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What are Mutual Funds? How Mutual Funds Work and its Definition

Mutual funds are investment tools that pool money from multiple investors to invest in a diversified portfolio of securities managed by professionals.

  • 6,241 Views | Updated on: Apr 07, 2024

Mutual funds help you invest your funds in different classes, such as equity, debt, and other assets. The scheme provides liquidity, accessibility, flexibility, and expert management benefits. Moreover, it is the best tax-saving option which is safe and transparent.

Increasing inflation rates have invested a necessity to become financially secure. Several investment vehicles, such as stocks, bonds, mutual funds, real estate, etc., are available in the financial market. Though multiple options are available, you often plan to begin investing but stop due to insufficient time or knowledge. This is where mutual funds come into play. Mutual funds are considered one of the best investment options as your portfolio is diversified and managed by experts.

What are Mutual Funds?

A mutual funds scheme is a financial tool in which your money is invested in various assets such as equity, debt, and/or other money-market instruments. Investors can choose a short-term, mid-term, or long-term investment plan according to their preferences. Since the returns and capital gains directly depend upon the market volatility, a solid allocation strategy is required to minimize the risk. The funds are allocated in different securities according to the risk-taking appetite of the investor. The funds are managed by the fund manager (investment advisor).

How Mutual Funds Works in India?

In India, mutual funds come in various types, each categorized by the asset class they invest in, their structure, risks, and benefits. Investors have the option to invest in mutual funds through a Systematic Investment Plan (SIP) or by making a lump sum investment.

Professional fund managers, supported by a team of skilled researchers, oversee the pooled money from investors. They allocate investments across different asset classes based on their expertise, aiming to achieve the fund’s objectives. Investors receive their share of the mutual fund in the form of units, and any returns generated by the fund are distributed among investors according to their investments.

Broadly speaking, mutual funds fall into two categories: actively managed funds and passively managed funds. In actively managed funds, the fund manager conducts market research and adjusts the fund’s portfolio based on their analysis. Conversely, passively managed funds seek to replicate the performance of a stock market index or benchmark.

Let us delve into the process of mutual fund operation, starting from the launch of a mutual fund scheme to investing in and redeeming mutual funds.

Launch of New Fund Offer (NFO)

An asset management company (AMC) initiates a first-time subscription offer for a new mutual fund scheme, known as a new fund offer (NFO). Through the NFO, the fund house raises capital from the public and then invests in securities such as shares, bonds, etc., by the fund’s strategy. NFOs have a limited subscription period, after which investors can only purchase units of the fund.

Pooling of Funds

Mutual funds gather money from a large number of investors, each contributing small amounts. This pooled investment allows investors to access diversified portfolios of securities.

Returns Distribution

The performance of a mutual fund scheme is evaluated based on its Net Asset Value (NAV), which represents the market value of all securities held by the scheme. NAV fluctuates daily in line with changes in the market value of securities. Returns generated by mutual fund schemes are either distributed among investors or reinvested back into the fund. In dividend-paying mutual fund schemes, returns are distributed to investors in the form of dividends.

Redemption

Investors have the option to sell or redeem their mutual fund investments. To facilitate this, the fund manager utilizes the portfolio’s cash balance to fulfil redemption requests from investors.

Types of Mutual Funds

Mutual funds are categorized based on various factors, including the asset class they invest in and the investment objectives they aim to achieve. Understanding the different types of mutual funds can help investors make informed decisions about their investment portfolios.

Based on asset class

An asset class refers to a category of financial assets with similar characteristics and behaviours, such as stocks, bonds, real estate or cash equivalents. Discover diverse Mutual Funds categorised by an asset class.

Equity Funds

Equity Funds invest in shares of companies. For example, large-cap Equity Funds target well-established, large companies, while small-cap funds focus on smaller, high-growth businesses.

Debt Funds

Debt Funds invest in bonds, providing a steady income. They include categories like Government Bond Funds and Corporate Bond Funds.

Money Market Funds

Money Market Funds invest in low-risk, short-term securities, such as Treasury bills and commercial paper.

Hybrid Funds

Hybrid Funds blend both stocks and bonds, like balanced funds that aim for growth and stability in a single package.

Based on Investment goals

These funds cater to specific financial objectives, offering diverse options to match the investors’ unique goals.

Growth Funds

Growth Funds focus on capital appreciation by primarily investing in stocks of companies with high growth potential. They are suited for long-term investors seeking substantial returns.

Income Funds

They emphasise regular income generation by investing in bonds, fixed-income securities or dividend-yielding stocks. They suit investors looking for a steady income stream.

Liquid Funds

Liquid Funds prioritise liquidity and safety, investing in short-term debt instruments. They are ideal for investors seeking quick access to funds with minimal risk.

Tax Saving Funds

Tax-saving funds, or ELSS, offer tax benefits under Section 80C. They invest primarily in equities and serve as a tax-efficient investment option.

Aggressive Growth Funds

Aggressive Growth Funds target substantial capital appreciation and are willing to accept higher market risks. They suit investors with a long-term horizon and a risk-taking approach.

