Mutual Fund: Definition, Advantages, and Disadvantages of Investing in it

Mutual Fund Definition
Mutual Fund: Definition, Advantages & Disadvantages

Mutual funds are an investment option designed to make investing in securities easier.  mutual funds offer these services through a fund manager who manages the fund instead of you picking stocks, creating a portfolio, and managing it. The fund manager in a mutual fund also pools money from different investors. 

The portfolio of a mutual fund will be according to the theme of the fund. There will be more equity presence in the portfolio if the fund is trying to be aggressive. Similarly, there will be more debt presence in the portfolio if the fund is trying to be conservative. 

Investing in mutual funds also makes monitoring and management of portfolios easier. The help of the experienced fund manager is available here as well.

Ease of investing is the biggest advantage of a mutual fund. One major disadvantage would be a lack of choice in the portfolio since a fund manager handles the same. 

What is a mutual fund?

A mutual fund is an investment vehicle where money is pooled from different investors to invest in a portfolio made of different security categories like stocks, debts, commodities, currencies, etc. Every fund will have a goal. The fund manager appointed to manage the fund will create a portfolio according to this goal. 

Mutual funds give investors an option to invest without much hassle. If you plan to invest directly, you will need to pick stocks according to your goals and risk appetite, create a portfolio and then monitor the same. Your role is limited to finding a mutual fund that suits your goal when it comes to a mutual fund. Mutual funds also don’t require regular intervention or monitoring most of the time. 

How does a mutual fund work?

How a mutual fund works are simple. Fund houses create mutual funds and appoint fund managers. Every fund will have a theme. The manager then creates a portfolio according to the theme of the fund. For instance, the portfolio will have more equity presence if the fund’s theme is aggressive. Then, the fund house will advertise the mutual fund. Investors with an investment horizon that matches the fund’s theme will be interested. The fund manager then pools these investors’ money and invests it in the portfolio.

From an investor’s point of view, they will need to find a mutual fund that matches their goals and invest either directly or from a broker’s website. 

How to buy a mutual fund?

Buying a mutual fund is an easy process. Below are the steps you follow.

buy a mutual fund
How to buy a mutual fund?
  1. Find a mutual fund that works for your goals. You may use resources on the internet for the same.
  2. Measure your risk tolerance. This refers to determining if you like to keep things safe or take certain calculated risks and whether you have a high or low tolerance for risk. You can tolerate market volatility and make investment decisions depending on your risk tolerance.
  3. You must look into the mutual fund schemes and AMC’s historical performance. You must select a mutual fund company with a sizable amount of assets under management (AUM).
  4. Mutual funds are sold in units. You will need to fix many units to buy or how much money to invest, and the right number of units will be automatically credited when you buy.
  5. There are two ways to invest in a mutual fund – direct and indirect. You will need to choose a method in the second step. The direct method means more processes as you need to buy the fund units from the fund house website without the help of an agent. The indirect method is buying through agent/broker websites, but more charges will apply.
  6. Sign up on the website you chose and complete the registration. You will need to submit your identity and address proof in this step.
  7. Once you are signed up, choose the amount to invest. The units, according to the amount you have chosen, will be automatically credited to you. 

The amount you invest is more important than the units you buy for mutual funds. 

How to sell a mutual fund?

You can sell your mutual funds units in three main ways – through the AMC, through a broker, and through the offline process. You can choose to redeem through AMC if you have invested from their website. Similarly, you can choose the broker website if you have invested through them. The offline process is viable, but the process could be strenuous. 

You can follow the below steps to sell your mutual fund units.

  1. Login to the website from which you bought the mutual funds.
  2. Choose the mutual fund investment you want to redeem if you have multiple investments.
  3. Choose the amount of wish to withdraw and redeem.
  4. Units in accordance with the amounts will be automatically redeemed, and the money will be credited to the account from which the investment was made. 

Some mutual funds come with a lock-in period. It is a period when selling mutual funds units are prohibited. Ensure you keep this information in mind while trying to sell mutual funds. 

What are the advantages of a mutual fund?

Easy to invest and manage; Mutual funds make investing easier. Mutual funds are also easier to invest and manage as well. They don’t need constant intervention also.  

Low cost: Investing in a security comes with broker charges. But when you invest in a mutual fund, the amount of money goes through only one transaction, meaning lesser investing costs, especially in the long term.

