Note: This primer is specific to mutual funds in India and attempts to convey conceptual clarity in plain English. Some experts may regard what I have done as a gross oversimplification. If that makes you uncomfortable, I suggest searching on the internet for other resources. I have none to recommend.
Let’s start by keeping aside mutual funds for a moment, and looking at the instruments available to us, to invest our money. Some of the options are:
- Equity shares
- Real Estate
- Gold
- Debt instruments (such as Bank Deposits, Post Office Schemes, Company Deposits, the Public Provident Fund (PPF), RBI Bonds etc.)
While we do have the choice to directly invest into these options, there are some firms out there which offer to build portfolios of such investments, on our behalf, for a fee.
Now, why would we want to do that?
Right away, I can think of up to five reasons.
Firstly, some options call for expertise in selection (e.g. equity shares).
Secondly, in our individual capacity we may have limited access to some investment options. For instance, within debt instruments, there is an entire category called ‘money market instruments,’ which individuals would find difficult to access.
Thirdly, there could be tax benefits to doing so.
Fourthly, it could help us quickly, and conveniently, build diversified portfolios.
Fifthly, there is the possibility of better returns.
While such firms go by different names, loosely, these are often referred to, as ‘money managers.’
Legally speaking, money managers can offer their expertise in various ways. One way of doing so is by registering themselves as mutual funds.
Each mutual fund floats schemes that are open to the public at large, to invest into. Each scheme is defined by the choice of instruments it will invest into.
Some schemes, for instance, will invest exclusively into equity shares. These are usually referred to, as ‘equity schemes,’ or ‘equity funds.’ Then, there are schemes that invest exclusively into debt instruments. These are usually referred to, as ‘debt schemes,’ or ‘debt funds.’ Furthermore, within debt funds, there are schemes that invest exclusively into Government securities (‘gilt funds’) or schemes that invest exclusively into money market instruments (‘liquid funds’). Each scheme could well have thousands of investors, or even more.
This brings me to two key points that I would like to make about mutual fund schemes:
Key Point # 1: Know that all mutual fund schemes are not alike.
They may all be called ‘mutual funds,’ but, to take an example, a debt fund is as different from an equity fund, as a bank deposit is from equity shares.
Key Point # 2: Know where any scheme will be investing.
The single most important thing to know about any mutual fund scheme is the kinds of instruments into which the scheme will be investing. This becomes all the more important given the plethora of ambiguous scheme names and categories. There is no definitive way to categorize mutual fund schemes, and there are very few universally understood descriptors in fund names and fund categories.
Let me now explain how an investor makes money in these schemes.
When you invest into a mutual fund, in return for the amount that you invest, you are issued ‘units’ that represent your share of the investments made by the scheme. When you want to exit the fund, you could sell back these units.
The price at which you are issued units, and the price at which you can sell back your units, are both linked to the value of the underlying investments of the scheme. The value of each unit is referred to as Net Asset Value (NAV). The NAV (and hence, the prices) will change daily, in line with the changes in the underlying investments of the scheme. In effect, to make money, you have to sell your units at a price that is higher than the price you bought them.
For most investors that I have met, the single biggest obstacle to coming to terms with mutual funds has been the process of comprehending and dealing with the fluctuations in NAVs. I won’t go into an elaborate explanation here, but I will make two additional key points that may help in dealing with this.
Key Point # 3: Know that the expected return and possible risk of investing in a scheme is linked to the expected return and possible risk of the investments made by the scheme.
Since each scheme is effectively a means to invest into certain instruments, the potential return from a scheme and the risk in investing in a scheme is closely linked to that of the instruments into which that scheme is investing.
For an investor in an equity fund, it would be fair to expect similar range of returns to what could be expected from equity shares. The risks, too, would be mostly similar to the risks that come with investing in equity shares.
For an investor in a debt fund, it would be fair to expect similar returns to what can be got from investing in comparable debt instruments. At the same time, the risks would be mostly similar to the risks that come with investing in comparable debt instruments.
Key Point # 4: Know that it helps to not be scared of NAV fluctuations.
As with any investment that carries price fluctuations, with mutual funds, too, it is worthwhile to remember not to panic when prices go down or get overly excited when prices go up. If the scheme is managed reasonably well, over time these swings should get averaged out. If you still feel tempted to try and time the market, Warren Buffett’s advice in this regard may be useful: “…try to be fearful when others are greedy and greedy when others are fearful.”
I hope that this primer has given you a basic understanding about mutual funds. I also hope that it has sparked some questions in your mind, the answers to which you should be able to find elsewhere on this blog, or through internet searches. I wish you all the best in your investing journey!
