Mutual Funds: A complete guide on how mutual funds work with example

Ordinarily, when most people think of investment, they think of gold, stocks, real estate, property, or fixed deposits. However, there exists another form of investment: mutual funds. How does a layman understand the term mutual funds? If you read the words out loud and repeat them, you’ll come to realise that the term ‘mutual funds’ is quite self-explanatory and is not as complex and confusing a concept as people often think it to be.

Due to its relation to banking, finance and the capital market, people oftentimes presume that it is loaded with complexity. But such is not the case at all. Read the two words ‘mutual’ and ‘funds’ one after the other and then they come to make a lot of sense. Firstly, ‘mutual’ means experienced or done by each of two or more parties towards the other/s. Secondly, a ‘fund’ is equivalent to a certain amount of money. Thus, more than one or many individuals coming together to pool in their money for a common purpose are engaged in the act of investing in mutual funds. The main purpose of them doing so is to benefit from the capital market. This pool of money managed and supervised by a banking professional is called a mutual fund. Now that we know the basic meaning of mutual funds, let’s proceed to explore the process in depth.

Mutual Funds and its Many Types:

A mutual fund is a pool of money that is invested in stocks, bonds and other securities depending on the type of fund. At large, mutual funds are regulated by the Securities and Exchange Board of India (SEBI). Investing in Mutual Funds assures wealth creation and financial security as it is a safe investment that provides an enhanced level of liquidity through diversification and a lower level of risk.

To make maximum profit from the fund, the skill and expertise of keeping tabs on the capital market become important abilities. The common man possesses neither the knowledge nor the time to do so. Hence a mutual fund is managed by a professional fund manager who monitors the risks and reliability that is bound to affect the pool of investment.

The manager, appointed by an Asset Management Company (AMC), is highly trained and experienced. Once appointed to overlook a mutual fund, the fund manager studies the market and buys/invests in government or corporate bonds, treasury bills, stocks, and types of deposits. Now, the main objective of mutual funds is to make a monetary profit over years and years of investment. But this is just one of the various investment objectives. There are different types of mutual funds meant to satisfy different investment objectives. More importantly, one mutual fund is limited to and driven by only one investment objective. For example, the SBI Asset Management Company has 652 different schemes while the ICICI Prudential Asset Management Company has 1529 schemes to offer to its investors. These big numbers make sure that the investor has an option to finalize the scheme that suits them best!

We know that each mutual fund has an investment objective. Each of these objectives depends upon the two most important markers that are to be considered before opting for a mutual fund. They are risk-taking capacity and the time horizon.

Types of Mutual Funds:

Based on these factors and more, the 3 types of mutual funds available are:

1. Equity:

This category of the mutual fund caters to investors who are looking to only invest in equities and get maximum profit from the stock market.

2. Debt:

This type of mutual fund is for those who are solely interested in investing in the debt market.

3. Balanced:

For those who want to dabble in both equity and debt, the Balanced fund is the optimum fund.

There is almost no risk involved in mutual funds as they have a history of giving high returns. In fact, the return on large-cap funds, i.e. the funds which invest a large chunk of their pool in companies with huge market capitalisation, over the past 10 years has averaged at 14.97% which is an impressive figure in itself. Small-cap funds, while being equally profitable, have given 20.47% in returns.

Mode of Mutual Funds:

The process of applying for a mutual fund is as hassle-free and quick as it can be. Given below are the steps to invest in Mutual Funds:

1. Register for KYC

OFFLINE: Download KYC form, fill it up, get verified at your nearby fund house or,
ONLINE/E-KYC: either entirely online or through one-time password system or biometric system at the end of which you will be registered online

2. Choose your preferred type of Mutual Fund

3. Apply at

Mutual fund houses (online, offline, mobile applications)
Registrar and Transfer Agents (RTAs)
Investor Service Centres (ISC)
FINTECH investment platforms
DEMAT account
MF Utilities
Stock exchanges

It truly is as simple as that!

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FAQs

Q. Should I invest in mutual funds or stocks?

A. When you buy a stock, you become a partial owner of a company. When you invest in mutual funds, investors pool in their money to buy several stocks. Considering only the risk factor, it is much safer to invest in mutual funds than in the stock market. The financial risk in mutual funds is spread across the pool of numerous investors and is hence reduced if not completely absent.

Q. When’s the best time to invest in mutual funds?

A. There is no ideal time as such for you to invest in mutual funds. But, various factors are to be considered before investing. Your income (whether steady or irregular) and the market conditions (whether favourable or volatile) are the two most important factors.