What is a mutual Fund?

Hello Readers,

Trust you are all are safe, amid COVID 19. COVID 19 has rendered our economy in a very bad position, the stock market has fallen like anything. To capitalize this fall, I was going through various investment opportunities. What I realized is there are a plethora of instruments available in the market. One which particularly fascinated me was the Mutual Fund. I have done a lot of research on it and came across nitty-gritty of the mutual fund. So I decided to share my research on this platform.

In the Mutual fund industry, there is one disclaimer that you will come across every time, 'Mutual Fund investments are subject to market risks. Read all scheme related documents carefully'

Just like that our discussion on MF also comes with a disclaimer 'Creation of this content is for learning purpose only. The same is created based on publically available information and should not be considered as investment advice. Readers must seek advice from their financial advisors before taking any investment decisions based on the views expressed in this article. The creator of this content shall not be held responsible in any way by the use of the information'

So with this disclaimer, let's start our discussion.

1) What is Mutual Fund & How it works?

Let's understand the entities involved in the industry and how they are interlinked,

Sponsor - Sponsor is the promoter of the mutual fund. The sponsor brings in the capital and creates a mutual fund trust and sets up the AMC. A sponsor could be a bank, a corporate or a financial institution
AMC - Asset Management Company. AMC is the face of a mutual fund. An AMC is a company that manages a mutual fund.
Unitholders/Investor - In simple language, Unitholders are the person who buys the units of the mutual fund.

Generally, Unitholders buy/sell units of mutual funds for money. Units are just like a commodity that a unitholder buys at a lower price and later sells at a higher price to earn a profit.

The whole process of buying and selling of mutual fund units is done through RTA

R&TA - Registrar and Transfer agent. It is an entity tracking the daily purchases and sales of mutual fund units. R&TA maintains records of the unitholders' accounts. A fund may choose to hire an independent third party who is registered with SEBI to provide such services CAMS, Karvy so on and so forth.
Fund Managers - Now, once the money is pooled in, The AMC hires a professional money manager known as Fund Manager, who manages a fund i.e buys and sells securities in line with the fund's stated objective. So technically AMC essentially collects money from the public and makes it as a pool of funds and fund managers manage it.
Custodian - Managers will be buying and selling the securities as per the stated objective of the fund, such securities will be with Another Entity known as Custodian, who will hold those securities in safekeeping, settle securities transactions for the fund, collecting interest and dividends paid on securities and record information on corporate actions like stock splits, bonus issue, etc.
Regulators - Finally, Regulators come into the picture - SEBI & AMFI

SEBI - Securities Exchange Board of India - It supervises and monitors the whole mutual fund industry to protect the interest of the investor
AMFI - Association of Mutual funds in India is an SRO (Self-Regulatory Organization). It is dedicated to develop the Indian Mutual Fund Industry on professional, healthy and ethical lines and to enhance and maintain standards in all areas to protect and promote the interests of mutual funds and their unitholders.

Now, you are aware of all the entities involved and the structure of the Mutual Fund. Next question is how they earn,

Well, the Fund managers managing the fund will take a series of investment decisions to earn from the investment made and appreciate the value of the assets managed. Such series of the decision will result in a change of Net Asset of the fund, which in turn will change NAV (Net Asset Value).

The unitholders will redeem their units at higher NAV to earn a profit.

For example, Mr. A bought 100 units at NAV of 100 RS. The fund earned a return of 15% then the NAV of the fund will be 115 RS. When Mr. A will redeem his units at the new NAV of 115 RS, he will earn 15 RS per unit i.e. profit of 1500 RS.

