What is a mutual fund, a simple explanation

The most popular & simplest way to invest in equity market and earn returns more than 8% returns which is a normal PPF or Fixed Deposit rate is of course Mutual funds but a very few people know the purpose of this instruments or know how does it work. There are around 40-50 mutual fund companies offering around 1000 different types of fund, a retail investor becomes confused as to is he doing right by investing in mutual funds & he does not have an idea what should he choose.

What is a mutual fund?

Suppose there are 100 people who have little knowledge about investing want to invest in equity markets but they want to invest only Rs 1000. Now they have also learnt from media and by reading newspapers that one need to invest in different stocks and stocks from different sectors to diversify their risk and also maintain an asset allocation between debt and equity. They have also learnt that just like a doctor take care of a person’s physical health, they realised the need of fund manager to take care of their financial health, i.e their investment money. Now with Rs 1000 it is impossible for them to invest in shares of 15-20 companies and also invest in debt. Just to support with an example, they can’t buy Infosys of Rs 3000 with his investment amount of Rs 1000. Even all other 99 investors are also facing the same problem. So all 100 investors decided to pool in their money of Rs 1000 each and make it lump sum to Rs 100000 & gave it to a professional fund manager to manage their investments in different stocks and debt. And the fund manager decided to charge a nominal fee for his professional services. By this, the investors were able to diversify their portfolio and also get professional advice. Now, this fund managed by professional expert is known as mutual fund.

In all mutual funds schemes, there are units allotted to an investor unlike number of shares allotted to an investor in company. So if someone wants to invest Rs 10,000 in one of the schemes of a mutual fund and price for a unit is Rs. 20, he gets 500 units of that particular scheme of mutual fund, and as the equity market grow, the mutual fund investment grows and thus his per unit value grows which is called Net asset value (NAV) which you read in various financial dailies & on money control website.

Benefits of investing in Mutual Fund

Now talking about the benefits of mutual fund investment. The biggest advantage is the Diversification by which you are able to invest in various stocks across various sectors. He therefore minimizes his risk by dividing his investments in many shares of various sectors. There are also categories of fund, i.e balanced funds by which you are also able to diversify your portfolio in equity as well as debt.  Another advantage of investing in mutual funds is that the investor gets investment decisions from an expert and the cost of managing funds is minimal and one can liquidate his invest anytime apart from ELSS schemes where the lock in period is 3 years from the date of investment.

A fund manager can invest their corpus in different type of financial instruments ranging from shares, debentures, gold, FD, money market instruments and can maintain some cash also during bad economic times.There are two categories of mutual funds.

1. Open-ended: One can buy and sell mutual fund at any time

2. Close-Ended: Buy and selling points are restricted for some time.

What is NFO?

NFO stands for New Fund offer. Any new mutual fund which is offered to the public for investment is called NFO. Generally, NFO’s are more risky than the existing mutual funds as they don’t have any past record of performance or the track record of fund manager efficiency. One must avoid NFO even when they are highly publicised by the mutual fund companies and by the media.