A Guide to Understanding Mutual Funds

A mutual fund is an investment company that pools money from multiple investors to buy a diversified portfolio of stocks, bonds, or other securities.

Origin: The first mutual fund was introduced in 1924
Purpose: Goal-based investing for short-term and long-term objectives

Diversification, Risk-Reward Relationship, Realistic Expectations and Impact of Fees and Taxes

Income: Through dividends from stocks or interest from bonds.
Capital Gains: From the appreciation in the value of the fund’s investments.

1. Stock Mutual Funds – Invest primarily in equities
2. Bond Mutual Funds – Invest in debt instruments
3. Money Market Mutual Funds – Invest in short-term, low-risk securities

Mutual funds make saving and investing simpler, accessible, and affordable:

The price of a mutual fund share is based on its Net Asset Value (NAV)
NAV = Market Value of Fund’s Assets − Fund’s Liability / Number of Shares Outstanding

1. Stock (Equity) Funds

• These funds primarily invest in stocks
• Historically, stock mutual funds have outperformed all other funds
• They are generally suitable for investors with long-term growth goals

2. Bond Funds

• Invests in debt securities issued by corporations or governments
• It is similar to lending money to the issuer in exchange for regular interest payments until maturity, after which the principal is repaid.
• Aims to provide regular income and is usually less volatile
• Unlike individual bonds, bond mutual funds do not have a fixed maturity but maintain an average portfolio maturity.

a) Interest Rate Risk

• • • When interest rates rise, bond prices fall, and vice versa
    • The longer a bond’s maturity, the more its price will fluctuate
    • Bond mutual funds with a longer average portfolio maturity are more sensitive to interest rate changes

b) Credit Risk (Default Risk)

• • • Refers to the issuer’s ability to pay interest and repay the principal
    • If a bond issuer fails to meet its obligations, this is called a default
    • A default can led to a downgrade in the issuer’s credit rating, reducing the bond’s market value and impacting the fund’s NAV

c) Prepayment Risk

• • • Bond can be paid off earlier than expected, often due to falling interest rates
    • Pre-paid money is to be reinvested in bonds offering lower yields, potentially reducing income for investors

3. Tax-Saving Mutual Funds

• These are mutual funds that oƯer tax benefits under specific sections of tax laws
• The income earned may be tax-exempt, depending on the scheme
• It is a strategic decision based on your income tax bracket and financial goals

4. Money Market Funds

• Money market mutual funds invest in short-term, interest-bearing instruments
  • Government Treasury securities
  • Corporate commercial papers
  • State and local government debt
• These instruments typically have maturities of less than 397 days
• The goal is to preserve capital while providing a stable income through interest.
• These funds are ideal for conservative investors seeking liquidity and safety

• Must invest at least 95% of assets in highly rated debt securities.
• Cannot hold securities with a maturity longer than 397 days.
• The average maturity of the fund’s portfolio cannot exceed 90 days.

• Returns may not keep pace with inflation during periods of rising prices
• Though relatively low risk, they are not completely risk-free

• Allows investors to gain exposure to foreign markets
• These funds can access equities and bonds issued by companies and governments outside the investor’s home country.

• Currency risk: Exchange rate fluctuations can impact returns
• Political and economic instability in foreign countries
• Higher transaction costs, taxes, and regulatory diƯerences

An investment company is a corporation or trust that pools capital from investors and invests it in a diversified portfolio of financial securities.

1. Mutual Funds (Open-End Funds)

• Unlimited share issuance
• Fund size fluctuates as investors buy or redeem shares
• Shares are bought and sold at the Net Asset Value (NAV)

2. Closed-End Funds

• Fixed number of shares issued through an NFO
• Shares traded in the open market like stocks
• Market price trades at premium/discount based on supply and demand

3. Unit Investment Trusts (UITs)

• Fixed portfolio of securities (stocks/bonds)
• Limited duration; held until a termination date
• On dissolution, proceeds are distributed to investors

Investment goals vary by individual preferences, risk tolerance, and time horizon.

1. Retirement Planning
2. Education Funding
3. Emergency Reserves and Other Short-Term Financial Objectives

• Time frame: Short-term vs. long-term
• Desired outcome: Growth vs. Stability
• Risk appetite and market conditions

Systematic Investment Strategy

• Involves investing a fixed amount at regular intervals (e.g., monthly)
• Helps average out purchase costs over time
• Buys more units when prices are low and fewer when high

• Bull Market: Sustained period of rising stock prices
• Bear Market: Prolonged decline in stock market values

• Total Return: Includes capital gains + dividends reinvested
• Yield: Net income (interest/dividends) minus fund expenses—shown as a percentage of NAV

A return less than the inflation rate effectively reduces the investor’s wealth over time.

• Ordinary Dividends: Taxed as regular income
• Capital Gains Distributions: Taxed separately; rates vary based on holding period
• Tax-Exempt Funds: Certain funds may provide tax-free income

Tax treatment depends on fund type and the investor’s country-specific tax laws.

By regulation, all mutual funds must provide these to potential and current investors

1. Prospectus: Explains fund objectives, fees, strategies, risks, and procedures
2. Shareholder Reports: Includes fund performance, financials, holdings, and relevant changes

Newspapers, investment platforms, financial magazines, and third-party analyst reports offer objective insights.

1. Shareholder Fees
   • Sales charges (front-end or back-end loads)
   • Redemption or exchange fees
2. Operating Expenses
   • Day-to-day fund management costs
   • Expressed as an Expense Ratio (% of total fund assets)

Lower fees = higher potential returns for investors, all else equal.

• Funds are overseen by a Board of Directors of which at least 40% must be independent directors.
• They act as shareholder representatives

Mutual funds remain one of the most accessible and diverse investment options for individuals. By understanding the principles of diversification, fees, risk, and return, investors can make informed decisions that align with their financial goals and risk appetite.

– By Sahil Jain