Mutual Fund: Meaning, Features, Types, Benefits and Working
There has been an increased awareness regarding mutual fund investments in India. According to a report released by AMFI (Association of Mutual Funds in India), mutual fund SIP accounts stood at a whopping 6.12 crore as of December 2022. This data alone is a testimony to the rising popularity of mutual funds in India.
In this blog we have decoded all the questions related to mutual funds so that you have a better clarity before you start investing. Let’s dive in!
What is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from investors and invests the amount in securities, such as stocks, shares, government bonds, and other money-market instruments. The primary objective of a mutual fund scheme is to offer optimal returns to the investors. A fund manager manages a mutual fund scheme and defines the scheme’s objective. However, the fund manager’s role would vary based on the investmentment strategy – active and passive investing – more on this later. The Securities and Exchange Board of India (SEBI), along with the Association of Mutual Funds in India (AMFI), oversees the working of these fund houses.
How Do Mutual Funds Work?
A mutual fund scheme has a pre-defined investment objective. For instance, a large-cap mutual fund will only invest in stocks and equities of top 100 companies listed on the NSE (National Stock Exchange) having a market capitalisation of more than Rs.20,000 crore. The fund manager then allocates/invests funds in equities or company stocks based on the scheme’s objective. Since mutual funds are market-linked instruments, their performance is directly related to the market’s performance.
Point to Note: The primary objective of an actively-managed fund is to beat the benchmark index, while the intention of a passively-managed fund is to track or mirror the underlying index. NSE (Nifty) index is the most popular index in India followed by BSE index.
When you invest in a mutual fund, the Asset Management Company (AMC) will allot you a certain number of units as per the investment amount. The price of each unit is based on the fund’s Net Asset Value (NAV), which is the combined value of all assets held by the fund minus its liabilities. Therefore, an increase in a fund’s NAV represents how much profit you can make as an investor. Sounds complex? Let’s understand this with an example.
Consider that you have invested ₹1,000 in a mutual fund scheme with an NAV of ₹10. Based on this, the AMC will provide you with 100 units of the scheme by simply dividing your investment with the NAV of your scheme.
Say that the NAV of this scheme increases to ₹12 in the following year. Now, your investment will be worth ₹1,200 (₹12 x 100). This means that within a year, you have earned a 20% return on your investment.
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Types of Mutual Funds in India
1. Based on Asset Class
1. Equity Funds
Equity funds are also called stock funds as they invest primarily in stocks of various companies. These mutual funds are capable of bringing in high returns but they can also lead to major losses when the prices of stocks go down. The performance of these shares directly influences the gains or losses one might get from their mutual fund investments.
2. Debt Funds
Debt mutual funds are less risky than equity funds and hybrid funds. They are thus suitable for individuals who are looking for low-risk investments and decent returns. Debt mutual funds invest in fixed-income securities such as government securities, money market instruments, corporate bonds, etc.
3. Hybrid or Balanced Funds
Hybrid or balanced mutual funds are a proper blend of both stock and bond funds. The ratio of this mixture can be fixed or variable for both assets. Investors who are ready to take more risks than debt funds but fewer risks than equity funds can opt for hybrid funds for decent returns.
2. Based on Structure
1. Open-Ended Funds
In open-ended mutual funds, trading of units takes place on a continuous basis. Therefore, investors can invest and redeem fund units at their convenience. Whenever fund houses decide to purchase or sell their existing units, the prices of their outstanding units tend to rise or fall.
2. Close-Ended Funds
Close-ended mutual funds are open for investment during their NFO (New Fund Offer) period. Furthermore, they come with a lock-in period of around 5-7 years before which investors cannot exit their investments. Close-ended funds are listed in stock exchanges to provide an exit option.
3. Based on Investment
1. ELSS/ Tax Saving Funds
Equity-linked Savings Schemes (ELSS) have a lock-in period of 3 years. These funds allow you to save on income tax under Section 80C. With ELSS funds, you can invest in a diversified range of stocks across sectors and market capitalisations.
