Understanding Mutual Funds: Types and How They Work
What Are Mutual Funds?
Mutual funds pool funds from several investors and invest in a diversified portfolio of securities. These professionally managed funds offer a way for individuals to invest in a variety of assets, including stocks, bonds, and money market instruments.
Mutual fund investing offers instant diversification, and the fund’s holdings help mitigate risks. In India, mutual funds are regulated, which makes them transparent and highly popular with new and experienced investors.
How Do Mutual Funds Work?
In mutual funds, investors are allocated units based on the fund’s Net Asset Value (NAV).
NAV in a mutual fund is the per-share value of the fund. Investors are allocated units based on their total investment and the NAV of the fund. Calculating NAV involves dividing the total asset value of the fund by the number of outstanding shares. For instance, if the total asset value of the fund is Rs. 1 crore and the fund has 1 lakh outstanding shares, the NAV is the total asset value (Rs. 1 crore) divided by outstanding shares (1 lakh), which is equal to Rs. 100. Meaning, the NAV of the fund is Rs. 100.
Types of Mutual Funds
A. Based on the Fund Structure:
- Open-Ended Mutual Funds: These funds allow investors to buy or sell units at any time directly from the fund house. They do not have a fixed maturity date and continually issue and redeem units based on investor demand. Open-ended funds provide high liquidity and flexibility for investors.
- Closed-Ended Mutual Funds: Closed-ended funds have a fixed lock-in period, and their units are typically bought and sold on stock exchanges like shares. These funds have a limited number of units issued during their initial offering, and after that, investors can only buy or sell units through secondary market transactions. Closed-ended funds may trade at a premium or discount to their Net Asset Value (NAV).
B. Based on Asset Allocation:
- Equity Mutual Funds: These funds primarily invest in stocks or equities, offering the potential for higher returns but also higher risk. They are suitable for long-term investors aiming for capital appreciation.
- Debt Mutual Funds: Debt funds invest primarily in fixed-income securities like government and corporate bonds. They are considered lower risk compared to equity funds and are suitable for investors looking for a stable income with lower volatility.
- Hybrid or Balanced Mutual Funds: These funds invest in a mix of both equities and debt instruments. They aim to provide a balance between capital appreciation and income generation, making them suitable for investors with a moderate risk appetite.
- Money Market or Liquid Mutual Funds: Money market funds invest in highly liquid, short-term debt instruments like Treasury Bills and commercial paper. They offer high liquidity and stability, making them suitable for parking surplus funds or short-term goals.
- Sectoral and Thematic Mutual Funds: These funds focus on specific sectors or themes, such as technology, healthcare, or infrastructure. They are more specialized and carry sector-specific risks.