What are Mutual Funds and How to Invest in Them?

With the shift of household savings from physical assets into financial savings, Mutual funds are emerging as a preferred investment vehicle as also evident from the latest industry data issued by the Association of Mutual Funds of India (AMFI). From total Assets under Management (AUM) of Rs. 17.55 lakh crores at the end of March 2017, the industry witnessed a healthy growth during the FY 2017-18 and AUM as on 31st March 2018 stood at Rs. 21.36 lakh crores, of which equity and balanced schemes formed 51% of the total AUM for the sector. You may also be willing to invest in mutual funds but lack of knowledge acts as a hindrance. This article attempts to decode this investment option for you. Here are the basics of mutual funds for you.

What is a Mutual Fund?

A mutual fund is an investment instrument that pools money from investors and invests it on their behalf into diversified investment options. The investment decisions are taken by professional funds managers, duly supported by a team of research analysts.

Benefits of Investing in Mutual Fund

basics mutual funds

Mutual funds offer you the following benefits:

  1. Professional Management of Funds – MFs allow professional management of the money invested and are ideal for the investors who cannot understand the nuisances of the stock markets but still want to enjoy their returns.
  2. Portfolio Diversification – MFs pool the money of investors and invest in a basket of securities depending upon the investment objective of the scheme. As such, it renders automatic diversification to the portfolio.
  3. More Investment Options suiting Risk Appetite and Return Expectations – Different fund houses offer a variety of mutual fund schemes, which invest in varying asset classes and suit investors with varying risk appetites and return expectations. As such, each investor can find suitable investment options as per their financial goals. 

Terms you must know before Investing in Mutual Funds

 

Since you are now aware of the benefits of investing in mutual funds, you must be excited to invest in mutual funds. But before you take a step ahead to invest, here are few terms you must know before investing in mutual funds:

  1. NAV – NAV stands for Net Asset Value. As the name suggests, it is the value of one unit of a mutual fund scheme and thus, represents the price at which MF investors can invest or redeem one unit of the investment. It can be calculated as the market value of the portfolio net of amounts payable and divided by total outstanding units of mutual fund scheme.
  2. AUM – AUM stands for Assets under Management. It is the amount currently being managed by the fund manager in respect of that mutual fund scheme and denotes the market value of the money
  3. SIP – SIP stands for Systematic Investment Plan. It is an investment option which allows the investor to make an investment in a mutual fund scheme on a periodical basis. Investors enjoy complete flexibility in deciding the amount and periodicity of the investment. As such, it allows to make consistent investments and thus helps accumulate healthy corpus over a period of time.
  4. SWP – SWP stands for Systematic Withdrawal Plan. Just like SIP allows you to make periodic investments, SWP allows the investor to periodically redeem their mutual fund investments. As such, this works well in case the investor needs periodical cash flows.
  5. STP – STP stands for Systematic Transfer Plan. It allows you to switch your investments in one mutual fund scheme to another on a periodical basis. It can be used to transfer your investments in a less-risky fund scheme like debt fund to a more risky fund scheme like an equity fund or vice versa.
  6. TER – TER stands for Total Expense Ratio. It denotes the ratio of total expenses of the mutual fund schemes divided by the AUM of the scheme. Expenses of the mutual fund scheme will comprise of distributors’ commission/ brokerage, selling expenses, publicity expenses, transaction charges, fund manager’s fees etc. SEBI regulates the maximum ceiling for TER for the respective fund schemes. Lower the TER for a fund scheme, better it is for the investor, as higher TER eats into the returns of the investors.
  7. Exit Load – It is the amount charged by the fund house for redeeming your investment before the end of a specified period. This time period will tend to be higher in equity schemes while the same will be lower in debt schemes and generally zero in case of liquid funds. Exit load aims at disincentivizing the investors to exit the investment at an early stage.

Types of Mutual Funds on the basis of Investment Objective

basics mutual funds

SEBI has recently provided for rationalization of the existing and new mutual fund schemes so that an investor is able to evaluate different options available and thus takes an informed decision to invest in a particular scheme. Accordingly, the schemes are to be broadly classified as below:

  1. Equity Schemes – This category of Mutual Fund schemes will invest primarily in equity and equity-related instruments. Further sub-classification of such schemes would be on the basis of the size of companies wherein the investment is being made like large-cap companies etc., investment style like contrarian investing, value investing etc. or on the basis of the investment in particular theme/sector like banking etc. As such, further categories of equity schemes are multi-cap fund, large-cap fund, large & mid-cap fund, midcap fund, small-cap fund, dividend yield fund, value fund, contra fund, focused fund and sectoral fund.
  2. Debt Schemes – This category of MF scheme aims to invest primarily in fixed income securities and hence is more suitable for investors with conservative risk appetite. The returns from a debt scheme will come from the accrual of interest income on the debt investments and also from the capital appreciation in the market value of the investments due to changing interest rate scenario, upgrade/downgrade of the credit rating of issuing companies etc. Depending upon the type of debt securities and the duration of the securities for which investment is being made, debt schemes are further classified into overnight fund, liquid fund, ultra-short duration fund, low duration fund, money market fund, short duration fund, medium duration fund, medium to long duration fund, long duration fund, dynamic bond, corporate bond fund, credit risk fund, banking and PSU fund, gilt fund, gilt fund with 10-year constant duration fund, floater fund.
  3. Hybrid Schemes – Hybrid schemes aim to invest across asset classes. Depending upon the desired investment objective and risk structure, the hybrid schemes are classified into conservative hybrid fund, balanced hybrid fund, aggressive hybrid fund, dynamic asset allocation fund, multi-asset allocation fund, arbitrage fund, equity savings fund.
  4. Solution Oriented Schemes – As the name suggests, such schemes aim to fulfill specified objective like retirement planning etc. Such funds are to be further classified into retirement fund and children’s fund. Such schemes will have a lock-in period of 5 years or the achievement of the desired financial goal, whichever is earlier.
  5. Other Schemes – This category will be the residual category for MF categorization and will comprise of Exchange Traded Funds (ETFs) and Fund of Funds (FOFs). 

