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What are Mutual Funds: Ultimate Guide with Types and How to choose

What is a Mutual Fund

“Investments are subject to market risks. Please read the offer documents carefully before investments” – This fast spoken line has been the bottom of a joke for decades, but not a lot of us realize that mutual funds are not that risky. 

In fact, out of all the investment options available, they cost you the least, and if done in a calculated fashion, they are the least risky. But precisely what is mutual funds? How much money should I invest in mutual funds? 

What are Mutual Funds and How do I choose?

Mutual Fund definition

What is Mutual Fund

A mutual fund is the safest way to invest your money in the stock market, and other variables and grow it. Mutual funds collect money from various individual investors and invest in buying shares, stocks, or any securities as such. The people who manage these investments are called fund managers who try and ensure maximum returns. 

The investors cannot directly access, and manage their holdings such as stocks, equities, and other securities; but, stakeholder gets a proportion of gains or losses of the fund.

Mutual Funds’ investments are a systematic way of growing wealth. A mutual fund holds numerous types of securities to manage diversification at a low price and also to minimize losses of the investor. Let us explore this further by showing you how a mutual fund works with an example.

Mutual fund example

Let’s say, if an investor purchases a stock of an individual company and that company has had some crises in its previous quarter, then the investor may lose his colossal amount.

On the other hand, if he buys into a mutual fund of the same company, the loss is minimal as the MF diversify your money in different company shares and securities. The company (which had a lousy quarter) is just being a part of MF. 

You would like to read how to invest in Mutual Funds.

Can you lose money in Mutual Funds?

Yes, but it mostly depends on certain factors.

Mutual funds, equity ones, are subjected to market risks for sure, but given the diversity of the funds, it is less probable that you will lose your money if you choose the right mutual fund. It is essential that you do proper research before picking a fund and also to keep a watch on it as well.

Here, fund managers and their experiences play a vital role in choosing the fund. The Securities and Exchange Board of India (SEBI) is a regulatory body where all the mutual funds are registered. If the fund is not performing well, you may lose your money. Hence it is crucial to know how to choose a fund.

Understanding types of Mutual funds before choosing one

The first step towards investing in a mutual fund is picking up the right product that suits the investor’s investment goals, along with the investors’ understanding of risk.  

As an investor, you must first outline your investment goals, such as – buying a house, children’s education, wedding ceremony, or planning for retirement. 

If you are unsure about your goal, nonetheless, you should at least have an idea of how much wealth you want to gather in a substantial period of time. The investor has to categorize an investment objective, level of risk, payment methodology, lock-in period, etc. to pick the best scheme.

Types of Mutual Funds

First of all, you must know about the types of mutual funds because it will help to figure out which investments would be safe or riskier for you. Going through the types of mutual funds will help you to understand the investment goals of a specific fund. The following are the seven types of mutual funds you must know about:

1. Money market funds

Money market funds invest in short-term fixed-income securities like:

mutual fund example

A. Bankers’ acceptances

A bank represents a promised future payment through Bank’s Acceptance. It starts with a deposit along with the bank fees.

B. Certificates of deposit

A certificate of deposit is a financial product sold by credit unions, thrift institutions, and banks. It has a fixed term of 1-5 years with a fixed interest rate. 

C. Government bonds

The national government issues government bonds, which promise to pay face value on maturity as well as periodic interest payments. 

D. Commercial paper

Corporations issue commercial documents as short-term debt instruments. The maturity of commercial papers generally lasts for up to 270 days. 

E. Treasury bills

When the government needs to raise money, it issues treasury bills as financial instruments. Their maturity time lasts up to 364 days.

Due to such investments, the money market funds are considered as the safest type of mutual funds. However, these funds will give you a lower potential return in comparison to other types of mutual funds. 

2. Fixed income funds

Fixed income funds mainly aim to mint money through interest. These funds pay a fixed rate of return by buying investments such as:

types of mutual funds in india

A. Government Bonds

B. Investment-grade corporate bonds

Investment-grade corporate bonds are at very low risk of default as they offer exposure to high-quality corporate bonds.

C. High-yield corporate bonds

Due to its higher risk of default, high-yield corporate bonds offer a higher rate of interest to the investors.

Out of these funds, it is generally riskier to invest in high-yield corporate bond funds than the funds which hold investment-grade and government bonds.

3. Equity funds

Are mutual funds safe

For the reason that Equity funds focus on growing faster by investing in stocks, you face a higher risk with Equity funds than fixed income or money market funds. These funds include the following investments or even their combinations:

A. Small-cap stocks

The stocks of startups, as well as stable companies with small industry size, are called small-cap stocks. They might offer huge returns but are quite risky to invest in. 

B. Mid-cap stocks

The stocks of companies that are smaller than well-established companies in terms of size, profitability, and revenue are called mid-cap stocks. Investors flock to these stocks due to their possibility of being an overnight success. 

