Essential guide for first-time investors: Understanding mutual funds and their risks

A new wave of first-time investors, fresh out of college and entering the job market, may be eyeing mutual funds as an investment option. Before they commit money, they would do well to understand the spectrum of schemes available, the risk profile of each asset class, the costs involved, the return potential, and the optimal investment horizon.

WHAT TYPE OF MUTUAL FUND SCHEMES ARE AVAILABLE TO INVESTORS?
Investors can choose from pure equity funds, ranging from large-cap, mid-cap, small-cap, and micro-cap schemes to diversified options like flexi-cap funds that invest across market categories. On the fixed-income side, investors could consider ultra-shortterm vehicles like overnight funds to long-duration gilt funds with a five-year horizon. Corporate bond funds are suited for investors parking money for one to two years. Beyond stocks and bonds, mutual funds also offer exposure to commodities such as gold and silver. For those seeking diversification in a single package, hybrid schemes blend multiple asset classes such as equity, debt, gold or silver depending on the product’s investment objectives.

WHAT ARE THE RISKS?
Returns from equity funds could rise and fall in line with the stock market and can be negative in the short run. Debt funds tend to be generally more stable over time, but in the near term, they can face mark-to-market movements and credit risks. The same goes for gold and silver funds. Unlike a bank fixed deposit, mutual funds don’t promise assured returns. So, there’s always the possibility of capital losses. Also, those “12% returns” from equity schemes that you may often hear about are based on assumptions or past performances. It’s not a guarantee of what you’ll actually earn.

WHAT ARE THE COSTS OF INVESTING IN A MUTUAL FUND?
Every mutual fund comes with a cost. It is charged to investors as an expense ratio—a fee that mutual funds collect from unitholders every year. Part of the charges goes to the fund house as a management fee, and in regular plans, a portion is paid as commission to the distributor. Opting for a direct plan cuts out the distributor commission, but you’ll need to pick schemes yourself or pay a separate fee to a registered investment advisor. Expense ratios vary widely—from about 5 basis points to 225 basis points—depending on the scheme and plan you choose. Equity funds have higher expense ratios than debt funds on the grounds that they require more active research, stock selection, and portfolio management. Similarly, actively managed schemes—handled by money managers—also tend to be more expensive than passive or index funds, which simply track a benchmark.

HOW SHOULD AN INVESTOR CHOOSE A MUTUAL FUND SCHEME?
An investor should pick a scheme that matches their risk profile and investment horizon. Younger investors with a time frame beyond five to seven years can consider equity funds. If you need the money in the next one or two years, fixed-income or debt funds would be a better option. Investors with lower risk appetite can opt for hybrid categories such as arbitrage, equity savings, balanced advantage, or multi-asset funds, which keep equity exposure low.