What Is A Mutual Fund And How Does It Work?

What is a Mutual Fund and how does it work

Learn what is a Mutual Fund and how does it work and also understand all the Mutual Fund jargon.

Meaning of Mutual Fund

Mutual fund is nothing but collection of stocks or bonds that a professional Fund Manager buys on behalf of you. Fund Manager decides which stock or bond to buy and how much. A mutual fund then distributes the entire investment amount in small units (called units). Investors can buy these units instead of buying stocks directly.

mutual fund works

How does a Mutual Fund start – NFO?

A company that is in the business of managing mutual funds (also called fund house ) will decide to launch a new fund. Such a launch is called New Fund Offering (NFO). The fund house will then advertise the fund to the potential investors, through ads in paper, TV and online. Interested investors then provide the money (called Application Money). The fund house gives the investors an account identified by a number (called Folio Number) and puts units of a newly launched fund to that account. They may deduct a portion of the application money (called Entry-Load) to cover the launch expenses like advertising costs and the dealer commission. Each unit price (called Net Asset Value or NAV) is usually 10 at the time of fund’s NFO.

Central Know Your Customer (KYC)

Before a fund can accept your investment, they have to legally verify certain details about the investor. This includes the identity, the address and the bank account details. This is to prevent the money earned through illegal means from being invested in the fund. This process is called Know Your Customer (KYC) and is usually followed by all the companies that accept money from the investors including banks, insurance companies etc. From Feb 1, 2017 you need to do CKYC to invest in mutual funds.

What does a Mutual Fund do with your money?

The money with the Mutual Fund (called Assets of the Mutual Fund) will be given to an employee (called Fund Manager) to invest as advertised to the initial investors. Fund manager of an equity fund will buy shares of companies (called equity). Fund manager of a debt fund will invest in deposits of companies and/or government (called debt). Depending on how these investments perform, the fund’s assets will change with a corresponding change in the Net Asset Value (NAV) of each unit. Note that the number of units will not change.

Mutual Fund Expense Ratio

A fund house will take some money from the fund to cover its expenses. These expenses include employee salaries, distributor commission, marketing costs, and profit for the fund house. This expense is charged as a percentage of the total assets (called Expense Ratio) and is usually in the range of 0.5% to 3%.

Dividend and Growth Mutual Funds

Depending on the fund, some money (called Dividend) may be returned to the investor periodically (typically every year). This dividend is paid out of the fund’s assets and will reduce fund’s NAV. Some funds offer two options, namely (i)a Dividend option and (ii) a Growth option with no dividend. As you would expect, a dividend option will have lesser NAV as compared to the growth option for the same fund.

Investing in an existing Mutual Fund

Investors may decide to invest in an existing mutual fund. Such investors will have to buy the fund’s units at the current NAV. This investment will be added to the fund’s assets and the fund’s units will increase accordingly. Note that the fund’s NAV does not change when a new investment is made.

Redemption – Taking money out of a fund

When an investor wants money from the fund, he will get an amount equal to the number of units sold multiplied by the current NAV. Depending on the fund, the investor may be charged an expense (called Exit Load). Once the money is paid out, the fund’s assets and the number of units will decrease with no effect on the NAV.

Type of Mutual Funds

There are 20K+ mutual fund schemes.

  1. Open: You invest and redeem anytime. Most popular
  2. Closed: You invest only during the start and redeem when it’s tenure ends
  3. Interval: You can invest or redeem only some pre-defined dates

Broadly, there are 4 types of mutual funds based on the investment by them.

  1. Equity: invest in equity they are risky but provide high return
  2. Debt: invest in bonds (give interest) issued by the government, banks and corporates. They are safe but provide low returns
  3. Hybrid: invest in both equity and bonds they have moderate risk and provide moderate returns
  4. Others: invest in gold, real-estate, commodities, etc. They are also of moderate risk and provide moderate returns

The First Type: Equity

Equity mutual fund can be further classified into 5 types listed below

  1. LargeCap: Invest in stocks of large company with market cap more than $5B. They are relatively less risky
  2. Small/ MidCap: Invest in stocks of medium/ small companies with market cap less than $5B. They are relatively more risky.
  3. MultiCap: Invests in all types of large, medium and small companies. They are relatively more risky than LargeCap but lesser than Small/ MidCap.
  4. Sector Funds: Invest in specific sector like IT, Pharma, Banking. They are considered risky as they have sector specific risk but some sectors like pharma, IT are inherently less risky.
  5. Others: Invest in themes like Rural, MNC, etc. They are also high risk.
  6. Tax Saving Mutual Funds (ELSS): Special kind of mutual funds that provide tax advantage under section 80C of IT Act. Both principal (upto a certain limit) and gains are tax free.

