Importance of Mutual Funds

“Mutual funds (MFs) are subject to market risk. Please read all scheme related documents carefully before investing,”

If you are like most investors, this was your first introduction to MFs.

Today, mutual fund schemes are an incredibly popular investment choice. This is because they are diversified, professionally managed, and promise a good risk-return trade-off. The higher the risk you take, the greater the returns you can potentially make.

MF categories allow you to choose a scheme entirely based on their investable amount, risk tolerance, financial goals, investment term, etc. Finding the right investment instrument that aligns with your financial goals and risk tolerance is no easy task. But, if you understand the basics and do your homework, you can have a financially rewarding investment experience.

So let us look at how these schemes work and the benefits of investing in mutual funds.

How do MF schemes work?

A mutual fund pools money from various investors. The accumulated wealth is then invested in securities like government bonds, company stocks, money market instruments, corporate bonds, etc., as per the scheme’s investment objective.

While investing in MF schemes, you share the profit and loss with other investors in the pool. Here, you receive regulative safety from the Securities Exchange and Board of India (SEBI) and professional management from a fund manager.

Since you invest in a fund comprising numerous assets, you never risk putting all your eggs in one basket. Besides, the mutual fund house is responsible for fund management, tracking market movements, and research.

Asset Management Companies (AMCs) manage your MF scheme, and the fund manager selects investments to build a diversified portfolio. With professional fund and investment management, your scheme is more likely to outperform other financial vehicles.

When you contribute to the pooled fund, the fund house allots your units. These units have Net Asset Value (NAV) per unit. Here, NAV denotes the fund’s market value on a given day.

The portfolio’s value hinges on the price movements of the assets. It is calculated by dividing the net of liabilities, expenses, and income accrued by the outstanding units in the scheme. A higher NAV reflects gains, and a lower NAV means portfolio value incurred a loss.

What are the average returns I can earn?

The returns you earn will depend on factors like:

• Type of scheme
• Fund manager’s expertise
• Overall market performance

While debt funds deliver an average return of 8-9%, equity funds can offer returns as high as 12-14%. Do note that you have to pay an expense ratio on your portfolio. Thus, your effective returns are slightly lower than the ROI of the scheme.  

Additional Read: What kinds of investors should opt for mutual funds?

Benefits of investing in mutual funds

#1 Liquidity

Let’s assume you want to sell your property to get some cash in hand. How long will it take you? From timing the sale properly to getting paperwork in order, it can take you anywhere from a few weeks to a few months.

But in the case of MF investments, converting your assets to cash is much easier. Unlike traditional financial instruments, you can redeem your units at any point in time. You can even sell your fund units when the share market is bullish and make a profit.

While MF schemes offer flexibility in buying and selling, you should consider factors like exit-load and pre-exit penalty before retrieving your money.

#2 Portfolio diversification

The importance of mutual funds in diversifying your portfolio is unparalleled. Why? Because they allow individual investors to invest in asset classes otherwise inaccessible, such as government bonds.

Besides, since the performance of equity funds depend on the stock market movement, your investment value never shoots or drops in tandem. In MF schemes, your fund manager spreads your investments across industries, stocks of companies, and sectors.

In this way, you gain maximum exposure at minimum risk. How? When an asset class value is in decline, your investments in other sectors can minimise overall loss. This helps safeguard your investment interests and makes your portfolio’s performance relatively less volatile.

#3 Smaller initial investments

For investing in MF schemes, you don’t necessarily have to shell out a large sum of money. You can even start investing with as little as Rs. 500 in Systematic Investment Plans (SIP). This reduces your initial investment costs and allows you to spread your investments across the lows and highs of the share market. 

If you have a regular income, do invest in SIPs. Here, a fixed amount gets automatically debited from your account either monthly or quarterly. To figure out an ideal SIP amount and estimate how much your MF investments can fetch you, you can use Tata Capital Moneyfy’s SIP calculator.

#4 Costs incurred

A significant benefit of mutual funds is the low costs involved. Before starting your investment, you can compare the expense ratio of various MF schemes and select the one with the lowest percentage. Here, the expense ratio denotes the annual maintenance charges applicable on MF schemes. These costs include management fees, annual operating costs, advertising costs, allocation charges, etc.

Moreover, if you purchase multiple fund units at once, the commission charges and processing fees will be lower than buying a single fund unit.

#5 Tax efficiency

Now, let us look at the importance of mutual funds as a tax-saving investment avenue. Under Section 80C of the Income Tax Act, the Equity Linked Savings Scheme or ELSS qualifies for tax exemption up to Rs. 1.5 lakhs. ELSS generates favourable returns at a short lock-in period of 3 years.

Additional Read: Understanding Mutual Fund Terminologies

Different types of MF schemes

#1 Equity funds

Equity funds primarily invest in stocks of different companies. Here, factors like revenue forecasts, company policies, earnings, management changes, and economic policies impact overall returns and price movements. They can further be categorised into the following:

#2 Debt funds

You invest in fixed-income securities like corporate bonds, treasury bills, government securities, commercial papers, and other money market instruments through debt funds. Market fluctuations do not usually impact the returns on debt securities. These low-risk investment avenues have a pre-defined interest rate and maturity period.  

#3 Balanced funds

Balanced funds allocate the assets in both debt and equity instruments. These funds are considered to deliver an excellent risk-reward balance since they allow good capital gains at the lowest possible risks.

Typically, fund managers fill 40%-60% of the fund’s portfolio with equity securities and the rest with debt vehicles. Therefore, the NAV is comparatively less volatile. Thus, if you want to leverage market movements with a low-risk potential, these equity-oriented funds serve the purpose.

Things to know about MF schemes

#1 Charges

You have to pay a fee for the professional management of your fund’s portfolio. This charge, coupled with other expenses, is deducted from the MF scheme’s net assets and can bring the NAV of the fund down. And fund performance is not dependent on higher management fees.

So, comparing different MF schemes and their additional charges before making an investment is a must.

#2 Dilution

Similarly, while diversification can minimise your potential risks of loss, it can also dilute your profits. To avoid this, you should invest in limited MF schemes simultaneously.

#3 Fund’s performance

Before investing, review the ratings and advertisements issued by companies. These give you a solid idea of a fund’s past performance. But, remember that excellent past performance does not guarantee similar returns in the future.

Summing up

As you can see, the benefits of mutual funds are compelling enough for investors of all categories and risk appetites. Investing in MF schemes helps you generate long-term wealth on a sum otherwise left idle in your account. These funds suit diverse life goals, right from growing your wealth to creating a safety net for retirement.

You will have schemes for aggressive, first-timers, risk-averse, or seasoned investors. However, when you invest your hard-earned money, duly consider your investment goals, income, and risk-taking capacity.

Are you looking for a smart and reliable partner in your investing journey? Download Tata Capital’s Moneyfy app. Set goals, check out the top-rated mutual funds, compare investment options, and invest in the most suitable financial vehicle.

Happy investing!