What are Mutual Funds: Basics, Types and How to Invest
What is a great way of generating potentially better returns compared to conventional investment avenues (like Fixed Deposits)?* Mutual funds! But before you start investing, getting a thorough understanding of what mutual funds are can help you make informed decisions. This article helps simplify mutual fund meaning, types, benefits, taxation, risks involved and more. Keep reading!
Mutual Fund Basics
Mutual funds are an investment vehicle where you invest your money alongside other investors. The Asset Management Company (AMC), where you have invested your money, in turn, invests your money in assets and securities and the investors receive the profits.
A fund manager working on the AMC’s behalf will collect a large sum of money from many investors, which he/she will invest into a variety of assets like stocks, bonds, money market instruments, gold, real estate, etc. Then, they will redistribute the profits from these investments among investors in the proportion to their holdings.
These funds are classified based on the types of securities they invest in. The most prominent ones are equity, debt and hybrid funds. Equity funds invest in stocks primarily, and debt funds in fixed-income securities. But, hybrid funds invest in stocks and fixed-income securities in different proportions.
The better a mutual fund’s underlying assets perform, the higher will be its Net Asset Value (NAV). NAV is the collective market value of all assets held by a mutual fund. As this value goes higher, investors who have stayed invested can redeem the fund units to make a profit.
How Do Mutual Funds Work?
A mutual fund collects funds from numerous investors. Then, it allocates the investment corpus to various securities. Essentially, your wealth gets indirectly invested in stocks or other financial instruments (bonds, debentures, etc.).
Moreover, an investment is made depending upon the theme of a mutual fund. For instance, a large-cap mutual fund only invests in stocks of large-cap companies.
When you invest in a mutual fund scheme, the Asset Management Company (AMC) will allot specific units based on the fund’s Net Asset Value (NAV). Let’s understand this by way of an example:
Suppose you invest Rs.1,000 in a mutual fund scheme that has a NAV of Rs.10. Therefore, its AMC will allocate you 100 units of this mutual fund scheme.
Now, let’s say that the scheme’s NAV reaches Rs.12 in the second year. This implies that in a span of one year, you have received a 20% return on your investment.
Additionally, in this manner, you can track your investments and keep a tab of your return.
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Types of Mutual Funds
1. Equity Funds
These funds invest their fund corpus in shares of companies. So, their returns depend on the performance of the stock market. Although equity funds have the potential to offer high returns, the associated risk is very high. Therefore, such funds are suitable for investors with a high-risk appetite and long-term investment horizon.
Based on their features, these funds can be of different kinds. These include ELSS, Small-cap funds, Mid-cap funds, Large-cap funds, etc.
2. Debt Funds
Debt funds invest in fixed-income securities, such as treasury bills, corporate bonds, and government securities. These mutual fund schemes can offer regular and stable income to investors. Moreover, they are associated with lower risk compared to equity funds. Furthermore, debt funds can be categorised into different types, which include low-duration funds, credit risk funds, Gilt funds, etc.
3. Hybrid Funds
These mutual funds invest in both equity and debt instruments. Depending on the sub-category of hybrid funds, the ratio of investment can vary or be fixed. Hybrid funds are classified into various types, such as aggressive funds, balanced funds, conservative funds, and more.
4. Solution-oriented Funds
Investing in this type of mutual fund requires a specific goal, such as creating a corpus for your retirement or your children’s education and marriage. Solution-oriented funds usually come with a lock-in period of at least 5 years.
Individuals should take note of the investment horizon and returns from each of these fund types to ensure that they align with their financial goals before investing. For instance, individuals with long-term financial goals such as retirement or a child’s wedding can choose to invest in equity funds or solution-oriented funds. Contrarily, investors looking to generate a fixed income can consider investing in debt funds, and so on.
Who Should Invest in Mutual Funds?
Mutual funds are perfect for the following types of investors:
- Investors wanting to diversify their portfolio
Investors already know that it is too risky to invest a huge amount of money or their entire corpus in a single asset or security. However, by investing in mutual funds, one can diversify his/her investments as the money is invested in various securities and asset classes.
So if ever the market crashes, the investor will not end up losing too much money. This is because a downturn in one asset class does not usually correlate to downturns in another.