2. Growth Funds
As the name suggests, investors opt for this mutual fund to increase their capital growth. This type of mutual fund promises high returns, along with major risks. Therefore, investors with a long term investment plan and high-risk appetite can opt for growth funds.
3. Pension Funds
Also known as superannuation funds, pension funds allow investors to save a huge amount for life after retirement. These mutual funds usually invest in low-risk government securities and bonds for stable returns.
4. Liquid Funds
Liquid mutual funds invest in certain debt securities that have a short maturity of up to 91 days. They do not have a lock-in period and offer high liquidity as per its name. Also, owing to their short maturity period, liquid funds are less risky investments than growth funds.
4. Based on Plans
1. Direct Plan
Direct plans involve buying mutual fund units directly from the AMC (Asset Management Company). Seasoned investors or those who are confident about picking mutual schemes without any third-party assistance usually prefer direct plans. These plans have a lower expense ratio.
2. Regular Plan
Regular plans are mutual fund plans which involve buying mutual fund units via a third-party. Beginner investors consider investing in regular plans due to the fund selection assistance offered by the brokers. However, the broker might charge a certain commission for their services and this could significantly increase the expense ratio, which in turn increases the overall cost of the fund.
5. Based on Investment Strategy
1. Active Investing
For active investing, a fund manager takes the decision regarding buying and selling of stocks. The primary aim of the fund manager is to provide benchmark-beating returns to the investor. Since a fund manager has a significant role to play, a certain amount is charged to the investor as a fund management fee.
2. Passive Investing
A fund manager has little role to play when it comes to passively managed funds or index funds. The fund manager only creates a portfolio of stocks (for passively-managed equity funds) that mirrors the performance of the underlying index, let’s say Nifty 50. Passively-managed funds are low-cost funds due to their significantly lower expense ratio compared to active funds.
Features of Mutual Funds
1. Convenience
With the popularisation of online investment in mutual funds, you do not need to visit a fund house physically. You can invest in any fund of your choice using your phone or computer. All you need to do is visit the portal or app of the AMC and log in here to make a purchase.
2. Flexibility of Investment
This is one of the attractive features that mutual funds have to offer. You can opt for any mode between SIP or lumpsum to invest your money in mutual funds.
3. Liquidity
You can also withdraw or redeem your funds to meet any emergency. Depending on your scheme, you will receive the amount within 3-4 business days. Liquid funds transfer this amount to your account in the following business day. Hence, mutual funds carry decent liquidity as investors can redeem them anytime.
4. Income Tax Benefits
With a long-term investment in mutual funds, you can pay less taxes due to their high tax efficiency. You can also get income tax deductions by investing in ELSS funds while earning high returns.
5. Minimal Charges
Mutual funds are also affordable for every earning individual. You need to pay a small amount, known as the expense ratio, to your fund houses to invest in mutual funds. The expense ratio and other additional charges might vary between fund houses. However, the costs are less than other managed funds.
6. Regulated by SEBI
Every fund house must register itself under SEBI before launching a mutual fund scheme. SEBI overlooks the transparency and accountability of fund houses and protects investors. By doing so, SEBI prevents any arbitrary use of investors’ money. This makes mutual funds safe from fraud and malpractices.
7. Operated by Professionals
Every fund house employs professionals known as fund managers to operate mutual funds. They study the market pattern and invest your money in equities or debts according to the scheme’s objectives.
8. Good for Portfolio Diversification
Mutual fund schemes allow you to avoid placing all your eggs in one basket. They uniformly invest in high and low-risk mutual investments on your behalf to balance your profit and losses. This lets you access a diversified portfolio, which can deliver profits even during periods of economic downturns.
Benefits of Investing in Mutual Funds
The primary goal of any investor should be to outperform inflation. With other savings instruments providing low returns, investing in mutual funds has become necessary to keep up with the market. One can also choose to invest in mutual funds because of the following benefits.
1. Variety
Mutual funds are of numerous types, which have been discussed above. Investors can select a mutual fund scheme that is in line with their financial objectives. On account of the different available options, investors can build a diversified investment portfolio in a cost-effective manner.
