What are Mutual Funds?

It is an investment vehicle where multiple investors come together and pool their funds. This pooled money is then invested by the fund manager across various asset classes including equity, debt, gold, and other securities to generate returns. The gains and losses incurred from such investments are divided among investors in the proportion of the share of investment.

How Do Mutual Funds Work?

To understand how mutual funds work, let us first understand the concept of NAV (Net Asset Value). NAV per unit is the price at which investors can buy or redeem their mutual fund investments. Investors in mutual funds are allotted units proportional to their investments and this is calculated on the basis of the NAV. For example, if you invest Rs 500 in a mutual fund with a NAV of Rs 10, you will get (500/10), 50 units of the mutual fund. Now, the NAV of the mutual fund changes every day on the basis of the performance of the assets in the mutual fund is invested in. If a mutual fund invests in a particular stock whose price goes up tomorrow, the same will reflect in the NAV of the mutual fund and vice versa. So, in the above example, if the NAV of the mutual fund goes up to Rs 20, then your 50 units that amounted to Rs 500 earlier will now amount to Rs 1000 (500 units x Rs 20). Hence, the mutual fund’s performance is driven by its underlying assets, which generate its returns to investors. So, if you redeem your mutual fund units, you shall receive Rs 1000 against the Rs 500 you originally paid. This gain of Rs 500 is known as a capital gain. The market value of the mutual fund portfolio is not fixed but varies every day; consequently, NAV also tends to change daily, based on the valuation of the fund portfolio. Hence, this gain of Rs 500 can be a loss also, depending on how the NAV moves and the underlying assets perform. Since mutual fund investments are market-linked, the returns are not guaranteed and are also, dynamic in nature. Mutual fund returns (capital gains) are subject to tax, known as capital gains tax. Capital gains tax will impact when you choose to redeem your investment; like in the example above you will be liable to pay a tax on the Rs 500 you have earned. Bear in mind two things though: The capital gains tax is applicable only if you redeem the investment and not if you stay invested. The extent of capital gains tax will depend on the types of mutual funds and your investment holding. Mutual funds are subject to short-term capital gains tax (STCG) and long-term capital gains tax (LTCG). The periods of short-term and long-term capital gains tax are defined differently for mutual funds.

Types of Mutual Funds?

