Beginner's guide to mutual funds

What is mutual fund?
Mutual funds combine the savings of a large number of investors and manage them as a single pool of money. Instead of investors worrying about what stock, bond or commodity to invest in, professional fund managers do the job. Mutual funds are run by mutual-fund companies, also known as asset management companies (AMCs). Each AMC operates several fund schemes that suit different types of investment needs.

In most funds, it is possible to start investing with as little as a few hundred rupees. Also, unlike many other investments, mutual-fund investments are highly liquid and can be withdrawn without any delay.

Diversity of funds
There are a wide variety of mutual funds, with a wide range of risk levels, profit potentials, and the qualities of fund management.

As you would expect, funds that invest in equity offer the highest potential returns with the highest levels of risk. At the other extreme, some funds invest in short-term bonds and deposits, which offer returns that are in the range of what bank deposits offer with a higher degree of safety than equity funds. Moreover, funds are quite diverse in terms of their quality. This means that not all funds are able to deliver what they promise and investors also have to keep an eye on the track records of specific funds, the fund manager and AMCs.

Types of mutual funds: their suitability and alternatives
1) Liquid funds: Suitable for investors looking to park their money for a few days to about six months. Not suitable for investing for a time horizon of more than six months, given their low return potential. Alternative can be savings bank accounts.

2) Short-duration debt funds: Suitable for investing for goals one-five years away. Not suitable for investing for a time horizon of more than five years. Alternatives can be bank fixed deposits, post office time deposits, national savings certificate and recurring deposits (for accumulating gradually).

3) Equity-orinted funds: Suitable for investors looking to accumulate wealth over a long-term horizon of five years or more. Not suitable for investment horizon of less than five years and for investors who cannot withstand temporary declines in the value of their principal. Alternatives can be direct stock investing, provided you have the required skills and can devote time to research.

Benefits of mutual funds
1) Instant and easy diversification: A tenet of safe investing is to spread your money across different investments. Mutual funds are an easy way to do this. Funds spread money across a large number of investments.

2) Professional research and investment management: There are hundreds of companies to track and their prospects could change without warning. Mutual funds employ professional, full-time investment managers and research staff. Their cost and effort get shared 'mutually' among all the investors of a fund.

3) Variety: Mutual funds are available for all kinds of returns and risk levels and suitable for all kinds of time horizons. No matter what kind of investment you want, you can choose one as per your requirements.

4) Convenience: You can easily make investments and withdraw any amount that you like. Investments can be made by filling up a simple form or by going online with direct debit from your bank account. Similarly, redemptions can be made directly into your bank account within three working days. If you want to directly buy shares to have a diversified set, you will need a lot of money. However, through a mutual fund, you can invest in a diversified set of stocks for far less.

5) Tax efficiency: When you buy or sell any investments, you have to pay tax on the profit you make. However, this doesn't happen when the buying and selling are done on your behalf by a mutual fund. To maximise profits, the fund manager could keep buying and selling stocks as needed, but you have to pay tax only when you redeem your investments from the fund.

6) Transparent, well-regulated industry: Mutual funds are obligated by law to release comprehensive data about their operations and investments. Almost all funds release net asset values (NAVs) daily and most release their complete portfolios every month. SEBI regulates the fund industry very tightly and is constantly refining the applicable rules to protect investors better.

7) Providing access to inaccessible assets: Some investments can be made only through mutual funds. For instance, it's not easy for individuals to buy government bonds, but they can buy funds that invest in such bonds. While investing directly in foreign stocks could be tricky, you can easily invest in global markets by investing in funds that reside in India but invest in international markets.