How to Invest in Mutual Funds?

Summary

• Mutual funds are an excellent tool of wealth creation for passive investors
• It is a cost-effective method to take exposure in the capital markets without much expertise
• Mutual funds could be bought with little money in the pocket and provides the investor diversification as well as exposure to various sectors

Mutual funds (MFs) are of immense importance when it comes to managing your wealth. For a know-nothing investor, who lacks the understanding of the capital markets and businesses; does not have the time to follow the market, it is a good idea to consider taking exposure in these markets through pooled investments such as Mutual funds.

Mutual funds are passively managed funds. Investment in these funds provides the investor diversification as well as exposure to various sectors and different realms of capital markets. Hence, by investing in these funds, a layman could easily diversify his portfolio without much effort.

Why Mutual funds?

Mutual funds are professionally managed; however, one needs to note that big returns can never be guaranteed in any investment, including these. It can be said that the asset/investment managers have professional knowledge, and the returns depend upon the strategy which they deploy. However, the lack of expertise and access to market insights or tools could deter individual investors from reaping benefits.

Another thing to consider for investors seeking regular income is dividends. A stock might pay or slash/cancel its dividend like many companies have done in recent times to preserve liquidity and stay afloat during these unprecedented times. Mutual funds distribute income or allow to reinvest for cumulative growth based on the earnings by the fund from the stock they hold.

Mutual funds offer portfolio diversification for the investors, as it has a huge basket of securities. The gains and losses made by each security are offset, resulting in an overall positive or negative return on the investment. Using diversification in stocks is possible; however, it would require comprehensive analysis and expertise; or guidance from a financial adviser. Notably, investment in mutual funds could be made with little money in the pocket.

Do read: Investors Need Not Miss These Top 5 Online Share Dealing Accounts

A stock market index is a snapshot of a majority of businesses trading in an economy. These businesses produce goods & services across the economy. With generations passing by, we tend to consume more products & services in comparison to the previous generation. Therefore, with the passage of time, the value of the index is likely to rise. Therefore, for a passive investor, investing through mutual funds could be a good starting point.

Mutual Funds are excellent instruments for long-term investor’s wealth creation, yet they do have certain advantages and disadvantages when compared to directly investing in stocks and other financial instruments. The main advantages of mutual funds are that they extend to the investor economies of scale, greater diversification, liquidity in comparison to direct investing and that they are managed by expert fund managers. On the other hand, they could be a touch more expensive than active investments in securities on account of the fees and expense ratio they charge.

Also read: What do you Look for Before Investing in an Index Fund or an ETF?

Basic things you need to understand before investing in MFs

A mutual fund is divided into units, with each unit having a predetermined face value. In the United Kingdom, it is in the form of unit trusts, a fund of money, which is divided into units. Investors participate in Mutual funds by buying these units, the value of which could either go up or come down depending on the performance of the mutual fund. The value of a unit at any time is known as its NAV or Net Asset Value, and this is the price per unit which the investor must pay to subscribe to a fund. An investor will be able to subscribe to a fund at face value per unit only during the initial offer period of the fund. After that, when units are offered on a continuing basis, investors will have to purchase additional units always at the applicable NAV on any given day. Unlike ETF’s, mutual funds are not exchange traded. One can buy them directly from asset management companies. This means that mutual funds have a lesser liquidity risk in comparison to ETFs.

In addition, before investing, it is important to read the terms and conditions between the lines. For instance, is the fund open-ended (no lock-in period) or closed-ended (one might have to stay invested for a specific tenure).

Open-Ended Mutual Fund – In this type of fund investors can freely enter and exit the fund as per their convenience. Owing to the above, the number of units outstanding goes up and down any number of times, thereby increasing or decreasing the size of the fund. The units of the fund may be bought and sold at the NAV (Net Asset Value) prevailing at the time of purchase or redemption.

Close-Ended Mutual Fund - In this type of fund, the fund only issues units once, and subsequent buying and selling of units take place among investors in a secondary market for these units, much like shares. Since the units, in this case, have a secondary market of their own, they are not bought and sold at their NAV (Net Asset Value), and their prices are determined by the forces of demand and supply prevailing in the market, which may value the units at a discount or a premium to its NAV.

Types of Mutual Funds classified according to their investment objectives

You might have come across several mutual funds on several online share dealing applications and websites. These schemes are tailormade and linked to a specific investment objective. Broadly, mutual funds could be classified into three categories: Equity, Debt, and Mixed.

• Equity Funds

An equity fund is a mutual fund that invests majorly in the equities. Within this style of fund, there can be many a sub-division with each seeking a differentiated objective. The most common is the plain vanilla type of fund which seeks long term capital appreciation along with dividend income. These funds might be suitable for investors who are young or might have a higher risk appetite.

• Debt Funds

These funds are dedicated to debt products and invest a large portion of their funds into debt securities both the government as well as corporates. These types of funds are generally less risky than equity funds and provide lesser returns. Within this style of fund as-well, there can be many a sub-division with each seeking a differentiated objective. These funds might be suitable for investors who are in the middle to older age bracket or might have a lower risk appetite.

• Mixed Funds

These types of funds usually invest in both debt and equity, albeit in varied proportions which put their risk profile between a pure debt fund and a pure equity fund. This characteristic makes these types of funds well suited for investors who want to diversify their risk among the two classes of securities. Within this class of Investment funds, there are broadly two types of funds. These funds might be suitable for investors who are in their mid-career or might have a medium risk appetite.

For a passive investor, investing in mutual funds could be a great starting point. Regular income-seeking investors can opt for dividend-paying mutual funds. Some sectors such as technology, pharmaceuticals, utilities, and essential services had been up and running during the unprecedented times and could be evaluated. Investors who are looking to take indirect exposure into these stocks might consider sector equity mutual funds. The bottom line is that the investor needs to find a way of investing in the index through cost-effective method because even a small percentage of expense ratio could burn a bigger hole in the pocket. Notably, every investment vehicle has a specific purpose as they all have different risks involved.