There are multiple ways in which mutual funds can be categorized, for example, the way they are structured, the kind of securities they hold, their investment strategies, etc. The Securities and Exchange Board of India (SEBI) has classified mutual funds based on where they invest, some of which we have tried to capture below. What we provide you with here is not an extensively categorized list of mutual funds, but rather a few popular ones to get you started. Types on the basis of the structure: Open-ended funds are mutual funds that allow you to invest and redeem investments at any time, i.e. they are perpetual in nature. They are liquid in nature and don’t come with a specific investment period. Close-ended schemes have a fixed maturity date. You can only invest at the time of the new fund offer and redemption can only be done on maturity. You cannot purchase the units of a close-ended mutual fund whenever you please. Types on the basis of asset classes: Equity Mutual Funds invest at least 65% of their assets in stocks of companies listed on the stock exchange. They are more suitable as long-term investments (> 5 years) as stocks can be volatile in the short term. They have the potential to offer higher returns but also come with high risk. Here are a few types of equity mutual funds– Large-cap Funds invest at least 80% of their portfolio in stocks of large-cap companies i.e. the companies that are ranked in the first 100 in the list of stocks prepared by AMFI depending on market capitalization. [Association of Mutual Funds of India (AMFI) is the industry body representing mutual funds and is tasked with protecting and promoting the interests of mutual funds as well as unitholders.] Mid-cap Funds invest at least 65% of their portfolio in stocks of mid-cap companies i.e. the companies that are ranked between the 101st and 250th based on their market capitalization Small-cap Funds invest at least 65% of their portfolio in stocks of small-cap companies i.e. the companies that are ranked 251st and above based on their market capitalization ELSS (Equity Linked Savings Scheme) is a tax-saving equity mutual fund. It invests at least 80% of its portfolio in stocks. The investment made under ELSS is eligible for tax deduction under section 80C, of the Income Tax Act, 1961 up to Rs 1.5 Lakh per annum. ELSS also comes with a lock-in of 3 years from the date of investment. Multi-cap Funds invest in stocks of any companies across all market capitalization, namely, large-cap, mid-cap, and small-cap stocks. There is no investment limit defined by SEBI at the market capitalization level. International Funds are schemes that invest equity of companies listed outside India. The objective of these funds is to provide an element of geographical diversification to investors and counter the volatility of Indian markets as foreign markets do not necessarily move in sync with Indian markets. Index Funds: An Index Fund is a type of mutual fund that simply impersonates an index. So when you invest in index funds, fund managers deploy your money in the same companies and in the same proportion as the index they are tracking. For instance, an Index Fund tracking SENSEX will buy all the 30 stocks that are part of SENSEX, and it will do so in the same proportion. Whenever a stock is removed from SENSEX, the index fund will also remove it from its portfolio, And if some new stocks are added to the SENSEX, then the fund will also replicate the changes in its portfolio. Debt Mutual Funds primarily invest in fixed-income instruments like Government securities, corporate bonds, and other debt instruments. They are not affected by stock market volatility and hence, can offer more stable returns compared to equity mutual funds. The types of debt mutual funds are differentiated on the basis of the maturity period of the securities they hold. Let’s look at a few types of debt mutual funds- is Liquid Funds invest in debt securities and higher-rated securities which have a maturity period of fewer than 91 days. This makes them relatively less risky than most other categories because a lower maturity mitigates any interest rate volatility (which is the risk of loss resulting from a change in interest rates). Liquid funds are a good avenue for parking emergency funds alternative to bank savings accounts. Overnight Funds invest in securities with a maturity of one day. These funds come with low risks safety again because of shorter maturity periods, the interest rate risk is on the lower side. These are commonly used by corporates to park their funds. Money Market Funds invest mainly in government securities (known as treasury bills) and similar instruments, which are short-term with maturity periods of less than one year. These funds are suitable for investors looking for stable and non-volatile funds as interest risk is less. Banking & PSU Funds invest at least 80% of their investment in debt securities of banks, public sector undertakings, municipal bonds, public financial institutions, etc. They can be better suited for investors looking for short to medium-term investment tenure. Glit Funds invest a minimum of 80% in Government securities across maturity periods. The nature of investment makes it more suitable for a long-term investment as Government securities can be volatile in the short term. Short Duration Funds invest in debt and other money market securities such that the average maturity of the portfolio is between 1-3 years. They are more suited for investors looking at an investment time frame of 1-3 years and moderate risk appetite. [Macaulay Duration represents the time required to generate returns equal to your investment in bonds] Hybrid Mutual Funds invest in both equity and debt in varying proportions depending on the investment objective of the fund. Thus, hybrid funds give you diversified exposure to various asset classes. Hybrid funds are categorized on the basis of their allocation to equity and debt. Let us look at a few categories- Aggressive Hybrid Funds are a type of hybrid fund that can invest 65-80% of their portfolio in equity and 20-35% in debt instruments. As a result of a greater allocation to equity, they prove to be riskier than the balanced hybrid category. Conservative Hybrid Funds invest at least 75-90% of their portfolio in debt securities and the remaining 10-25% in equity securities. Because of this allocation, they may prove to be relatively less risky than, say, an aggressive hybrid fund. Balanced Advantage Funds, also known as dynamic asset allocation funds keep their investments in equity and debt dynamic in nature. As per the market movement, their allocation to both asset classes keeps changing so as to maximize the gains and minimize the risks.

Ways/modes of Mutual Fund Investment?