Types of Mutual Funds on the basis of Liquidity

Mutual funds can be classified on the basis of liquidity as below:

  1. Open-Ended Mutual Funds – Such mutual funds do not carry a fixed investment period. Therefore, investors can invest and/or redeem their investments in such open-ended MF schemes on any working day. Such investment/redemption is made on the basis of NAV of the MF scheme as declared by the fund house.
  2. Close Ended Mutual Funds – Such mutual fund schemes carry a fixed maturity date and further, are open for investment only during a specified period. However, to impart liquidity to the investors, such close-ended MF schemes are generally listed on stock exchanges by the fund houses. 

Types of MFs on the basis of Mode of Investment

As an investor-friendly measure, SEBI has directed mutual fund houses that investors investing directly with the fund house should not be made to bear the burden of distributors’ commission/brokerage. Accordingly, it was decided to create two plans under all the MF schemes as below:

  1. Direct Plan – Investors investing directly with the fund house without any intermediary/distributor are allotted units under the direct plan. Since such investors do not entail payment of any commission/ brokerage, such plans will have lower expense ratios and hence, result in better returns to the investors.
  2. Regular Plan – Investors investing through advisors/brokers/intermediaries are allotted units under Regular Plans. Needless to say, such plans will have relatively higher expense ratios and thus, will be giving lower returns to its investors.

Investment Options under Mutual Funds

Mutual fund schemes allow the following two options for investment :

  1. Growth Option – Under the Growth option, the gains realized from the portfolio investments are ploughed back into the portfolio. Thus, the investor can realize the returns from the respective investments at the time of redemption only. However, since the profits are reinvested into the fund portfolio, it also helps in realizing the power of compounding. The NAV of a growth option will always be higher than the NAV of the same fund under dividend option.
  2. Dividend Option – Under the Dividend option, the mutual fund scheme declares a dividend to the investors on a periodical basis which can be daily, weekly, monthly, quarterly or as may be decided by the fund scheme. This option is therefore suitable for those investors who seek regular cash flows from their investments. However, since the dividend can be declared only out of the realized profits, the investors cannot be guaranteed the quantum of cash flows. Further, Net Asset Value (NAV) of the scheme reduces to the extent of dividend along with the impact of Dividend Distribution tax, if any.

Taxation of Capital Gains from Redemption of Mutual Funds

For the purposes of taxation, the mutual fund schemes are classified as equity-oriented mutual funds and non-equity oriented mutual funds. Equity-oriented mutual funds are those mutual fund schemes whose minimum 65% portfolio is invested in equity shares of domestic companies listed on a recognized stock exchange. The respective taxation laws in respect of the gains realized for these mutual fund schemes are as under:

  1. Gains from Equity Oriented Mutual Funds – Short-term capital gains from equity-oriented mutual funds (wherein the investment period is less than 12 months) are taxed @ 15%.

As regards long-term capital gain from such schemes, the same was treated as tax-exempt in the hands of the investor till the financial year 2017-18. However, with effect from 1st April 2018, LTCG tax has been introduced on long-term capital gains from the sale of equity shares and equity oriented mutual funds. Thus, income tax @ 10% shall be payable on such long-term capital gains without any indexation benefit. Further, such tax will be payable only for such gains exceeding Rs. 1 lakh in a year.

  1. Gains from Other Mutual Funds – Short-term capital gains from other mutual funds like debt funds, gold funds etc. are subject to tax at the regular tax rates as applicable to the investor. Further, long-term capital gains are taxed at lower of 20% without indexation benefit or 10% with indexation benefit.

Taxation of Dividend Income from Mutual Funds

The dividend income received by the investor remains exempt in his hands, whether received from an equity fund, debt fund or any other fund. However, the fund may be liable to pay dividend distribution tax on the dividend so declared which is also deducted from fund’s NAV and accordingly, the investor indirectly bears the burden of such tax.

How to invest in Mutual Funds

basics mutual funds

Here are few ways to invest in Mutual Funds :

  1. Through mutual fund Websites/ Apps – You can invest in mutual fund schemes directly by visiting the websites of the respective mutual fund houses or by accessing their mobile apps. You can register for investment, perform e-KYC, select the MF scheme, make the payment and the process is done.
  2. Through Financial Advisors – You can invest in Mutual Fund schemes through your financial advisor which can help you choose the suitable mutual fund schemes on the basis of your financial goals and risk appetite. Financial advisors may provide you facility of online investment or help you submit your forms offline.
  3. Through RTA Investor Service Centers – You can also submit the filled up application forms for investment in mutual funds in the investor service centers of the Registrar & Transfer Agents (RTA) of the respective mutual fund scheme e.g. Karvy, CAMS etc. RTAs have also enabled investing through their websites and mobile apps making the investment process more easier and simpler.

So, now that you are aware of the basics of Mutual Funds, take your first step tow towards investing in mutual funds. Share your investment experiences in the comments below.