- Those with a small budget to invest
In order to invest in mutual funds, you do not require to invest a huge sum of money. One can start investing with as low as Rs.10 by investing money through SIPs (Systematic Investment Plans) in Navi Mutual Fund.
There are more than 2500 active mutual funds schemes in India that investors can choose to invest in. Historically, most mutual funds give good returns, so you can invest in one.
- Investors who want tax benefits
Investing in mutual funds will allow individuals to get certain Income Tax benefits. If an individual invests in Equity Linked Saving Scheme (ELSS), he or she can claim a maximum amount of Rs.1.5 lakh in deductions on their Income Tax payments in a particular financial year. This has been stated in Section 80C of the Income Tax Act 1961.
- Those who want help with investing
In mutual fund investments, it is not necessary for individuals to manage everything on their own. Investors can take the help of professional fund managers who will guide them through the process of investing.
These fund managers make investment decisions on behalf of investors. They will also research and observe the performance of assets held by the fund and buy/sell accordingly. This is an extremely useful option for beginner investors who do not have much idea about the share markets.
- Those looking for high liquidity
Most mutual funds are open-ended, so you can buy and sell them at any time. The total redeemable or buyable value of a mutual fund is solely based upon the Net Asset Value (NAV) of those funds on that particular day.
On the other hand, one can also liquidate close-ended funds as well. Close-ended funds are issued for a fixed duration. However, they are listed on the exchange after the closing of the New Fund Offer (NFO). So, it doesn’t really matter if an individual invests in closed-ended or open-ended funds as both allow you to easily redeem your investments.
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Why Should You Invest in Mutual Funds?
The primary goal of any investor should be aligned with how to beat inflation. With other savings instruments giving low returns, it has become necessary to invest in mutual funds to stay at par with the market.
Furthermore, you can choose to invest in a mutual fund scheme due to the following benefits:
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.
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).
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.
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.
Taxability of Mutual Funds
Investors can earn 2 types of income from their mutual fund investment – dividend and capital gains. Both of these have varying tax implications. Moreover, taxation differs based on the type of scheme and the duration of holding an investment.
Allow us to elaborate –
Dividend Income
According to the Budget 2020 proposal, dividends are added to an investor’s income and taxed as per his/her applicable tax slab.
Capital Gains
Capital gains refer to the profit earned on the sale of a mutual fund investment. Moreover, taxation of capital gains varies with the type of scheme:
- Equity Funds
In the case of equity-oriented schemes, if an investment is held for a period of 12 months or less, the returns are termed Short-Term Capital Gains (STCG). Such gains are taxed at the rate of 15%. If an investment is held for longer than 12 months, the realised returns are known as Long-Term Capital Gains (LTCG). Such gains are taxed at 10% if they exceed Rs.1 lakh.
- Non-Equity Funds
If investors sell their units in non-equity mutual funds within 36 months, the returns that they earn are regarded as STCG. Such returns are taxed as per an investor’s income tax slab rate. If individuals redeem the units post-completion of 36 months, the gains are deemed as LTCG, and a tax rate of 20% is applicable. Furthermore, non-equity mutual funds offer indexation benefits in the case of LTCG. Here, indexation benefit refers to adjusting an investment’s purchase price so that it reflects the effect of inflation.
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 funds that offer tax benefits under Section 80C of the Income Tax Act, 1961.
When Should You Invest in Mutual Funds?
There is no ideal time to invest in mutual funds. So, you can make investments as and when you wish. That said, it is wise to purchase units of a mutual fund scheme when their NAV is lower. As a result, you can maximise returns. However, make sure to consider various essential aspects, such as past returns of the fund and the experience of the fund manager before investing.
With Navi, you can start an SIP with Rs.10 or make a lump sum investment. You also have the option to invest in the top 50 companies through Nifty 50. The benefits include – the lowest expense ratio*, easy-to-navigate dashboard, 100% paperless KYC and zero transaction charges*. If you want to unlock the power of passive investing, visit Navi Mutual Fund and explore a host of mutual funds
*T&C applied
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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 on Mutual Funds
Ans: 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.
Ans: Only in the case of equity funds, long term capital gains of up to Rs.1 lakhs are tax-free.
Ans: 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.
Ans: 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.
Ans: 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.
Ans: Fixed deposits guarantee fixed income; however, the returns can be significantly lower compared to mutual funds.
Ans: 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.
Ans: 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.