2. Various Modes of Investments
You can invest in mutual funds through a one-time or lump sum investment. Or, you can opt for other options, such as a Systematic Investment Plan (SIP), Systematic Withdrawal plan (SWP), and Systematic Transfer Plan (STP).
3. Disciplined Investing
A mutual fund encourages one to invest over a considerable period of time, which is vital for significant wealth creation. Moreover, you can opt for a Systematic Investment Plan (SIP) and invest a specific amount at regular intervals, thereby investing in a disciplined manner.
4. Accessibility
Many fund houses allow individuals to invest as little as Rs.1000 as a lump sum investment in mutual funds. Besides, one can opt for an SIP and start investing with a nominal sum of Rs.10.
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How to Invest in Mutual Funds?
An investor can invest directly in mutual funds by visiting the application or portal of the fund house. Alternatively, they can take the help of a financial intermediary to invest in mutual funds via regular plans.
To invest in mutual funds directly, follow these steps:
- Visit an AMC’s website and open a new account.
- Select a fund and enter the investment amount.
- Choose whether you want to invest via lump sum or SIP.
- Enter payment details and select a payment mode.
- Complete the KYC verification by entering the required details.
Ways to Invest in Mutual Funds
1. SIP
In a Systematic Investment Plan (SIP), investors invest a fixed amount at regular intervals in a Mutual Fund scheme. In SIPs, a fixed amount is invested at a defined frequency. This allows investors to invest hassle-free without having to time the market.
2. Lump Sum
The investment is a one-time one, like Rs 1,000,000. You may consider making a lump-sum investment if you have a substantial amount to invest and have a high risk tolerance.
Documents Required to Invest in Mutual Funds
1. Mutual Funds Application Form
In order to get a mutual fund, you may need to fill out more than one application form. You will need one form to open a mutual fund account, another form if you want to enroll in a SIP plan within the fund, and an ECS form if you want to make an electronic transfer from your bank account. A Risk Profile form may be required by some Asset Management Companies.
2. KYC Individual Form
Investing in mutual funds requires a PAN verification under Know Your Customer (KYC) norms implemented by the Government of India. The website of CDSL Ventures Limited (CVL) allows you to check your KYC compliance or register for KYC. The KYC acknowledgement letter or a copy of the KYC-compliance page must be submitted if you are already KYC-compliant.
3. Proof of Identity: Any of the Following Documents Can Be Submitted as Proof of Identity:
- PAN with photograph
- Aadhaar
- Passport
- Voter’s ID card
- Driving licence
- Identity card/document with applicant’s photo, issued by the following authorities: Central/State Government and its Departments, Statutory/Regulatory Authorities, Public Sector Undertakings, Scheduled Commercial Banks, Public Financial Institutions, Colleges affiliated to Universities, Professional Bodi
4. Proof of Address: Any of the Following Documents Can Be Submitted as Proof of Address:
- Aadhaar
- Driving licence
- Passport
- Voter’s ID card
- Ration card
- Registered lease/sale agreement of residence
- Flat maintenance bill
- Insurance copy
- Utility bills; landline telephone bill, electricity bill, gas bill (ess than 3 months old)
- Bank account statement/passbook ( less than 3 months old)
- Self-declaration by High Court and Supreme Court judges ( allowing the new address in respect of their own account)
- Proof of address; issued by Bank Managers of Scheduled Commercial Banks/Multinational Foreign Banks/Gazetted Officer/Notary Public/Elected Representatives to the Legislative Assembly or Parliament/a document issued by any Government or Statutory Authority
- Identity card/document with address, issued by any of the following: Central/State Government and its Departments. Statutory/Regulatory Authorities, Public Sector Undertakings, Scheduled Commercial Banks, Public Financial Institutions, Colleges affiliated to Universities and Professional Bodies such ICAI, ICWAI, ICSI, Bar Council etc. to their Members
- For Foreign Institutional Investors (FII)/sub account, Power of Attorney given by FII/sub-account to the Custodians, duly notarised and/or apostiled or consularised
- Proof of address in the name of the spouse is also acceptable
Mutual Fund Charges, and Other Fees
1. Entry Load
Entry load was assessed when one invested in a mutual fund scheme. This particular fee was subtracted from the Net Asset Value (NAV). The charges were generally 2.25% of the investment value. However, SEBI ordered discontinuation of the entry load later on.