(1) Shorter lock-in period as compared to other tax-saving investments.
(2) Chance of higher returns as compared to other safe-investments.
(3) Ease of purchase and redemption.

Read more on tax saving mutual funds: Top Equity Linked Saving Schemes (ELSS) – Tax Saving Funds

The Second Type: Debt

Debt mutual fund can be further classified into 5 types listed below

  1. Liquid: Invest in bonds mostly by banks and govt. with maturity (time to get the principal back) of ~90 days. They are considered safest type of mutual funds. They give returns very similar FD
  2. Ultra Short Term: Invest in bonds by banks, govt. or corporates with maturity of ~1 year. They are considered very safe type of mutual funds. They have ~1% returns higher than FD but returns vary by ~2%.
  3. Mid/ Short Term: Invest in bonds by banks, govt. or corporates with maturity of ~3-6 years. They are also considered safe.They have ~2% returns higher than FD but returns vary by ~5% due to interest rate variation.
  4. Gilt Long Term: Invest in bonds by only govt. with maturity of ~7-12 years. They are also considered safe from principal perspective but they carry high interest rate risk.They have ~3% returns higher than FD but returns vary by ~8%.
  5. Dynamic: Invest in bonds of different maturity depending on an expectation of interest rates. So maturity can vary.They are also considered safe from principal perspective.They have ~3% returns higher than FD but returns vary by ~10% due to interest rate variation.
  6. Income: Invest in bonds to generate regular income. They returns and risk is between Mid/Short-term funds and Long-term funds.
  7. Credit Opportunities: Invest in bonds by corporates with high interest rates. They are considered most risky type of debt mutual funds.

The Thrid Type: Hybrid

Hybrid mutual fund can be further classified into 3 types listed below

  1. Balanced: These equity oriented hybrid fund with ~65% of AUM in invested in equity and rest in long-term debt. For tax purposes, these considered as equity mutual funds. 
  2. Debt-Oriented: These are debt oriented hybrid fund with majority AUM invested in debt and rest in equity. For tax purposes, these considered as debt mutual funds. 
  3. Others: Invest in all types of securities debt, equity and gold. For tax purposes, these considered as debt mutual funds. 

Tax on Mutual Funds

There are broadly 4 types of mutual funds from tax perspective.

  1. Equity and Balanced Mutual Funds: Mutual funds with 65%+ of investment in equity shares of Indian companies.
  2. Debt Mutual Funds: Any other fund other than Equity Mutual Fund.
  3. Money Market/ Liquid Funds: They are special kind of Debt funds that invest in <90 days maturity securities. The only difference is the dividend treatment for such schemes.
  4. Gold Mutual Funds: They invest in gold/ gold based securities but are also treated very similar to Debt funds from tax perspective.

 

Type of Mutual Fund Definition of Short term & Long term Short term Cap gain Treatment Long term Cap gain Treatment Dividend Distribution Tax (DDT)(paid by MF house/company)
Equity or Balanced (>65% equity) Mutual Funds Less than 365 days is Short Term. 15% taxation under section 111A Nil (Exemption under section 10(38) Nil (No DDT Payable as per section 115R)
365 days or more is Long Term.
Debt Mutual Funds(non Liquid schemes) Less than 3 years is Short Term. Taxed as per individual tax slab of the investor 10% without indexation OR 20% with indexation, plus 3% cess 25% plus 5% surcharge plus 3% cess, totally 27.038%
3 years or more is Long Term.
Money Market and Liquid Schemes Less than 3 years is Short Term. Taxed as per individual tax slab of the investor 10% without indexation OR 20% with indexation, plus 3% cess 25% plus 5% surcharge plus 3% cess, totally 27.038%
3 years or more is Long Term.
Gold ETFs Same as Debt Mutual Funds Same as Debt Mutual Funds Same as Debt Mutual Funds Same as Debt Mutual Funds

Hence, from tax perspective, Debt Mutual Funds score above FDs in case tenor of investment is more than 3 years. Equity Mutual funds are best from tax perspective but come with inherent equity risk attached to it.