Capital Protection Funds

Capital Protection Funds focus on safeguarding the principal amount while generating modest returns. They are ideal for risk-averse investors looking to protect their investments.

Fixed Maturity Funds

Maturity Funds have a predetermined maturity date, providing investors with a clear investment horizon. They are suited for those looking for fixed returns and minimal interest rate risk.

Pension Funds

Pension Funds aim to create a corpus for retirement by investing in a mix of assets. They cater to individuals planning for a secure post-retirement financial future.

What are the Benefits of Mutual Funds?

Mutual funds have become a cornerstone of modern investment portfolios, offering benefits to investors of all backgrounds and experience levels. These investment vehicles take funds from various investors to invest in a diversified portfolio of stocks, bonds, or other securities. Let us delve into the mutual fund investment benefits.

Liquidity

Unlike conventional investment options like fixed deposits, mutual fund schemes provide liquidity. As a result, one can redeem their units quickly at any point in time. However, an appropriate penalty or exit load is applicable on the withdrawal.

Diversification

Most people hesitate to invest due to the instability created by market fluctuations and volatility. However, putting all the eggs in one basket is never a piece of wise advice. To minimize the risks of losses, mutual funds are generally diversified in various securities depending upon the plans and terms you opt for.

Expert Management

Experts manage mutual funds with a deep understanding and thorough market knowledge. They know where to put your money for the safest and maximum outcomes. In addition, the fund managers take care of timely exit and new investments.

Flexibility and Accessibility

There is enormous flexibility available to the investor regarding their investment, even when investing a comparatively low amount. One can invest monthly or quarterly using the Systematic Investment Plan (SIP) at your convenience. Mutual funds can be easily traded when needed in a brief period. The excellent combination of low cost and ease of use makes mutual funds accessible. You can begin investing from anywhere in the world through brokerage firms, Asset Management Companies (AMC), or online investing platforms.

Transparency

Your financial advisors go through the statistics, financial statements, and other crucial understanding of the company before investing so that you can rest assured. In addition, however, you can track the performance of your funds using regular Net Asset Value (NAV) updates and monthly fund factsheets.

Tax Benefits

You can avail of tax benefits under Section 80C of the Income Tax Act for investments in Equity Linked Saving Schemes or ELSS. This is because the government wants its citizens to be financially secure and encourages the investment culture, following which these tax benefits are provided not only on the amount invested but also on the amount earned as mutual funds returns. This is a win-win for the investor, where your money sits in mutual funds, makes profits, and saves you taxes.

Final Thoughts

Investing in mutual funds is an excellent choice as you can put your money to work and grow wealth with even novice market knowledge. Also, as experts manage the funds, you do not have to worry about understanding mutual funds and the financial market. In addition, you are provided transparency, liquidity, the lowest lock-in period, and tax benefits with the mutual funds.

Key Takeaways

  • Mutual funds are investment vehicles that pool money from numerous investors to purchase a diversified portfolio of stocks, managed by professional fund managers.
  • Mutual funds offer accessibility to a wide range of investors, regardless of their financial expertise or capital.
  • They provide diversification, spreading investments across various asset classes to reduce risk.
  • Professional fund managers conduct research and analysis to make investment decisions aligned with the fund’s objectives.
  • Investors purchase shares or units of the mutual fund, and returns are distributed based on their holdings.

FAQs


1

How are mutual fund returns generated?

Mutual fund returns are generated through capital gains and dividend income. Capital gains occur when the value of the fund’s investments appreciates, while dividend income is earned from dividends paid by the underlying securities held within the fund’s portfolio.



2

What are the different types of mutual funds?

Mutual funds come in various types, including equity funds, bond funds, money market funds, index funds, sector funds, and balanced funds. Each type of mutual fund has its own investment objectives, risks, and potential returns.



3

What is the difference between actively managed and passively managed mutual funds?

Actively managed mutual funds are actively overseen by fund managers who make investment decisions based on market research and analysis. In contrast, passively managed mutual funds seek to replicate the performance of a specific index or benchmark and typically have lower management fees.



4

How can investors invest in mutual funds?

Investors can invest in mutual funds either through a Systematic Investment Plan (SIP), which involves investing a fixed amount regularly or via the lump sum route, where investors invest a single large amount at once. They can purchase mutual fund shares directly from the fund company or through a financial advisor or broker.

- A Consumer Education Initiative series by Kotak Life

Amit Raje
Written By :
Amit Raje

Amit Raje is an experienced marketer who has worked in various Fintechs and leading Financial companies in India. With focused experience in Digital, Amit has pioneered multiple digital commerce in India. Now, close to two decades later, he is the vice president and head of the D2C business department. He masters the skill of strategic management, also being certified in it from IIMA. He has challenged his challenges and contributed his efforts in this journey of digital transformation.

Amit Raje
Reviewed By :
Prasad Pimple

Prasad Pimple has a decade-long experience in the Life insurance sector and as EVP, Kotak Life heads Digital Business. He is responsible for developing user friendly product journeys, creating consumer awareness and helping consumers in identifying need for life insurance solutions. He has 20+ years of experience in creating and building business verticals across Insurance, Telecom and Banking sectors

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