Learn what a Mutual Fund is and how it works:

What Is a Mutual Fund?

Mutual fund is nothing but a collection of stocks or bonds that a professional fund manager buys on your behalf. The fund manager decides which/how many stocks or bonds to buy.

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 )decides 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 the 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 cost and dealer commission. Each unit price (called Net Asset Value or NAV) is usually ₹10 at the time of NFO (All NFO’s are first priced at ₹10).

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 any of the funds.
  • +This process is called Know Your Customer (KYC) and it is usually followed by all the companies that accept money from the investors, including banks, insurance companies etc.

How Do Mutual Funds Work?

  • +The money with the Mutual Fund (called Assets of the Mutual Fund) is 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 the corresponding change in the Net Asset Value (NAV) of each unit. The number of units will not change though.

Mutual Fund Expense Ratio

  • +A fund house will take some money from the fund to cover its expenses. These expenses include employee salaries, distributor’s 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%.

Growth and Dividend 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 asset and it reduces the 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, the 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 to withdraw money from the fund, he will get an amount which is equal to the number of units sold, multiplied by the current NAV.
  • +Depending on the fund, the investor may be charged with an expense (called exit load). Once the money is paid, 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 can invest and redeem anytime. It is the most popular scheme.
  2. Closed: You can invest only during the start and redeem when it’s tenure ends.
  3. Interval: You can invest or redeem only on pre-defined dates

Broadly, there are 4 types of mutual funds based on investments:

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

 Equity Mutual Funds

Equity mutual funds can be further classified into 5 types listed below:

  1. Large Cap: They invest in stocks of large companies with a market cap of more than $5B. They are relatively less risky.
  2. Small/ MidCap: They invest in stocks of medium/ small companies with a market cap less than $5B. They are relatively more risky.
  3. Multi Cap: They invest in all types of large, medium and small cap companies. They are relatively more risky than large caps, but less riskier than small/ mid cap.
  4. Sector Funds: They invest in specific sectors like IT, pharma, banking, etcetera. They are considered risky as they have sector specific risks but some sectors like pharma and 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): These are special kinds of mutual funds that provide a tax advantage under section 80C of IT Act (exempted upto ₹1,50,000). Both principal (certain limit) and gains are tax free.They have a shorter lock-in period as compared to other tax-saving investments and have a chance to garner higher returns as compared to other tax saving instruments

Top Equity Linked Saving Schemes (ELSS) – Tax Saving Funds

 Debt Mutual Funds

Debt mutual funds can be further classified into 5 types listed below:

  1. Liquid: They mostly invest in bonds by banks and the government. It has a  maturity (time to get the principal back) of 90 days.
    They are considered the safest type of mutual fund. They give returns very similar FD.
  2. Ultra Short Term: They invest in bonds by banks, governments. or corporates and have a  maturity of 1 year.
    They are deemed as a safe mutual fund and give 1% higher returns than fixed deposit. The returns may sometimes vary by 2% as well.
  3. Mid/ Short Term:  They invest in bonds by banks, governments, or corporates. It has a maturity of 3-6 years.
    They are also considered safe and provide returns which are 2% higher than fixed deposits, but returns vary by 5% due to interest rate variation.
  4. Gilt Long Term: They invest in bonds by the government and have a maturity period of 7-12 years.
    They are also considered safe from the principal perspective but they carry high interest rate risks.
    They provide 3% higher returns than fixed deposits, but returns vary by 8%.
  5. Dynamic: They invest in bonds of different maturity depending on an expectation of interest rates.
    Hence, the maturity can vary. They are also considered safe from the principal perspective and provide 3% higher returns than fixed deposits, but the returns vary by 10%, due to interest rate variation.
  6. Income: They invest in bonds to generate regular income. The returns and risk are between mid/short-term funds and long-term funds.
  7. Credit Opportunities: They invest in bonds by corporates which have high interest rates. They are considered as the riskiest debt mutual funds.

Hybrid

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

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

 Mutual Fund Taxation

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

  1. Equity and Balanced Mutual Funds: These are funds with 65%+ of investment in equity shares of Indian companies.
  2. Debt Mutual Funds: Any other fund other than an equity mutual fund.
  3. Money Market/ Liquid Funds: These are special kinds of debt funds that invest in <90 days matured 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 the tax perspective.

 

Type of Mutual FundDefinition of Short term & Long termShort term Cap gain TreatmentLong term Cap gain TreatmentDividend Distribution Tax (DDT)(paid by MF house/company)
Equity or Balanced (>65% equity) Mutual FundsLess than 365 days is Short Term.15% taxation under section 111ANil (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 investor10% without indexation OR 20% with indexation, plus 3% cess25% plus 5% surcharge plus 3% cess, totally 27.038%
3 years or more is Long Term.
Money Market and Liquid SchemesLess than 3 years is Short Term.Taxed as per individual tax slab of the investor10% without indexation OR 20% with indexation, plus 3% cess25% plus 5% surcharge plus 3% cess, totally 27.038%
3 years or more is Long Term.
Gold ETFsSame as Debt Mutual FundsSame as Debt Mutual FundsSame as Debt Mutual FundsSame 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.