Mutual fund fundamentals

In simple terms

A mutual fund pools money from many investors and invests it in shares, bonds or other assets according to a stated objective. Each investor owns units of the fund, in proportion to what they put in. Gains and losses on the fund's holdings, after expenses, flow through to the units.

Funds give small investors access to diversification and professional management that would be hard to achieve alone, as the diversification lesson explains.

Who does what

• The asset management company (AMC) runs the fund: it decides what to buy and sell within the fund's stated objective.
• Trustees oversee the AMC on behalf of investors.
• A custodian, independent of the AMC, holds the fund's assets.
• SEBI registers and regulates mutual funds, sets rules on disclosure, categories and costs, and supervises them.

This structure separates the people who manage the money from the people who hold it, which protects investors if the AMC itself gets into trouble. It does not protect against investment losses.

NAV and units

A low NAV does not mean cheap. A fund launched recently may have a NAV of ₹10 or ₹12; one launched decades ago may have a NAV of several hundred rupees. If both hold similar shares, a 10% rise in their holdings gives both a 10% gain. Unlike a company's share price, NAV says nothing about value.

Fund categories

SEBI groups funds into categories with defined rules, so investors can compare like with like. Broad groups include:

• Equity funds: mainly shares, such as large-company, mid-company, small-company, multi-cap, sector and index funds.
• Debt funds: mainly bonds and money market instruments, of different maturities and credit quality.
• Hybrid funds: a mix of equity and debt.
• Other funds: such as index funds, exchange-traded funds and funds of funds.

The exact definitions, for example which companies count as large, are set in SEBI's rules and can change. Read a fund's category and its stated investment strategy before investing.

Direct and regular plans

Most schemes come in two versions holding the same investments:

• Regular plans are sold through distributors, and part of the fund's expenses pays the distributor's commission.
• Direct plans are bought directly from the AMC or through platforms without a distributor's commission, so they have lower expenses and, over time, higher returns.

The conflicts of interest lesson showed how much a 1% yearly difference compounds. The expense ratio lesson explains costs further.

SIPs

A systematic investment plan (SIP) invests a fixed amount at regular intervals, often monthly. It:

• builds a habit of saving;
• spreads purchases over time, buying more units when prices are low and fewer when they are high;
• removes the temptation to time the market.

A SIP is a method of investing, not a product, and it does not guarantee returns. A SIP into a poor or unsuitable fund remains poor or unsuitable.

Exit loads and documents

Some funds charge an exit load, a percentage deducted if you redeem within a set period, to discourage short-term trading. Check it before investing.

Every fund publishes documents explaining its objective, strategy, risks, costs and holdings, including a scheme information document and regular factsheets. Reading the factsheet's portfolio, expense ratio, risk level and benchmark tells you much of what you need.

Why it matters

Mutual funds are how most people in India own shares. Understanding their structure, what NAV does and does not mean, the cost difference between plans, and how SIPs work helps you choose sensibly and avoid common misconceptions that sellers sometimes exploit.

Limitations

Funds can lose money; regulation and structure protect against misuse of assets, not against market falls. Category rules, costs and tax treatment are set by regulators and the law and change over time. Past performance shown in fund documents does not guarantee future results.

Common mistakes

• Choosing a fund because its NAV is low.
• Buying regular plans without knowing about direct plans.
• Treating a SIP as a guarantee.
• Ignoring exit loads and the fund's category and strategy.

Try it yourself

1. Find the factsheet of any equity mutual fund on its AMC's website.
2. Note its category, benchmark, expense ratio for the direct and regular plans, and its ten largest holdings.
3. Compare the direct and regular plans' expense ratios, and work out the yearly difference on ₹1 lakh.
4. Check the exit load and the period it applies to.