2. Exit Load
You must pay an exit load if you sell your mutual fund scheme within a short period of time. This fee is imposed to deter investors from leaving the scheme and to limit the number of withdrawals. The exit fee is usually a percentage of the mutual fund’s Net Asset Value (NAV). As a result, when selecting a plan, it is critical to consider both the exit load and the expense ratio. However, exit fees are not included in your expense ratio.
3. Transaction Charges
A one-time fee charged to investors. AMCs are permitted to charge a transaction fee of Rs. 150 for new investors and Rs. 100 for existing investors on investments worth Rs. 10,000 and above. If the investment is less than Rs. 10,000, no transaction fees are charged. In the case of SIP, a TC of Rs. 100/- is payable in four equal instalments, beginning from the 2nd to the 5th instalment, if the total commitment to SIP is Rs.10000/- or higher. You can find the transaction amount in your statement of accounts.
4. Expense Ratio
The expense ratio is a yearly fee expressed as a percentage of a fund’s daily net assets. An asset management firm charges it for managing a mutual fund scheme. As a result, it covers all of the expenses associated with managing and operating a mutual fund scheme. Sales and marketing expenses, administration fees, distribution fees, fund manager’s fees, and so on are examples of such costs.
How Can You Save Taxes with Mutual Funds?
A higher purchase price results in lesser profits, which leads to lower tax. As a result, investors of non-equity funds with LTCG can use indexation benefits to lower their gains, which reduces their taxable income.
Additionally, if you wish to save tax with mutual funds, you can invest in ELSS (Equity-Linked Savings Scheme) funds that offer tax benefits under Section 80C of the Income Tax Act, 1961. You can claim tax benefits of Rs.1.5 lakh on your ELSS investments. However, note that ELSS funds come with a lock-in period of 3 years.
Final Word
Mutual funds stand out as a simple and straightforward vehicle for investing, both for new and seasoned investors. Other than diversifying your portfolio, mutual funds tend to offer higher returns than common savings instruments. You can start investing online through an SIP or as a lump sum at your convenience. However, individuals must determine their risk appetite, investment horizon, and financial goals before investing.
If you are ready to invest, download the Navi App and get started now!
Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
FAQs
Yes, if you choose the right fund that aligns with your risk appetite, investment horizon, and goals. Also, before investing, you must take into account other essential factors, such as past returns and the expense ratio of the fund.
Only in the case of equity funds, long term capital gains of up to Rs.1 lakhs are tax-free.
Mutual fund houses used to charge a fee when an investor is joining a scheme. This is typically called entry load. The amount was charged to cover the cost of distribution. However, since August 2009, SEBI (Securities & Exchange Board of India) made a norm of not charging any entry load.
Similar to the now defunct entry load, mutual fund houses charge a fee to investors exiting a scheme partially or completely within a certain time period, as mentioned in the fund scheme document. However, not all schemes charge an exit fee. For better clarity, go through your scheme’s fine print thoroughly.
To reach your financial goal and beat inflation, you need to make investments diligently. And investing in mutual fund schemes could be one of the ideal solutions to reach your financial goals. It’s best that you start investing early. You can utilise investing in a variety of mutual funds serving different investment objectives.
Fixed deposits guarantee fixed income; however, the returns can be significantly lower compared to mutual funds.
The expense ratio refers to the annual maintenance charge levied by mutual funds on investors. It comprises operating expenses, allocation charges, maintenance fees, advertising costs, etc.
The absolute returns from lumpsum investment is given by the following formula:
FV = PV (1+r/100)^n; where FV is the future value of the investment, PV is the present value of the investment, n is the investment tenure and r is the estimated rate of return.
However, it is ideal to utilise a mutual fund return calculator to get accurate results in this regard.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
