Guide to Investing in Mutual Funds: How to Choose the Right Scheme for Investment

With mutual funds (MFs), investors have diversification opportunities. Also, they can gain from price movements without worrying a lot about their investments. This is because, in MFs, the money is managed by a professional fund manager, backed by a team of researchers.
It’s imperative to note that returns generated from the mutual fund investment are distributed proportionally among the investors. However, understanding how mutual funds work is the first step in any investment journey.

So, let’s get started on how it works

When you invest in mutual funds, you buy the units of that particular scheme based on the Net Asset Value (NAV) of that fund on the day of the transaction. NAV is the unit price of the MF scheme. The fund manager then invests the funds in various avenues like equities, debt and money market instruments, which generate returns for unitholders.

Types of Mutual Funds

There are several mutual funds available, and you can invest in them based on your objectives and risk-taking abilities. There are broadly three types of mutual funds — equity, debt, and hybrid mutual funds.

1. Equity mutual funds

Equity mutual funds invest in stocks of different companies. In this, the fund manager spreads investment across companies from different sectors or market capitalisations. These funds generally deliver better returns than debt funds. However, their performance depends on market conditions and hence they are risky.
Equity mutual funds can be further categorised based on market capitalisation and tax benefits.

a. Equity funds based on market capitalisation

Large-cap equity funds: These funds invest at least 80% of the corpus in stocks of large-cap companies. These companies are part of the top 100 companies listed on the exchanges.
Mid-cap equity funds: These funds invest minimum 65% of the corpus in mid-cap companies, which are 101st-250th companies in terms of market capitalisation.
Small-cap equity funds: These funds invest minimum 65% of their investment corpus in small-cap companies, which are beyond 251st companies in terms of market capitalization.
Multi-cap equity funds: These funds are required to allocate at least 75% of the corpus in equity with exposure of 25% each in large, mid, and small-cap stocks.

b. Equity funds based on tax benefits

Equity Linked Savings Scheme (ELSS): This is a tax-saving equity mutual fund that comes with a lock-in period of three years. ELSS offers tax deductions under the provisions of Section 80C of the income tax act. Under this section, taxpayers can avail tax deductions of up to Rs 1,50,000 a year.

2. Debt mutual funds

Debt funds are pooled assets that invest in fixed income securities like bonds, government securities, or treasury bills. These debt funds are classified based on maturity profile of the underlying instruments. Ideally investors should invest in category of debt funds that matches its investment horizon.
Investment value in a debt fund comes down when India’s central bank, Reserve Bank of India (RBI), increases the repo rate and vice versa. This is because market interest rates and fixed-rate bond prices move in the opposite direction. For example, imagine you hold a bond with 3% coupon rate (annual interest rate) today. A year later, the RBI announces a cut in market interest rate to 2%. Now if you were to sell the bond with 3% coupon rate before maturity, chances are there will be more takers for it and its price will rise. But remember, yield to maturity or the annual rate of return for the bond will go down for those who buy this bond at the new higher price.

3. Hybrid mutual funds

These funds are a mix of equity and debt assets. They help in leveraging the benefits of both while reducing the basic risk of the portfolio.
Mutual funds can also be classified based on investment. There are open-ended schemes and close-ended schemes.
Open-ended schemes are open for investment at any point in time and offer liquidity to investors. In this, units can be bought and sold freely.
On the other hand, in a closed-ended mutual fund, the investment is locked in for a specified period.

How to invest in mutual funds

There are two ways to invest in a mutual fund scheme — Systematic Investment Plan (SIP) and lump sum.
An SIP allows you to invest a fixed sum regularly. It helps in averaging out the cost of investing. Tools like a SIP Calculator can help you calculate this average cost more effectively. You can instruct your bank/broker to automatically transfer a particular amount on a fixed date every month toward the SIP. It’s a great tool to inculcate the habit of regular saving and investing and build financial discipline.
There are several SIPs available in the market that you can choose based on your goals and risk appetite. You can use an HDFC SIP Calculator to estimate how your monthly investments may grow. And you can start investing with an amount as low as Rs 500.
Lumpsum Investment, on the other hand, refers to a one-time investment in the chosen scheme. If you have a large sum of disposable income and can take a risk, you can opt for a lump sum investment.

How to Choose the Right Scheme for Investment

Here are a few things to remember while buying the right fund:

• Identify financial goals: Choosing the right fund starts with defining your goal. It may be retirement, children’s education, etc. Accordingly, you can select the type of fund you want to invest in.
• Evaluate risk factors: Before identifying a mutual fund, you should evaluate the risks associated with the investment. Equity funds can be risky as they are subject to the volatility of stock market. But the returns can be relatively higher than other types of funds. On the other hand, debt funds are less risky and therefore have relatively lower returns.
• Fund performance: The performance of the fund is also key in case you are investing for the long term. A Mutual Funds Return Calculator can help assess historical return patterns alongside data from trusted financial websites. It makes sense to do your research well before selecting a fund.
• Assets Under Management (AUM): Asset under management or AUM refers to the total market value of the investments that a fund manages on behalf of investors. While a higher AUM may indicate larger investor interest in a fund, it is best to assess it in conjunction with other metrics like it’s track record and risk-return profile before investing.
• Mistakes to avoid while investing in MFs: Some of the common mistakes that you must avoid when investing in a mutual fund are:
• Investing without an objective: Before deciding on any investment portfolio, it’s important to have a financial objective, which is associated with the period of investments.
• Investing based on past returns: It’s a common mistake that investors make. They invest in funds only after looking at their track records. However, it’s advisable to do a complete evaluation of the fund in terms of AUM, fund manager profile, etc., before investing.
• Focusing too much on tax saving: Tax saving should not be the only guiding principle. It’s better to assess the portfolio and choose the fund.