What Are Mutual Funds And Why Should You Invest In Mutual Funds?

Mutual funds

A Mutual fund is a well-diversified investment vehicle that can help you achieve your financial goals. With investment channels like Fixed Deposits giving low returns, more investors are inclining toward mutual funds to grow their money. 

You can start investing in SIPs with an amount as low as Rs. 500 or you can choose to invest in a lump sum. However, before investing, you should have a comprehensive understanding of mutual funds’ meaning, how mutual funds work, their benefits, and the risks involved.

Here’s all about mutual funds that you need to know!

What are Mutual Funds?

A mutual fund comprises a large amount of money pooled in from several investors. Each mutual fund scheme has a dedicated fund manager responsible for analysing and investing in securities using the pooled wealth. These securities can be stocks, gold, and fixed-income securities such as bonds, commercial papers, and treasury bills.

Mutual 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. 

Who Should Invest in Mutual Funds?

Mutual funds make for ideal options for individuals looking to grow their wealth, instead of parking them in low-return investment channels. Following is a list of parameters that mutual fund investments can help fulfil individuals’ goals whose objectives align with the same to consider investing in them:

Convenience

As mentioned earlier, mutual funds allow you to leave decision-making and the required research up to fund managers. So, you can do away with the time-consuming job of evaluating a portfolio’s asset location, keeping an eye on the market, and researching individual stocks.

Further, in the case of passively managed funds, such as index funds, the mutual fund tracks the performance of benchmark indices. Thus, fund managers don’t have an active role to play in their asset allocation. In such cases, the fund’s expense ratio, alongside an individual’s total cost of investment, is further lowered, thereby increasing his/her convenience.  

Diversification

Since mutual funds have a diversified portfolio, they cushion the impact of underperforming securities, thus minimising portfolio risk. 

Lower Costs

A mutual fund spreads the cost of trading across all its investors. Therefore, it reduces the cost per investor.

Also Read: Best Ways To Invest In Mutual Funds Online

A Closer Look at Mutual Funds

Before we delve further into understanding mutual funds’ meaning, it is important to understand how they 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. 

Types of Mutual Funds

Based on asset class, there are three 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 small-cap funds, mid-cap funds, large-cap funds, ELSS, 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 a long-term financial goal 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.

Also Read: Different Types of Mutual Funds: How To Choose The Right Fund

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.

Mutual funds offer portfolio diversification to investors at a seemingly low cost. Though mutual funds are subjected to market risk, your diversified portfolio will act as a balancing factor in case any of the securities don’t perform. 

Furthermore, you can choose to invest in a mutual fund scheme due to 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 objective. 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 lump sum or one-time 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 a SIP and start investing with a nominal sum of Rs. 500.

Also Read: Things To Know Before Choosing A Mutual Fund In India

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. 

1. 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. 

2. 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:

3. 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. 

4. 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. 

Also Read: What is dividend stripping: How it works & tax implications

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 experience of the fund manager before investing.

Role of Fund Manager in Mutual Funds

Every mutual fund has a fund manager who is assigned to manage the portfolio and monitor the fund’s overall performance. A mutual fund manager can opt for a passive or active style of management. The two types of fund managers have been discussed below. 

• Active fund managers: They take an active part when it comes to managing the portfolio. They are professionals who select the components of the portfolio themselves, which has a significant impact on the performance of the fund. 
• Passive fund managers: They manage the portfolio as per the components of a set index. A passive fund manager’s role is to replicate the returns of an underlying index rather than outperform it. 

Apart from monitoring the portfolio, a mutual fund manager has additional responsibilities. Here is a list of the duties of a fund manager. 

1. Protecting investor assets: It is the fund manager’s responsibility to safeguard the wealth of the investors. The manager should not manage the fund recklessly; it has to be done with due diligence. 
2. Compliance with regulatory bodies: The fund manager has to see that the operations of a mutual fund are in accordance with the rules set by SEBI and other governing agencies. Fund managers can be held accountable in the event of non-compliance. 
3. Fulfilling reporting requirements: Fund managers must design portfolios as per the reporting standards set by the regulatory bodies. They must ensure that the investors know about the risks and rules associated with the mutual fund. 

Top Tips to Consider Before Investing in Mutual Funds

Here are some points to keep in mind before investing in mutual funds. 

• Financial goals: Before investing in a mutual fund, try to determine the reason behind your investment. Consider assessing a fund based on its returns, risk, liquidity and tax liabilities. You should plan out your financial objectives before starting your investment journey. 
  
• Risk tolerance: Investors should consider selecting a mutual fund depending on their risk appetite. For example, risk-averse individuals can choose to invest in debt-oriented funds which offer regular income. On the other hand, aggressive investors can opt for equity-based mutual funds that promise high returns. 
  
• Mutual fund portfolio: Many mutual funds invest your money in particular segments like infrastructure, banking, etc. Some mutual funds are also hybrid in nature – they offer a mixture of equity and debt securities. Investors should assess the asset allocation in a mutual fund portfolio before going ahead with their investment. 
  
• Investment approach: There are many ways to invest in a mutual fund. You can opt for a direct plan and purchase the units directly from the fund house. On the other hand, you may also invest through intermediaries by choosing a regular plan. 
  
  Mutual funds also offer two primary investment modes – Systematic Investment Plan (SIP) or lump sum investment. Choosing an investment plan that is aligned with your financial goals is of utmost importance. 

• Past performance of the mutual fund: Investors should consider examining the historical returns of a mutual fund. The numbers will offer an idea of how a mutual fund has performed over the years against other mutual funds. Try to opt for a mutual fund that has reaped consistent returns for a period of 5-7 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 a SIP or as a lump sum at your convenience.

However, individuals must determine their risk appetite, investment horizon, and financial goals before investing.

FAQs on Mutual Funds

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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.