Mutual funds were created to make investing easy, so consumers wouldn’t have to be burdened with picking individual stocks.
~Scott Cook
Over the weekend, I was thinking about what my next post would be about. The thought that came to my mind was it should be beginner-friendly but informative and complete at the same time. Something that by the looks of it, everyone is investing in. The “Mutual Funds Sahi hai” campaign aims to increase public awareness and participation in Mutual Funds. So what are Mutual Funds? and how do they work? Let’s start with the basics.
What are Mutual Funds?
A mutual fund is what you get when you apply crowdfunding to investments. Investments can mean stocks, commodities (for example Gold), and debt (the money collected will be used to give loans). There are a couple of steps involved here:
1)Collect small amounts of money from many individual investors (like you and me)
2)Invest the money in whatever the fund deems fit.
With me so far? Good. At this point, you would probably have two questions. How does the fund decide what to invest in? Do you have a say in what the fund invests in? Let me start with the second question.
Q) Do you have a say in what the fund invests in?
A) Nope. The fund has a fund document that will tell you the “philosophy” that they will follow while using your money for investments. A very crude example would be that the fund invests exclusively in the stock market. The individual stocks that will be chosen by the fund, will be at the fund’s discretion and you will mostly not have a say in that. If you don’t have a say in where your money is getting invested, how is this good? You’ll get an answer to this soon.
Q)How does the fund decide what to invest in?
A) Firstly, there will be a philosophy that the fund follows. Secondly, the fund often has a Fund Manager (FM) and a research team to decide what next to invest in. If it’s an equity-oriented fund, they will decide which stocks to withdraw from and which stocks to invest in. Now you should see the purpose of mutual funds, people often complain that they don’t have time to analyze stocks. Well, here you have a set of experts that manage money as their day job. I hope this answers the question I raised earlier.
Why Mutual Funds?
For simplicity, I am making two assumptions, you are investing for the long haul(5 + years at the minimum) and you are choosing equity-oriented mutual funds. There are mutual funds that invest in other instruments (other than the stock market), but when it comes to the returns ( given a “sufficiently” long duration) earned equity-oriented funds trumps them over a longer duration of time.
| Investment | Returns |
| Real Estate | 11.6% *(Average) |
| Stocks(NIFTY50) | 12.5% **(Average) |
| Term Deposits | 8%*** (Maximum) |
* – The Reserve Bank of India’s House Price Index
** – NIFTY50 Returns over the past 15 years
***- Maximum of Term Deposit rate in the past 10 years. (Average is much lower)
If you are wondering what NIFTY50 is, It comprises the 50 largest companies in India. Together they are considered representatives of the stock market. So the implication here is if you would have blindly invested in the 50 largest companies over the last 15 years, you would have received 12.5% as the returns on your money. There are some details that I have skimmed through, will go into details in a later post. We do have mutual funds that will track NIFTY50, so you can get similar returns using Mutual Funds as well.
Why is it suddenly becoming so popular in India?
Seeing adverts left and right might make you wonder why the popularity has risen for mutual funds all of a sudden. There are a couple of reasons for this :
1) The stock markets are at an all-time high and many people are eager to get into the market. Mutual Fund Companies(AMCs) are just tapping into that.
2) Percentage of the stock market owned by institutional investors(mutual funds and other “institutions”) is much lower here in India. In fact, according to the latest numbers, individual investors have grown to 45%. AMCs are eyeing a much larger share of the stock market in India. In the US, roughly 70% of the stock market is held by institutional investors. It is nowhere near that in the Indian markets.
What’s in it for the AMCs?
They aren’t doing it for free. They charge a “small” fee which is often a percentage of the total money that they maintain. It will always be less than 3 % of the total amount that they maintain. It is popularly called the Total Expense Ratio(TER). A good rule of thumb would be to check the TER of any fund you purchase.
Lower TER directly translates to higher returns.
It’s difficult to cover everything related to mutual funds in a single post. I hope this post is a good starting point. Please leave your comments below. As always, more content coming soon!
Nice information to start with !! Got a good glance of various jargons used in investment world. Also such posts will help with people understand the actual backend and will encourage them to invest.
Thank you!
Nice post for beginners !
Thanks, Stephen!