Liquidity: If you invest in a mutual fund without a lock-in period, you divest from mutual funds at any point, making it decently liquid. But at the same time, it may take 3-4 days for your redemption process to be complete.

Transparency: Since mutual funds are controlled by centralized authorities like SEBI, everything about mutual funds, including your portfolio, is transparent. 

Flexibility: There are multiple ways you can invest in a mutual fund. For example, you can invest a lump sum if you want to accelerate your corpus and, at the same time, invest every month through SIPS to create a corpus. 

Variety: Mutual funds have an option, no matter what kind of investor you are. For example, if you are an aggressive investor, you could opt for equity investments. On the other hand, if you are a conservative investor, you could opt for a debt investor. 

Diversification: Diversification is a key element that every portfolio needs. It ensures your corpus is protected, and at the same time, there is enough acceleration. Mutual funds are able to provide diversification by default since they invest in multiple securities. 

What are the disadvantages of mutual funds?

Fluctuating returns: Returns from mutual funds are dependent on the securities they invest in. Hence, the returns are often fluctuating, and this may affect investment planning.

Bias: Mutual funds are managed by experienced fund managers. This helps with investors’ portfolio management, but portfolio design could have bias. 

Expense ratio: Mutual funds come with an expense ratio. This is charged to compensate the fund managers. The expense ratio is usually a small percentage of your investigation. This could eat into your earnings, especially if you are earnings are lesser. 

Over diversification: Diversification is the main quality of mutual funds. But there is a risk of over-diversification as well. 

What are the different types of mutual funds? 

Mutual funds are categorized mainly based on the type of asset class the fund chooses to invest in and the investment goals the fund supports mostly in.

different types of mutual funds
Different types of mutual funds

Below are the different types of mutual funds based on the former.

  • Equity funds are mutual funds that primarily invest in stocks of different companies. Similar to the property of stocks, equity funds are also known for their aggressive nature. Equity funds usually work better for long-term investments. 

Equity mutual funds are further broadly categorized into three – large-cap,mid-cap, and small-cap funds. Large-cap mutual funds are equity-focused funds that invest in publicly traded firms with a high market capitalization. These funds are appropriate for investors with a moderate-to-high risk tolerance and a long-term investment objective..Equity funds called Mid Cap Mutual Funds invest in mid-sized businesses. The businesses are among the fastest-growing in India and are in the same position as today’s heavyweights were a few years ago. Small-cap mutual funds are investment options for start-ups or developing companies with market capitalizations under Rs 500 crore.

  • Debt funds primarily invest in different debt instruments, including bonds, government securities, treasury bills, etc. They tend to be more conservative. 

Compared to equity funds, there are many types of debt funds. They are classified as below, according to the Association of Mutual funds in India.

Overnight Funds – Invest in One-Day Maturity Notes (securities)

Liquid Funds – invest in money market products maturing in less than ninety days 

Floating Rate Funds- invest in debt securities with floating interest rates 

Ultra-Short Duration Funds- invest in debt securities expiring within three to six months

Low Duration Fund — invest in securities with maturities within six to twelve months.

Money Market Funds – invest in money market products having maturities of one year or less.

Short Duration Funds – invest in securities maturing in 1-3 years

Medium Duration Funds – invest in debt securities having a maturity of three to four years

Medium-to-Long Duration Funds – invest in debt instruments with a maturity of between 4 and 7 years

Long-Term Investment Funds – Invest in Long-Term Debt (over 7 years)

Banking & PSU Funds – invest in the bank, PSU, and PFI debt

Gilt Funds – invest in various maturities of government bonds

Dynamic Funds – invest across maturities in Debt Funds securities 

Credit Risk Funds – invest in corporate bonds with ratings below the highest.

  • Money market funds have a portfolio mainly filled will short-term fixed-interest securities like currency, treasury bills, etc. They are known for being a conservative option. 
  • Hybrid funds try to give investors a balanced portfolio by investing in equities, debt, and other instruments alike, according to the market situations. Hybrid funds give investors a more balanced portfolio option by default. 

Below is the categorization of funds based on investment goals

  • Growth funds enable you to make the most of compounding by reinvesting your profits back into the corpus. Growth funds mostly do this on a daily basis.
  • Income funds distribute dividends and other profits from the fund at regular intervals.

