It is almost always assumed that anyone reading an analysis on mutual funds (or the fund management industry) knows the intricacies of the same. This is not universally true and, at all times, there are a) new people trying to understand the basics, and b) people who want to brush up their knowledge of the fundamentals.

We will use this 6-part series to understand mutual funds from their very basic concepts. Here is the first part.

What are mutual funds?

If we break the phrase 'mutual funds' and analyze the words, we realize that it refers to funds that are raised and invested mutually, i.e. on behalf of everyone participating in the scheme. If you and your friend both pool your money and invest it jointly, you have created your own mutual fund.

When the concept of companies initially formed, people who knew each other and were willing to take the risk of the venture used to put in the share capital of the company. Slowly, entrepreneurs realized that many are interested in investing financially in the company but do not want to take the day-to-day hassle of managing the company. Thus began the concept of passive investing in companies: with shareholders and executives separated.

Similarly, in the case of mutual funds, people are not interested in the day-to-day management of the funds but are interested in the final outcome of the investment. Hence, they pool their money together, hire an investment manager who manages funds for them and expect to earn a return on them.

Interestingly, while the process started from the point of view of the investor and the fund was the outcome, in today's time, it is hard to see the reality this way. With rampant (mis?)marketing of the mutual funds, it seems as if the funds came in first and they want the investor money to increase their assets under management.

How do the funds raise money?

The asset management companies (AMCs) that manage the mutual funds define avenues where they think profitable opportunities exist. For example, currently many AMCs believe that small and medium cap stocks will yield significant return over the medium to long term. Hence, they launch a 'fund' (called a new fund offer: NFO) which seeks to bring all those investors together who believe similarly.

The AMC releases a prospectus wherein it details the objective of the fund, the credentials of the company and the fund manager and the avenues where the money will be invested. Based on this information, the investor needs to decide whether this fund meets his objective or not. If the investor (or his advisor) believes that the new fund fits his required risk-return profile, the investor invests in the fund.

You might wonder that you have never seen a prospectus but only an application form for investing. Well, sometimes you give the authority to your financial advisor to choose what is best for you (and sometimes, when you lose control, s/he just chooses on your behalf!)

Where do mutual funds invest?

Mutual funds, unlike companies do not take the risk of a business directly. For example, Reliance faces the risk of change in refining margins and Hindalco faces the risk of fall in aluminum prices. Companies take the risk head-on and craft strategies to maximize their competitive position and profits.

Mutual funds, however, take one step back and invest in the companies which take on business risks. Funds which invest in the shares (or equity) of the company are called 'equity mutual funds.' Funds like PruICICI Power or Reliance Growth are examples of such funds.

Similarly, funds can invest in government securities (bonds issued by central or state governments, PSUs or other government entities) or corporate debt (issued by companies and banks). These funds are called 'debt funds.' Funds like Reliance Income Fund invest primarily in medium and long-tenor debt. Again, there are funds that invest in very short term loans (typically overnight to up to three months): these funds are called money market mutual funds. Examples include HDFC Cash Management - savings plan.

While the above three are the basic avenues for the funds to invest, many funds combine the three types in various proportions and produce 'hybrid or balanced funds.' HDFC Prudence and SBI Magnum Balanced are examples.

Based on where the funds invest, they expect returns and have corresponding risks. Equity funds are the most risky followed by debt funds; cash funds are considered almost risk less. Based on the standard theory of finance, the riskiest funds are expected to deliver the highest returns over the long run.

In the next article, we will look at the various styles and themes on which mutual funds raise money.

• Part 2: Mutual funds, demystified!

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad almunus. He can be contacted at tilotia.akhilesh@parkfa.com