An investor can invest in mutual funds in the following ways: Lumpsum: When you want to invest a significant amount in a mutual fund in one go. For example, if you had a sum of Rs 1 lakh to invest then you could go in for lumpsum investment and invest the entire amount of Rs 1.0 lakh at one go in a mutual fund of your choice. The units allotted to you will depend on the NAV of that fund on that particular day. If the NAV is Rs 1000, you will end up getting 100 units of the mutual fund. SIP: You also have the option to invest small amounts periodically. In the above example, say, you don’t have Rs 1 Lakh but can commit to an investment of Rs 10,000 per month for 10 months, and you can align your investments with your cash flows. This way of investing is known as Systematic Investment Plan (SIP). SIP encourages regular investment of fixed amounts bi-monthly, monthly, quarterly and so on, depending on your need and the options available with the mutual fund. This method of investing inculcates a discipline of investment and also eliminates any need to look for the right time to invest. Many investors try to time the market which generally requires considerable time and expertise. What a SIP does instead is to average out your costs and the investor doesn’t need to time the market. When the NAV is low, it gets you higher units and vice versa. SIPs, when done regularly over the long term, can help you build a more considerable mutual fund investment corpus. The minimum amount for lump sum and SIP investments are defined by mutual funds and can vary but can start at as low as Rs 100.

Features & Benefits of Investing in Mutual Funds?

Now that we know what mutual funds are and how they work along with their types, let us look at the advantages of investing in mutual funds. Diversification: The saying ‘do not put all your eggs in one basket’ perfectly fits mutual funds as spreading investment across multiple securities and asset categories lowers risk. For example, compared to direct equity investing, where your funds are deployed in individual company stocks, equity mutual funds invest in a basket of stocks across sectors, thereby reducing risk. Professional management: Mutual funds are managed by full-time, professional fund managers who have the expertise, experience, and resources to actively buy, sell, and manage investments. A fund manager continuously monitors investments and rebalances the portfolio accordingly to meet the scheme’s objectives. Transparency: Every mutual fund has a Scheme Information Document readily available on the fund house’s website that can give you all the details about its holdings, fund manager, etc. In addition, the portfolio investment value (NAV) is published daily on the AMC site, and AMFI site for investors to track the portfolio of the mutual fund. Liquidity: You can redeem your investments on any business/working day at the NAV of the day of your redemption. So, depending on the type of mutual fund you have invested in, you would receive your invested funds in your bank account in 1-3 days. However, close-ended funds allow redemption only at the time of the maturity of the mutual fund. Similarly, ELSS mutual funds have a lock-in period of three years. Tax Savings: Investment of up to Rs. 1,50,000 in ELSS mutual funds qualifies for tax benefit under section 80C of the Income Tax Act, 1961. Mutual fund investments, when held for a longer term, are tax-efficient. Choice: There are many options to invest in mutual funds to meet your different needs. To name a few- Liquid funds, is for investors looking to benefit from the safety of debt and low-interest rate risk, flexi-cap funds, if you are looking for stock diversification and solution-oriented mutual funds if you are looking to invest for a particular goal like retirement or children’s education, etc. Cost-effective: Mutual funds are a low-cost investment vehicle. The pooled investments from several investors in a mutual fund enable the fund to invest in a basket of stocks and debt securities which otherwise may be out of reach for the ordinary investor or require a higher investment amount. Thus, these pooled investments provide advantages of economies of scale. In return, lower costs to investors, such as brokerage, etc., are addressed in the minor form of fund expenses. This is why investing in direct mutual funds through ET Money makes sense because that helps you decrease the cost further. Returns: Mutual fund returns are not assured by mutual funds and are subject to market risks. But over the long term, equity mutual funds have the potential to deliver double-digit returns annually. Debt funds can also offer higher returns as compared to bank deposits. Well Regulated: In India, the mutual fund industry is regulated by the capital market regulator Securities and Exchange Board of India (SEBI). Therefore, mutual funds must follow stringent rules and regulations, ensuring investor protection, risk mitigation, liquidity, and fair valuation.