What is a mutual fund?
It is a pool of money collected from a large number of investors by a professional entity with an aim to invest in different avenues for a variety of purposes. These avenues could be equity, debt, gold, commodities, real estate and so on.
Presently in India, Mutual Funds are not allowed to invest in real estate directly, though they can invest in equity shares or bonds of real estate companies. Equity markets, debt markets and gold are the most popular asset classes that Indian MFs invest in.
The purpose of investment will vary according to the asset class chosen. Equity is usually a vehicle for long-term wealth creation; debt for some regular income and an attempt to protect your capital; and gold as an inflation hedge.
When do mutual funds work…
Unlike bank fixed deposits—where, whichever deposit you choose, you get a fixed rate of return—Mutual Funds don’t assure returns. The degree of risk varies from scheme to scheme. So, be mindful of which one you select. The good news is that risk is not a bad word; it means volatility and volatility can be managed.
…and when do mutual funds not work
MFs are not the right choice if you want guaranteed returns.Mutual Funds never guarantee returns; regulations prohibit them from doing so. Since they invest in equity and fixed-income markets, your money is subject to the volatility that these markets bring.
But since you end up taking risks, the chances that you earn returns higher than a typical assured-return instrument are also high. If you are certain that you need assured returns, avoid Mutual Funds.
Types of mutual funds
Broadly, there are four types of Mutual Fund schemes.
These funds invest in equity markets. They could either invest in large and well-established companies or medium- and small-sized companies. Some include a healthy proportion of both segments and are called multi-cap funds. There are thematic and sector funds as well, which invest in a few sectors or just a single sector, and are meant for those who have timely and informed views about the fortunes of select sectors.
Among the four categories of funds, equity funds are the most volatile. Use equity funds if your financial goal is at least five to seven years away.
These funds invest in fixed-income instruments such as bonds, government securities and short-term instruments such as certificates of deposit and commercial paper. Although they do not assure returns, they are less volatile than equity funds and are, therefore, used to earn regular income.
While liquid funds are least volatile (since they cater to investments of up to three months), bond funds rank high on the risk ladder since their underlying instruments mature after 3-5 years. Debt funds make money by managing credit risk and interest rate risk.
A credit risk is managed by investing in low-rated companies with the view that if credit ratings improve, their scrip prices would also go up. Interest rate risk is managed by managing the maturity of the underlying securities, depending on where the fund manager believes interest rates would go.
These funds invest in equity and debt markets at the same time. Here, too, risk profiles differ depending on how much they invest in equity markets. Balanced funds typically invest 50-70% in equity markets.
Monthly income plans (MIPs) invest between nil and 20% in equity markets and the rest gets invested in fixed-income markets. Therefore, balanced funds are meant for long-term goals. Whereas, MIPs are more conservative and are used for goals that need to be reached within 5 years with measured risks.
These funds invest in gold. They have passively managed funds and they track the price of gold. Instead of buying physical gold and then having to store it—which will require adequate safety and space—investing in gold funds is a good alternative to buying physical gold.
If you have a demat account, you can invest in a gold exchange-traded fund (ETF), which is a passively managed fund that gets listed on the stock exchanges. Or, if you don’t have a demat account, you can invest in a gold MF scheme, like any other scheme, which then invests your entire sum in a gold ETF.
So which category of mutual fund will suit you
Ascertain your investment time horizon
Ask yourself for how long would you need to stay invested, at the minimum? This depends on how distant is your financial goal. Say, you want to buy a house after 5 years, or you want to send your kids to a good college after 10 years. Or, you want to retire after 20 years and need to build yourself a retirement kitty.
Ascertaining the tenure is important because you need to choose an appropriate fund that matches it. That’s because different MFs cater to different tenures. For example, liquid funds are meant for short-term (parking) needs. Equity funds are meant for long-term goals, but you need to wait out for at least 5 to 7 years, sometimes even longer.