Mutual Funds 101: Basics of Mutual Funds and How Do Mutual Funds Work?

Mutual funds present a dynamic investment option. There are different types of Mutual Funds that vary according to risks. Investors need to consider what kind of risk they are comfortable with while investing and select their Mutual Funds accordingly.

Investment vehicles like mutual funds are composed of a pool of funds derived from multiple investors. It then invests the funds in a diversified portfolio of instruments.

Mutual funds companies thus manage your money by investing in various assets and securities on your behalf. For this, in turn, the asset management company charges a fee.

The Working of Mutual Funds

Mutual funds are organised in the form of a company or corporation by a fund sponsor (like financial institutions or non-banking financial companies). The fund sponsor accepts funds from the public as well as from corporations. After the fund sponsor collects the money, they invest the corpus in securities (stocks, bonds or money market instruments) as well as maintain cash.

Unlike the stock market where investors make direct purchases, units of a mutual fund are purchased from a fund. An investor can sell its allocated units back to the fund, ensuring his or her liquidity of funds.

Mutual funds come in many forms but in terms of risks involved, and there are 5 categories

  1. High-Risk Funds: Some of the best examples of high-risk funds are sector funds, thematic funds and sectoral ETFs. They are high in risk because respective sectors can be subject to volatility. Also because investment in this category is made regarding a single sector like technology, pharma, agriculture, etc., the performance varies from year to year.  These are suitable for those who expect higher returns and are ready to take higher risks.
  2. Moderately High-Risk Funds: Some mutual funds have a certain level of considerable risk attached to them but are associated with consistent returns. Balanced or Hybrid funds combine investment in debt and equity, and Index funds are instruments representative of a particular index on the exchange market. Another type of mutual funds in this category is the Gold Exchange-Traded Funds that combine the best features of the stock market and gold investments.
  3. Moderate Risk Funds: Moderate risk-based mutual funds are long-term debt funds, gilt funds or MIP Funds. For long-term debt funds, the choices could be government bonds, company debentures or fixed income assets. Gilt funds are debt funds that invest in government securities. Moderate risk-based funds are usually linked to higher return on investments as compared to low-risk funds.
  4. Moderately Low-Risk Funds: This kind of risk can be found in debt funds, and they usually make up a safe investment tool. For attaining a reasonably low-risk feature, investors can opt to invest in short to medium risk debt funds
  5. Low-Risk Funds: Mutual Funds with the lowest risk are Liquid Funds and Ultra short-term funds. The crucial purpose of such funds is to provide liquidity. The risk in these funds is low and associated with moderate returns on investment, making it ideal for those who prefer short spans of their investments. Examples of these funds are Commercial Papers, Treasury bills, etc.

Mutual funds are ideal for investors who follow the golden rule of investment-not putting all your eggs in one basket. What more? The mutual funds offer the investors with professional fund management, tax benefits and different levels of liquidity. So now that you know how do mutual funds work and the type of mutual funds you can invest in, get started today and start investing. However, do note that you always read the offer documents carefully before investing.