Chapter 2A: What are Mutual Funds?
Picture this –
Four friends are heading for dinner and are super hungry. On their way, they discussed and mutually agreed to spend roughly 400 to 500 per person on this all-inclusive meal. Setting up a total budget of around 2000/- all incl, they reach the most famous pizza joint around the street, selling the best pizzas in the city.
They decide to enter the restaurant, and to their surprise, they find out that they only sell a large 12” loaded pizza, which costs around 2000 rupees for the entire pizza, including a 10% service charge that the restaurant levies for all dinners.
Now, although all 4 friends were super hungry, they knew that ordering one loaded pizza per person wouldn’t make sense as they wouldn’t be able to finish all alone, and ordering multiple pizzas would be out of budget as well.
So they decided to order one large pizza and ask the restaurant owner to cut it into four equal slices. This way, all four would get an equal share, and they could enjoy the pizza without wasting food. This would fit their budget, too.
After they finished their meal, they split their bill equally. All four agreed to share the cost and went back home with the satisfaction of having a great, affordable meal without any hassle of wasting food.
This is exactly how mutual funds work!
Definition of Mutual Funds
A mutual fund is an investment alternative in which money from many investors is pooled together to buy various stocks, bonds, or other securities like gold, silver, etc.
This mix of investments is managed by a professional money manager, who provides individuals with a portfolio structured to match the investment objectives stated in the fund’s prospectus.
Let’s break this down –
Mutual funds are a budget-friendly way to collectively invest savings into shares, bonds, debentures, and other asset classes.
Mutual funds are ideal for investors who either lack a large corpus for investing or those who desire to create a meaningful corpus but lack the skill, expertise, or the time to research the market yet want to grow their wealth systematically.
The pool of money created by asset management companies (AMCs) by collecting small amounts of investments from multiple investors is then invested by these AMCs by professional fund managers in various schemes. Each scheme has certain objectives, and the fund managers choose different asset classes and create an optimum portfolio mix that aligns with the scheme’s stated objective.
For this, the fund house charges a small fee, which is deducted from the investors’ investments. The fees charged by mutual funds are regulated and subject to certain limits specified by the Securities and Exchange Board of India (SEBI).
Fund managers are qualified/expert money managers who showcase their talent and expertise to generate returns on behalf of investors who have shown their faith in trusting them with their hard-earned savings.
We shall dive deep into how mutual funds work, but before we do, let us understand…
Why should you consider investing in mutual funds in India?
Globally, India has one of the highest saving rates in the world ( Gross savings rate is approximately 30% on average per year). Now, these savings need to be deployed somewhere.
Most Indians who saved had a deep inclination towards traditional investments, such as Fixed Deposits (FDs) or fixed-income instruments, which gave assured returns.
This bias towards fixed instruments was mainly due to high interest rate regimes, where a bank FD was typically up to 12% per annum in the 1990s. (Yes! That is true.) However, as interest rates start declining, normally reaching a point where FDs or any fixed instrument can barely beat the high long-term inflation rates, Indian investors are looking for better alternatives to compound their wealth in the long term.
That’s where mutual funds come in, empowering Indian investors to participate in India’s growth story. As we all know, India is the world’s third largest economy (close to 3.73 trillion USD, 2023), growing at roughly 6% ( GDP ). It’s impossible to achieve all this growth without Indian companies increasing their earnings and profits, isn’t it?
Mutual funds help naive investors seek professional help and invest in stock markets. They can also invest in these growing corporations and get better/higher returns than traditional investments.
Of course, the risk is higher, considering stock markets are more volatile, but as the saying goes, “ Higher the Risk, Higher the Returns .“
But a word of caution here, and maybe you must have heard it a million times,
In quote box: “Investing in mutual funds is subject to market risk. Please read all scheme-related documents carefully before investing!”
Although higher risk could probably enable investors to get higher returns, there’s always the risk of losing money since mutual funds invest fully or partially in stock markets, varying depending on the schemes you choose to invest in.
Some Other Key Benefits
Diversification
Mutual funds let you access a wide mix of asset classes, including domestic and international stocks, bonds, and commodities, thereby reducing your overall portfolio risk. If one asset class falls, the other might outperform, offsetting the losses. Mutual Funds, in a true sense, help investors gain exposure to a multi-asset portfolio, thereby diversifying unsystematic risk ( risk related to a specific company/industry/asset class, in general).
Professional Management at Low Cost
Where else would you get a professional fund manager hired to invest on your behalf like a pro!
The cost and capital required are significantly more if you hire a Portfolio Manager or subscribe to Portfolio Management Services versus investing in mutual funds, which is quite cheaper since multiple investors hire a common money manager, and the costs are split amongst all.
Convenience / Ease of Investing
Mutual Fund Investing is nowadays as easy as online shopping. Just register, complete your KYC (Know Your Customer), select a scheme, choose the fund house you want to choose, and decide the amount you want to start with.
These days, financial intermediaries like banks and brokers like Dhan offer mutual fund investing on their platforms/apps, which almost instantly enable you to get started.
One additional benefit mutual funds offer is Rupee Cost Averaging through SIPs—Systematic Investment Plans! This superpower, if understood well, can work wonders for investors.
We shall discuss this soon in the coming chapters. For now, you know what a mutual fund is and how it works.
Before we learn in-depth about how Mutual funds work ( technically ), here is some jargon we should know! ( This will help you in the coming chapters )
See you in the next chapter!