C. Large-cap stocks

The stocks of companies that are already well-established with stable business models are called large-cap stocks. They offer moderate returns, but they are relatively safe to invest in. 

D. Income funds

Income funds are debt funds that invest in money market instruments such as certificates of deposit and government bonds. Income funds generally hold stocks that pay substantial dividends.

E. Growth stocks 

The stocks of companies that tend to increase in capital value are called growth stocks. These stocks usually don’t pay dividends.

4. Balanced funds

Balanced funds invest in a combination of fixed income securities and equities. Above all, these funds target on achieving higher returns against losing money in risky situations. Almost all balanced funds follow a formula of splitting money among various types of investments. They are less risky to invest in if compared with pure equity funds. But they are riskier to invest in than fixed-income funds. 

5. Index funds

How much money should I invest in mutual funds

Index funds focus on tracking the performance of a specific index like the S&P/TSX Composite Index. The value of an Index fund will be directly proportional to the growth of the index. In the case of Index funds, a portfolio manager doesn’t have to make too many investment decisions or conduct much research. As a result, these funds are less expensive than actively managed funds.

6. Speciality funds

Speciality funds aim at specific mandates like socially responsible investing, real estate, or commodities. For those who are unaware of a socially responsible fund, it generally invests in firms that support diversity, environmental stewardship, and human rights. It may also avoid investing in firms involved in weapons, military, gambling, alcohol, and tobacco. 

7. Fund-of-funds

It will probably sound odd, but Fund-of-funds are mutual funds that invest in other funds. Like balanced funds, they also try to make asset diversification and allocation easier for you. The MER for these funds tends to be higher in comparison with stand-alone mutual funds.

How do I choose a mutual fund?

How do I choose a mutual fund?

Before choosing a mutual fund, you need to look at the following factors

1. Long-term vs. Short-term 

Before buying an MF, be ready for the aim and risk of investment. Do you want to opt for long- term investment or short-term? A long-term investor holds the investment in a specific fund for a minimum of 10 years.

In this case, the investors execute a buy and hold strategy. It is also known as the ‘lazy portfolio strategy.’ Long-term investors typically invest in aggressive funds as these funds hold more equities and fewer bonds.

A short term investor invests in a short-term debt fund for about 1-3 years. Such funds give relatively stable returns, but they also come with a moderate amount of risk. You can consider these funds as an alternative for your FDs (fixed deposits) of an equivalent time-period.

If you want to opt for a short-term investment, then hold the investment for at least three years to save up more on taxes.

2. High Turnover Ratios

Before taking an investment decision, most importantly, check for turnover ratios, as it specifies the quality of the MFs. To calculate the turnover ratio, one has to check for the replacement of shares throughout the year. The more turnover leads to higher trading and tax cost, but then again, only if all the other factors are equal.  

3. Portfolio manager/analyst:

Portfolio managers will help you to invest in mutual funds that best suit your financial needs. They will ensure that you gain profits with minimal risk involved. Portfolio managers guide the investors about the risks involved in particular funds. They put in money on behalf of their clients. You should check the track records of several portfolio managers before finalizing one to handle your investments.

4. Do not put all eggs in the same basket:

By this, we mean when you are not sure about the market and unable to make a judgment, then better go for diversification of the assets. The investor can invest in different companies of dissimilar sectors through an MF. 

5. International funds:

International funds or foreign/overseas funds mean investing in the firms of the other country. One who believes in diversification and wants exposure to multiple geographies can invest in such funds.

Common Approaches for Investing in Mutual Funds

The following are the four conventional approaches to gain more profits from investing in funds:

average return on a mutual fund

1. Technical analysis 

Technical analysis involves studying the past market data and attempting to speculate the direction of investment costs. 

2. Bottom-up approach 

The bottom-up approach aims at choosing companies that are performing well, irrespective of the prospects surrounding the economy or their industry. 

3. Top-down approach 

The top-down approach involves finding nations or industries which seem to perform well in the upcoming times. In short, this approach focuses on the bigger economic picture. 

4. Combo of bottom-up and top-down approaches

In this approach, a portfolio manager chooses the nations to invest in based on the top-down analysis. It builds a portfolio of stocks within each nation based on the bottom-up analysis.

Conclusion

Mutual funds are better than any other type of investment opportunity related to the stock market.

They can be used to cut down on your taxes as well. (But please be aware that how mutual funds attract taxes too)

The ROI and risk factors of any two funds may not be identical, even if they are of the same type. You may consult a financial advisor to help you decide the types of funds that would meet your interests and needs.

While this should give you a brief idea of mutual funds, questions like “How much money should I invest in mutual funds?”Which is the best performing mutual fund? – are better answered by yourselves or through our portal. But feel free to ask us any questions you have, and we will try to answer.

Published on December 18, 2019