What is a Mutual Fund? Meaning, Types & How It Works for Investors

A mutual fund is a professionally managed investment scheme that pools money from multiple investors to buy a diversified mix of assets.

For example, if 1,000 people each invest ₹10,000, the fund gathers ₹1 crore. A professional fund manager then invests this amount in shares, bonds, or other assets to spread the risk. 

Investors earn returns when these assets increase in value or generate income through dividends or interest. In this blog, we will explain the different types of mutual funds, how they work, and the main benefits for investors.

How Mutual Funds Work?

• Investors pool money by contributing to a fund, for example, ₹1,00,000 each, creating a large pool of capital managed collectively. A professional fund manager invests this money in equities, debt, hybrid, or money-market instruments according to the fund’s objective.
   
• The Net Asset Value (NAV) is calculated daily by dividing the total value of the fund’s assets by the number of units outstanding. This determines the price per unit at which investors buy or sell units.
   
• Investors earn returns through capital gains (rising NAV), dividends, or interest from the investments.
   
• The fund charges an annual expense ratio, usually between 1% and 2.5% for equity funds and 0.5% to 1.5% for debt funds, to cover management and other costs.
   
• If investors redeem their units before a specified lock-in period, typically one year for equity funds or six months for some debt funds, they pay an exit load. This fee, usually 0.5% to 1%, is deducted from the NAV at redemption.

Example:

An investor invests ₹1,00,000 in an equity fund with a 1% exit load if redeemed within 12 months. After six months, the NAV grows to ₹1,10,000. If the investor redeems, the exit load would be ₹1,100 (1% of ₹1,10,000), so the investor receives ₹1,08,900.

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Key Terms:

• Net Asset Value (NAV): The price of one unit of the mutual fund, calculated daily by dividing the total value of the fund’s assets by the number of units.
   
• Expense Ratio: The annual fee charged by the fund to cover management and operational costs, expressed as a percentage of the total assets.
   
• Exit Load: A fee applied if you withdraw your investment before a specified period, meant to discourage early redemption.

Types of Mutual Funds

Mutual funds in India are classified into several key categories, each offering specific features suited to different investor needs.

a. Based on Asset Class
 

• Equity Funds invest primarily in shares and aim for higher growth while carrying higher risk. For instance, large‑cap equity funds focus on stable firms like Reliance or TCS.
   
• Debt Funds invest in fixed‑income instruments such as bonds and government securities, offering steadier returns with lower risk.
   
• Hybrid Funds combine both equity and debt. SEBI categorises sub‑types like Conservative Hybrid (10–25% equity, 75–90% debt), Balanced (40–60% each), and Aggressive Hybrid (65–80% equity).

b. Based on Investment Style

• Active Funds are managed actively by professionals who choose securities, aiming to exceed benchmark indices like the Nifty or Sensex.
   
• Passive Funds replicate a benchmark index. Examples include Index Funds and ETFs that track the Nifty 50 or the Sensex with lower expenses.

c. Based on Structure
 

• Open‑Ended Funds allow investors to buy or redeem units at any time at the NAV. They are highly liquid and most common in India.
   
• Closed-end funds are launched via a New Fund Offer (NFO) and have a fixed maturity. Investors can only exit at maturity or via the stock exchange where the units are listed.

d. Tax‑Saving Funds
 

• ELSS (Equity Linked Savings Scheme) is an equity‑oriented fund with a mandatory three‑year lock‑in period. It offers tax deductions under Section 80C and invests a minimum of 80% in equity instruments.

Knowing these categories helps you choose a mutual fund that suits your goals, risk level, and investment horizon.

Read More -  How To Invest in Mutual Funds

Risks & Considerations

Mutual funds carry several important risks and costs, which investors should understand clearly:

• Market Risk: Fund value can dip when markets fall. For instance, an equity fund invested in top‑cap shares may fall by 10 % during a market correction.
   
• Credit Risk: In debt or credit-risk funds, issuers may default. Some credit-risk funds invest in lower-rated bonds, which may offer 2–3 % higher yield but carry greater default risk.
   
• Expense Ratio: Annual fees typically range from 0.3 % up to 1.5 %. A ₹1,00,000 investment at 1 % expense ratio costs ₹1,000 yearly, reducing net returns.
   
• Lock‑in/Exit Load: Some funds charge exit loads, for example, 1 % if redeemed within 12 months.
   
• Taxation: Short‑term gains taxed at slab rates; equity LTCG over ₹1,25,000 taxed at 12.5 %; debt fund gains (purchased post‑1 April 2023) taxed at slab rates and no indexation benefit
   

These points help you assess whether a fund matches your goals and tolerance.

How to Start Investing?

Begin by choosing between a Systematic Investment Plan (SIP) and a lump sum investment.

• If you have a regular income, a SIP is a good option. For example, investing ₹5,000 every month for 5 years at a 12% annual return could grow your money to about ₹4,48,000 from a total investment of ₹3,00,000.
   
• If you have a large amount to invest at once, such as ₹3,00,000, and the market conditions look favourable, a lump sum investment might offer better returns. At a 12% annual growth rate, ₹3,00,000 could grow to around ₹6,03,000 in 5 years.

Choose a mutual fund that matches your risk appetite and investment horizon. You can invest directly through Asset Management Company (AMC) websites or trusted apps like Zerodha, Groww, or ET Money.

Review your portfolio regularly and rebalance if necessary to stay aligned with your financial goals.

Conclusion

Mutual funds are a smart and simple way to invest your money. They let you grow your wealth over time, even if you don’t know much about the stock market. By selecting the right fund based on your goals and risk tolerance and investing regularly, you can build a solid financial future.

FAQs

1. Can I start investing in mutual funds with just ₹500?

Yes, many mutual funds let you start a SIP with just ₹500 per month. It’s a good way to begin investing without needing a large amount.

2. Is my money locked in once I invest in a mutual fund?

Not always. Open-ended funds let you withdraw anytime. But some funds, like ELSS, have a lock-in period of 3 years.

3. Do mutual funds guarantee returns?

No, mutual funds don’t offer guaranteed returns. They depend on market performance. However, debt funds are generally safer than equity funds.

4. Can I lose money in a mutual fund?

Yes, like any investment, mutual funds carry risk. If markets fall, your fund value may drop too. That’s why it’s important to choose the right type of fund for your goals and time frame.