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Know what is mutual fund before investing

Author: Team Finapolis/Monday, January 15, 2018/Categories: Mutual Funds

Know what is mutual fund before investing

With the aim to bring uniformity in characteristics of similar type of schemes, the Securities and Exchange Board of India in October 2017 classified mutual funds (MF) into five categories. The schemes have been broadly classified into equity, debt, hybrid, solution oriented and others.

“This (classification) would ensure that an investor of mutual funds is able to evaluate the different options available, before taking an informed decision to invest in a scheme,” said Sebi in a statement.

However, before investing in MFs, it is important that every investor understand what is mutual fund.

A mutual fund is a mechanism to collect money from multiple investors. This pooled fund is invested in securities such as stocks, bonds, money-market instruments and other similar assets. In the best interest of the investor, the investments are spread across various industries and sectors to diversify the risk. Those who have invested get units of the mutual fund. Thus, investors of mutual funds are also called unit holders.

The income from the mutual fund is distributed among all the investors based on the ‘net asset value’ (NAV) of the scheme.

The Association of Mutual Funds in India (AMFI) describes NAV as the combined market value of the shares, bonds and securities held by a fund on any particular day after deduction of the expenses and charges. “NAV per unit represents the market value of all the units in a mutual fund scheme on a given day, net of all expenses and liabilities plus income accrued, divided by the outstanding number of units in the scheme,” states AMFI. As the market value of securities change every day, NAV also changes regularly.

There has always been a contention between investing in the share market directly and putting money in a mutual fund. While investments in equity requires a lot of research and constant monitoring of the share market movement, mutual funds is one of the ideal investment options for those who find it difficult to research the market before investing. The funds are managed by managers who are professionals with in-depth knowledge of the market. The fund houses are regulated by the Securities and Exchange Board of India (SEBI). Also, mutual funds are also favourable for those who do not always have a large sum of money at their disposition for investing.

A mutual fund should be selected depending on the need of the investor. While selecting a scheme priority should be given to what best suits the investor’s need such as income schemes, liquid schemes, tax saving schemes, equity schemes etc.  

Here are some things to know before investing in mutual fund:

Investing objective – The first step to investing in mutual fund is to identify the reason why the investor is looking to invest. This may vary from tax saving objective to growing your wealth. Similarly, the objective varies with age and propensity to take risks. For example, for a retired person or senior citizen the objective of investment could be to draw a periodic income payment from the mutual fund and also which is the least risky in nature. On the other hand, a salaried person may want to invest to save taxes. The investment objective determines the role a specific fund will play in the investor’s portfolio and how well it fits with his overall investing strategy.

Time horizon – Performance of mutual funds over the years have revealed that the longer the time of investment, the higher is the yield. This is because risks are spread out over a period of time. Those who invest for a shorter period of time have to settle for lower return on the investment.

Prioritising goals – Just like goal setting in personal life can help you achieve your needs, setting priorities can help you attain the desired results. Alot of decisions depend on the investor’s goals. Hence it is important to first set these goals before investing.

Liquidity requirements – Liquidity refers to how quickly an investment can be converted into cash. These needs will affect the type of investment one chooses to meet the goals. For example, if a person doesn’t have any short term liquidity needs, then he can afford to invest in less liquid investments where the potential for gain is much higher than liquid investments.

Scheme type – Choosing the scheme type also depends on the investor’s need from the investment. Each scheme has a different risk and return characteristics. For instance, an investor looking for growth will find equity oriented funds to best suit his needs, whereas an investor who wants regular income will look at debt fund or dividend investment.

Fund performance – One of the primary criterion for choose the fund is its performance. The return that the fund has generated relative to its benchmark should ideally outperform it. Usually the performance of the scheme is seen for a period of 3 to 5 years based on the nature of the fund. 

It is important that you understand what is mutual fund and your priorities before investing in it.

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