2) Classification of Mutual Fund

Now since you are aware of how it works, let us dive into the different type of mutual funds,

1. Based on the asset class

Equity Funds: These are funds that invest in equity stocks/shares of companies. These are considered high-risk funds but also tend to provide high returns.
Debt Funds: These are funds that invest in debt instruments e.g. company debentures, government bonds, and other fixed-income assets. They are considered safe investments and provide fixed returns.
Money Market Funds: These are funds that invest in liquid instruments e.g. T-Bills, CPs, etc. They are considered safe investments for those looking to park surplus funds for immediate but moderate returns.
Balanced or Hybrid Funds: These are funds that invest in a mix of asset classes. In some cases, the proportion of equity is higher than debt while in others it is the other way round. Risk and returns are balanced out this way.
Sector Funds: These are funds that invest in a particular sector of the market e.g. Infrastructure funds invest only in those instruments or companies that relate to the infrastructure sector. Returns are tied to the performance of the chosen sector. The risk involved in these schemes depends on the nature of the sector.
Index Funds: These are funds that invest in instruments that represent a particular index on an exchange to mirror the movement and returns of the index e.g. buying shares representative of the BSE Sensex.
Tax-Saving Funds: These are funds that invest primarily in equity shares. Investments made in these funds qualify for deductions under the Income Tax Act. They are considered high on risk but also offer high returns if the fund performs well.
Fund of funds: These are funds that invest in other mutual funds and returns depend on the performance of the target fund.

2. Based on structure

Open-Ended Funds: These are funds in which units are open for purchase or redemption throughout the year. All purchases/redemption of these fund units is done at prevailing NAV. These funds are preferred since they offer liquidity to investors.
Close-Ended Funds: These are funds in which units can be purchased only during the initial offer period. Units can be redeemed at specified maturity date. To provide for liquidity, these schemes are often listed for trade on a stock exchange.

3. Based on the investment objective

Growth funds: Under these schemes, money is invested primarily in equity stocks to provide capital appreciation. They are considered to be risky funds ideal for investors with a long-term investment timeline.
Income funds: Under these schemes, money is invested primarily in fixed-income instruments e.g. bonds, debentures, etc. to provide capital protection and regular income to investors.
Liquid funds: Under these schemes, money is invested primarily in short-term or very short-term instruments e.g. T-Bills, CPs, etc. to provide liquidity. They are considered to be low at risk with moderate returns and are ideal for investors with short-term investment timelines.

3) Options in a mutual fund Growth vs. Dividend

In Mutual funds, there two option available for all schemes Growth and Dividend which can affect the yield, so let us understand the same,

Growth Option - In this option, the scheme does not pay any dividend, but continues to grow. The aim of the scheme is capital appreciation

Dividend Option - In this option, the Mutual Fund scheme pays you from the profits made by the scheme. In the case of debt funds, it pays a dividend at regular periods, which could be monthly, quarterly, half-yearly or yearly in case of equity funds at irregular intervals.

Now, the question is which plan is better? The answer to this question is subjective, it differs from case to case. If you do not need any money in the interval and want to earn a better return on your investment than growth option will be a preferable option for you. If you are a retired individual, who wants money for a smooth living then the Dividend option will suit you.

Further, from my point of view, if you can invest the money in some instrument generating more return than the return provided by the scheme, the Dividend option will be preferable. If you do not have better avenues to invest, then the growth option is preferable.

For Example, if the fund is providing a return of 15% and you have another avenue to invest where the return is more than 15% say 20% then dividend option must be preferred and Dividend must be invested in other avenues for a better return. On the other hand, if you have another avenue to invest where the return is less than 15% say 10% then the growth option must be preferred.

I would like to quote Warren Buffet, 'My wealth has come from a combination of living in America, some lucky genes and compound interest'

Because of the effect of compound invest the NAV of a fund under growth option is always more than the dividend option.

In case if you do not fill any of the options, it will select the default option for the scheme as mentioned in its scheme information document, hence we should read all scheme related documents carefully, at this juncture we could recollect the disclaimer that 'Mutual Fund Investments are subject to market risk. Read all scheme related documents carefully.

Let us take a small pause now, I am writing another article in continuation on Mutual Fund and will cover of the topics like, various terms/jargon related to Mutual Funds (i.e NAV, Sharpe Ratio, Beta, Standard Deviation, Factsheet, etc.), different alternatives to invest in mutual fund (i.e Direct and Regular) and finally, I will share information on how to select a mutual fund scheme, which is divided into two steps 1. Internal Analysis and 2. External analysis. Stay tuned.

Further for more detail, you can check out my videos on mutual fund on YouTube Link
https://www.youtube.com/watch?v=XkWtxybObNI&list=PLcMH3ecLLtaEj8deXmAsSeNTFLKtVyB4J