Investing 101 Part 3: What are Mutual Funds and how do they work?


In Part 2, we discussed in detail the risk-return characteristics of the 4 investment asset classes available to us:

  • Equity
  • Debt
  • Real Estate
  • Gold

In this part, we will explore the role of Mutual Funds in investing, how they work and what are their benefits, if any.

Let us say, we wanted to actually invest in one of the investment asset classes. How would we go about it?

We could take the direct route e.g. if we wanted to invest in equities, we could purchase some stocks directly on the stock exchange based on our analysis, or a friend's recommendation.

It would be our job to maintain the portfolio then, and review it periodically to see if all stocks are still good to be stay invested in. This research and monitoring requires a lot of time expertise which we may not have.

Also, unless we have a lot of money to invest, it would be difficult to diversify across many different stocks if we invest individually.

Or, we could take the indirect route of Mutual Funds. A Mutual Fund is where a lot of people pool their money together, and give it to a fund manager who has the required expertise to manage it. Now, it is the fund manager's job to figure out where to invest the money.

She is usually assisted by a team of analysts and researchers - all working round the clock to ensure that your money is invested in the right place.

The fund manager and her team get paid for it, usually as a % of the money being managed by them. The better their fund does, the more money it attracts, thereby increasing their compensation. (You can read more about the costs associated with Mutual Funds here - http://blog.goalwise.com/the-costs-and-taxes-associated-with-investing-in-mutual-funds/)

A Mutual Fund has a common portfolio for all its investors, held on a proportionate basis. This pooling of money helps to lower the costs of professional management to any single investor. It also increases diversification, as now it is possible to invest only Rs 1000 and yet get access to the Mutual Fund's entire portfolio of 50-100 stocks.

A common misconception is that Mutual Funds are only for stock market investments. Mutual Funds actually exist for all asset classes. There are Mutual Funds for debt (i.e. deposits and bonds), there are Mutual Funds for Gold, and in developed markets there are Mutual Funds for Real Estate also (in India they are yet to come). Mutual Funds are more like a mode of investing rather than a particular investment asset class.

They have become quite popular for the Equity asset class, as equities require the most amount of professional expertise, as compared to other asset classes. But that does not mean that Mutual Funds for other asset classes don't exist, or don't provide similar benefits. In fact, there are more Debt Mutual Funds than there are Equity Mutual Funds!

When you make an FD with your bank, you are loaning money to just one bank. If that bank defaults, then your hard earned money will be gone. While this is fine for small amounts, but when the amounts get higher you might want to diversify your risk. When you invest in a Debt Mutual Fund, instead of making an FD with your bank, the mutual fund takes your money and invests in several FDs and deposits across different banks, RBI and credit-worthy corporates, thus diversifying your risk. There is also the added benefit of no lock-ins like FD and lower taxes (for 3 years and higher investment periods).

For all asset classes, Mutual Funds provide simple and cheap access to well-diversified and professionally managed portfolios so that as individual investors we don't have to deal with the nitty-gritties and we can focus on the bigger picture - our Goals.

In Part 4, the next and final part, we will see how to put together everything that we have learnt so far and come up with our own financial plan.