funds is high.
- Passively managed: In this, the fund managers track a specific market index and do not attempt to beat it. These funds’ expense ratio is less than actively managed funds.
Based on distinct investment strategies and goals equity funds can be divided into the following types:
- Sectoral Funds: As the name suggests these funds focus on specific sectors or industries, such as technology, healthcare, or energy. They invest primarily in stocks related to that sector.
- Dividend Yield Funds: These funds aim to generate regular income for investors by investing in dividend-paying stocks. They focus on companies with a history of consistent dividends.
- Value Funds: Value funds seek undervalued stocks based on fundamental analysis. The goal is to invest in companies trading below their intrinsic value, anticipating potential price appreciation.
- Focused Equity Funds: These funds have a concentrated portfolio of select stocks, usually 20 to 30. The fund manager actively manages these stocks to achieve higher returns.
- Contra Equity Funds: These funds take a contrarian approach by investing in stocks that are out of favor or temporarily undervalued. They bet on a reversal in market sentiment.
Apart from the management style of the fund mutual funds can be categorized based on the size of the companies they invest in. These categories are as follows:
- Large Cap Funds: These funds invest in companies with a market value of $10 billion or greater. Large-cap stocks are typically well-established and stable. They are the least riskiest kind of funds among all the funds mentioned here.
- Mid-Cap Funds: Companies with a market size of $2 billion to $10 billion fall into this category. These funds focus on mid-sized companies, which may have higher growth potential than large-cap stocks. These are riskier than Large Cap Funds.
- Small Cap Funds: These funds invest in companies worth $300 million to $2 billion. Small-cap stocks can be more volatile but offer growth opportunities. These are the most riskiest kind of funds among all the funds mentioned here.
- Flexi Cap Funds: Unlike traditional funds that focus on specific size categories, these types of funds are not restricted to investing in companies with a predetermined market capitalization. These funds provide exposure to stocks of all sizes and various sectors, driving an economy forward. The advantage here is that fund managers have the flexibility to change the portfolio based on market conditions.
- Multi-Cap Funds: These funds too do not focus on a particular capitalization of companies. The difference between Multi-Cap and Flexi-Cap funds is that they are limited by the regulatory board to a certain percentage of investment in different market-cap companies.
- Index Funds: These funds just follow the benchmark index, such as Nifty50, S&P 500, Nasdaq 100, etc. These funds use a passive investing strategy. Instead of actively picking securities or timing the market, they aim to match the risk and return of the overall market. They offer broad market exposure with minimal trading activity.
Fixed-Income Funds (Bond Funds):
These funds primarily invest in bonds and other fixed-income securities. These funds provide exposure to assets such as government bonds, corporate bonds, high-yield bonds, or certificates of Deposit (CDs). They aim for a steady income and are generally less volatile than equity funds.
investors lend money to bond issuers, who pay interest on the loan in regular installments. Different bonds have varying levels of risk and yield. For example, government bonds are low-risk but offer lower yields, while corporate bonds are higher risk and offer higher yields.
They are available as mutual funds or exchange-traded funds (ETFs). They offer simplicity, liquidity, and affordability compared to managing individual bonds.
Money Market Funds (Short-Term Debt):
Money market funds invest in short-term debt instruments that are highly liquid, like Treasury bills and commercial paper. They have two primary investment components: Cash and short-term debt instruments.
They are low-risk and provide stability. While not as safe as cash, these funds are still considered extremely low-risk investments.
These funds generate income but offer little capital appreciation. investors use these funds to temporarily park funds before investing elsewhere or for anticipated cash outlays. They are not suitable for long-term investments.
Hybrid Funds (Balanced Funds):
These funds combine features of multiple assets, generally stocks and bonds into a single fund. These funds aim to provide investors with a diversified portfolio which helps in maintaining stability.
Generally, there are two types of hybrid funds:
- Balanced funds: These typically hold around 60% stocks and 40% bonds, offering a balanced mix of risk and return.
- Blended funds: These combine growth and value stocks within a single portfolio, providing diversification across investment styles.
These are suitable for investors who seek a balance between growth and income.
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