Investing your savings is one of the best ways to grow it. Investing provides a return on your funds, shielding it from the impacts of inflation as well as providing a return. To an investor, there are different modes of investment for savings, depending on the risk profile i.e. whether the investor can accept a certain level of risk when it comes to investments.
For example, investing in real estate is risky since there is no guarantee of return until it is realized. On the other hand, investing in a fixed deposit or public provident fund is low risk, since returns are guaranteed and capital is protected.
One very popular investment option is mutual funds. But before making a mutual fund investment, it is important to know what are mutual funds, so you can select the right types of mutual funds for your needs. The risk element of mutual funds changes depending on which mutual fund you invest in, which makes it even more important to learn how these investments work.
What are Mutual Funds?
Mutual funds are called mutual because they collect or pool resources from many investors and then invest those funds in different assets. For a novice investor, picking the right stock to invest in can get daunting since it requires financial knowledge and understanding of the sector in which the company operates. For such investors, a mutual fund is perfect since it collects resources and invests it in different companies.
Mutual funds are professionally managed, which means these investment decisions are taken after proper research. SEBI guidelines also control the type of assets the mutual funds can invest in, thus making them regulated.
The returns that a mutual fund earns depend on the return or performance of the assets it invests in. For example, if the mutual funds investment is primarily in Government Securities, then its return depends on the yield of the securities. If it invests in equity shares, the return depends on the value of equity shares in the market.
Classification of Mutual Funds:
SEBI recently passed rules reclassifying mutual funds to make it easier for the investors to understand the type of asset the mutual funds invested in.
The broad categories of mutual funds are:
- Equity mutual funds
- Debt mutual funds
- Hybrid mutual funds
Equity Mutual Funds:
Equity mutual funds invest more than 60% of their resources in listed equity shares. These funds are named depending on the categorization of equity shares:
- Large cap funds
- Large and mid-cap funds
- Multi cap fund
- Mid cap funds
- Small cap funds
- Sectoral/Thematic funds
- Equity Linked Savings Scheme (ELSS) funds or Tax saver funds
- Value fund
- Contra fund
- Focused fund
Sectoral or thematic funds invest by picking a particular theme such as banking stocks or PSU stocks for example. Value funds invest in stocks that are currently undervalued in the market. Contra funds pick stocks that are presently underperforming in hopes that they will perform in the longer term. This strategy is against the current market trends. Focused funds limit their exposure to funds by investing in a limited number of funds.
Debt Mutual Funds:
These funds invest in debt instruments of different durations. Types of debt funds are:
- Long duration fund
- Medium to long duration fund
- Medium duration fund
- Dynamic bond fund
- Short duration fund
- Money market fund
- Low duration fund
- Ultra short duration fund
- Liquid fund
Debt mutual funds have a lower risk element as compared to equity since debt instruments have stable returns.
Hybrid Mutual Funds
Hybrid mutual funds invest in a mix of both equity and debt instruments. Depending on the percentage mix between these two types, hybrid mutual funds are further classified as:
- Conservative hybrid funds (Debt – 60% or more)
- Aggressive hybrid funds (Equity – 60% or more)
- Arbitrage funds
This includes exchange traded funds. ETFs mimic the movement of an asset for example gold or an index. The investment pattern follows that of the underlying asset. Though it may not be called specifically as mutual fund but the underlying are same i.e. stocks. Hence, you can consider investing in ETF in place of mutual fund.
For example, by investing in a Nifty 50 ETF, you are indirectly investing a small portion of your funds in the shares that comprise the Nifty 50 index in the same proportion. The ETF will grow in proportion to the underlying asset.
Mutual fund investments is an excellent way to grow capital especially in the longer term. Several schemes have provided inflation beating returns consistently, and some have even given double digit returns over a longer time frame. Hence, investing in mutual funds is beneficial.
Here are some of the benefits of investing in mutual funds that you must consider before making your investments:
1. Lower risk:
Investing in mutual funds has lower risk than investing in pure equities outright. Since mutual funds invest in a wide range of assets at once, it reduces the risk as compared to investing in one equity stock at one point of time. Hybrid mutual funds have a similar risk reduction objective. They provide a lower risk option for both conservative and aggressive investors by balancing both debt and equity components together.
2. Portfolio Diversification:
Mutual funds offer an alternative to diversify the portfolio. For example, a portfolio comprising primarily of equity instruments can use a debt mutual fund to lower risk and also diversify the portfolio. Similar is the case with a conservative portfolio. A conservative portfolio will invest a majority of funds in fixed income instruments. However, by investing a portion in equity mutual funds, the overall return of the portfolio improves since equity mutual funds have a higher rate of return over the medium to long term.
3. Professional Management:
Mutual funds are professionally managed. The fund managers are highly qualified and each investment strategy is made after careful research and deliberation. This ends up saving a lot of time for the individual investor in terms of researching companies, deciding themes and crafting an investment strategy.
Most mutual fund schemes do not have any entry or exit loads, which means no charges have to be paid while making investments and exiting them. The expense ratios for mutual funds are regulated by SEBI and are restricted, which means a majority of the returns are available for the investors.
Mutual funds are listed on the stock exchange, which means they are liquid. It is very easy for an investor to exit these mutual funds and get funds within 2 days. This is very helpful since this investment can be liquidated at any time.
It is possible to invest in mutual funds either by making a lumpsum investment or by making periodic investments called a systematic investment plan. The minimum amount to be invested for both modes is very low, which makes mutual funds investment accessible to both small and large investors.
7. Tax Benefits:
Investing in mutual funds can have a tax benefit. Investments made in Equity Linked Savings Scheme or ELSS funds gets a tax benefit under Section 80C of the Income Tax Act up to Rs. 1,50,000. However, the lock in period for ELSS is 3 years. This means any investment made in ELSS is locked in for a period of 3 years after which it can be withdrawn at any time.
Apart from this, dividend received from a mutual fund is tax free up to Rs. 10 lakhs. Any long term capital gains made on investments in mutual funds is taxable only if the gains exceed Rs. 1 lakh. This increases the returns on mutual fund investments.
Mutual funds investment is possible both directly with the mutual fund house as well as through a broker.
You can also invest through a Demat account. However, in that case a trading account will be required to sell off these investments. To make these investments, you can consider of opening a demat account and trading account with a reputed broker.
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