What are the best mutual funds to invest in?

The best mutual fund to invest in is a subjective topic, and it can depend on an investor’s goals and risk appetite. Having said that, below are some of the most chosen.

  • Axis Bluechip Fund
  • Mirae Asset Large Cap Fund
  • Parag Parikh Flexi Cap Fund
  • UTI Flexi Cap Fund
  • Axis Midcap Fund
  • Kotak Emerging Equity Fund
  • Axis Small Cap Fund
  • SBI Small Cap Fund
  • SBI Equity Hybrid Fund
  • Mirae Asset Hybrid Equity Fund

How to create a mutual fund portfolio?

An investor their mutual fund portfolio according to their investment goals and risk appetite. Hence, they should begin by analyzing the same. Understanding your investment goals give a better idea about which fund to invest in as well. For instance, if an investor is looking to build a retirement corpus, they should ideally select a long-term fund. Since the goal is defined here, making a choice becomes easier. 

Secondly, you should also understand your risk appetite clearly. Risk appetite defines the amount of risk you can afford to take with your investments. If you can take on more risk, you may invest in funds that have more equity presence. At the same time, if you are a conservative investor, a fund with more debt presence will work better for you.

Investors must make a portfolio considering the above two factors carefully. 

Are mutual funds taxable?

Yes. Mutual funds are taxable investment options. Mutual funds are taxed according to their portfolio choices, and it is applied when you divest from a fund most. There are two types of taxes – long-term capital gains and short-term capital gains. Long-term capital gains tax is applicable if you have invested for more than one year. Otherwise, short-term capital gains tax is applicable.

Now, let us consider the tax situation in India.

A flat tax of 15% is applicable if you divest from an equity mutual fund before one year of investment (short-term capital gains). A flat tax of 10% is applicable for the long term.

For the case of debt funds, the long-term capital gain tax is a flat 20%. For short-term gains, the profit is added to your current income bracket and taxed accordingly. 

Does investing in mutual funds have hidden charges?

Mutual funds don’t have any hidden charges since they are heavily regularized. At the same time, one charge investors should be aware of is the expense ratio. 

The expense ratio is the charge levied from investors in a fund for the upkeep of the fund. This includes compensation for the fund manager and profit for the fund house. This is usually a small percentage of the corpus you have invested. Investors are advised to keep a check on this fund as a higher expense ratio could eat into your profits. 

Is investing in mutual funds safe?

Mutual funds are usually as safe as the security they invest in. For instance, choosing an equity mutual fund that heavily invest in securities means it will have characteristics similar to that of equities. Hence, those funds will have higher return potential and higher risk. At the same time, a debt fund primarily invests in debt securities like bonds, government securities, currencies, etc., and shares similar conservative characteristics. 

As far as the trustability of a fund is concerned, all mutual funds are heavily regulated and monitored, and hence they are all authentic and safe to invest in.

Is it better to invest in mutual funds than stock?

Investing in mutual funds could be a better choice for your according to the type of investor you are. You will need advanced stock market knowledge and have to keep a close eye on the markets if you invest directly in stocks. First, you will need to figure out your investment goals and risk appetite. Then, you will need to choose stocks according to that. You will also need to pick the right time to invest in stocks. Even after an investor has bought the stocks, they will need to keep a close eye on how the stock performs and make changes accordingly.

But when it comes to mutual funds, an experienced fund manager takes care of the chores. But the downside is that it comes with an expense ratio, and there could be bias.

In the end, you should choose according to your expertise and preference. 

What is the difference between short-term and long-term mutual funds?

Short-term mutual funds are built for the short term, and long-term mutual funds are built for the longer term, as the name suggests. The portfolio choices of the funds also differ. Short-term funds invest more in short-term maturity securities like debt. On the other hand, long-term funds invest in securities like equities which provide more value to the investor in the longer term.

What is the difference between a pension fund and a mutual fund?

A pension fund is a retirement corpus-building investment option. It helps you build a corpus by allowing you to invest in a systematic way. Pension funds are regulated by governments in most countries.

On the other hand, mutual funds are an easy way to invest. It has a preset portfolio, and an investor can choose mutual funds for any investment goal, including retirement corpus building. 

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