Understand Mutual Funds & its Basics

Discover the dynamic universe of Mutual Funds! From understanding the fundamentals to exploring various types of funds, this insightful guide offers expert insights into how Mutual Funds work, their benefits, and essential investment strategies. Empower your investment journey with comprehensive knowledge and make informed choices for a prosperous financial future.

What is a Mutual fund?

Mutual funds are financial instruments that pool and invest money from various investors in securities like bonds, stocks, money market instruments, etc. A professional fund manager operates manages mutual funds, allocating the fund’s assets in the right places to produce income and capital gains. Mutual funds have structured portfolios, and professionals maintain them to match the investors’ investment goals and risk appetite.

By investing in mutual funds, retail investors gain access to managed portfolios of securities like bonds and equities. Therefore, each shareholder becomes a proportionate participant in the issuing company’s loss or profit. Mutual fund managers invest funds in a variety of securities, track their performance, and make adequate changes. In return, the fund manager charges a fee from the investors, known as the expense ratio. This fee may vary between fund managers and be a fixed fee or a percentage of the investment. SEBI is the regulatory authority to ensure compliance in the stock market, under which all the participants must perform activities.

Before investing in mutual funds, learn in-depth details about them to make informed decisions.

Types of Mutual Funds

Mutual funds can be of different types based on their structure, the kind of assets they hold, investment goals, etc. We have mentioned some of the most popular types of mutual funds below:

Types Based on Structure

• Open-ended mutual funds
  allow investors to invest and redeem the funds at any time, making them highly liquid with no predetermined investment period.

• Close-ended mutual fund schemes
  have a fixed maturity date, allowing investors to invest and redeem the investment only at maturity. Purchasing and withdrawing them at any time, as per the investor’s discretion, is not feasible.

Types Based on Asset Class

• Equity mutual funds
  invest more than 65% of their assets in company stocks listed on the stock exchange. Due to their high volatility, they are more suitable for long-term investments. Equity
  mutual funds can be of different types, including large-cap, mid-cap, small-cap, ELSS (Equity Linked Savings Scheme), multi-cap, international, and index funds.

• Debt mutual funds
  invest mainly in fixed-income instruments such as corporate bonds, government securities, and other debt instruments. Since they are not subject to market volatility, their returns are more stable than equity-linked funds. Debt mutual funds can further be of different types based on their securities’ maturity period. Some common types of debt mutual funds include liquid, overnight, money market, banking and PSU, gilt, and short-duration funds.

• Hybrid mutual funds
  involve investments in both debt and equity in various proportions depending on the fund’s investment goals. These funds give diverse exposure to different asset classes, distributing the risk for higher returns and better safety. Hybrid funds can further be of various types, including aggressive hybrid funds, conservative hybrid funds, and balanced advantage funds.

Types Based on Investment Goals

• Growth funds
  aim to offer maximum capital gains. However, they have a higher inherent risk due to investments in high-growth stocks. That is why they are appropriate for long-term investments.

• Income funds
  mainly focus on generating regular income for investors with investments in debentures, certificates of deposits, money market instruments, corporate bonds, government securities, etc. Investors invest in them and obtain higher returns after a certain period.

• Liquid funds
  have high liquidity. With a residual maturity of up to three months, investors can redeem liquid funds whenever they need funds. With these funds, the risk is low, and returns are moderate.

• Tax-saving funds
  provide tax benefits of up to ₹ 1.5 Lakh under Section 80C of the Income Tax Act. They are more suitable for investors looking for tax exemptions. However, these funds have lock-in periods of three years, before which investors cannot redeem them.

• Pension funds
  are highly popular among investors looking for an income source after retirement. By investing in debt and equity instruments, investors get a regular source of income when they need money after retirement. These are best suited for people working in private companies with no pension plans. Investors can withdraw the pension fund returns as a lump sum, opt for a monthly regular income stream, or go for a combination of both.

How Do Mutual Funds Work?

To understand the workings of mutual funds, one must first understand what Net Asset Value or NAV is. It is the per unit price at which investors purchase or redeem their investments in mutual funds. Mutual fund investors receive the number of units according to their investments, calculated based on NAV. For instance, if an investor buys mutual funds worth ₹ 500 with an NAV of ₹ 10, they get 50 mutual fund units at the rate of 10 per unit.

Now, it’s worth noticing that the mutual fund NAV changes daily based on the asset’s performance. If the mutual fund stock price increases, the fund’s NAV will also increase, and vice versa. For instance, in the above example, if the mutual fund’s NAV goes up to ₹ 20, the value of the 50 purchased units will go up to ₹ 1,000. Therefore, the performance of a mutual fund largely depends on its underlying assets, which ultimately generate returns for the investors. That means if the investor decides to sell or redeem the mutual fund, they will receive ₹ 1,000 against the ₹ 500 they originally invested, giving them a capital gain of ₹ 500.

A mutual fund’s market value changes every day, causing the NAV to fluctuate frequently based on the fund portfolio’s valuation. That means instead of gaining a profit of ₹ 500, it could be a loss if the fund’s value decreases. Since mutual funds are linked to market fluctuations, they are dynamic in nature and do not guarantee fixed returns. Mutual funds’ returns are taxable under the category of capital gains tax. However, the returns become taxable only when the investor redeems the profits.

What are the Documents Required to Invest in Mutual Funds?

The KYC documents required for verification include the investor’s identity and address proof. Here is a list of other valid documents required for mutual fund investments:

• A PAN card is a mandatory document

• Identity proof, including voter ID card, driving license, passport, Aadhaar card, or any other identity proof issued by the state or central government

• Address proof, including voter ID card, driving license, ration, card, passport, bank passbook, utility bill, etc.

While submitting all of these documents in hard copy is a tedious and time-consuming process, Religare Broking supports a fast and paperless solution to let investors open a Demat account and start investing in mutual funds.

Features & Benefits of Investing in Mutual Funds

Below are the features and benefits of investing in mutual funds:

• The Benefit of Professional Management

  Professional, full-time fund managers actively manage mutual fund investments, helping investors meet their investment goals and rebalance their portfolios. They have the experience, resources, and expertise to constantly monitor the investments and work accordingly, maximising returns and minimising risk.

• Risk Diversification

  Investing in mutual funds is an excellent way to diversify investments across various assets and securities like debt, equity, gold, etc. The strategy spreads the risk to minimise the loss. In case the value of one investment decreases, other assets may perform well to compensate for the loss.

• Freedom to Invest in Small Amounts

  Directly purchasing all units in a mutual fund is not feasible for most retail investors. Mutual funds have low minimum investment amounts that allow investors to invest at their convenience. SIPs further make mutual funds more affordable.

• High Liquidity

  Investors can easily redeem their open-ended mutual funds to cover their financial needs, giving them easy access to money whenever necessary. However, close-ended funds are non-redeemable before maturity. ELSS units also have a three-year lock-in period before which investors cannot liquidate them. That is why diversifying the portfolio with different types of investments is advisable.

• Low Cost

  The low expense ratio of mutual fund schemes is a significant benefit of mutual funds. SEBI has an upper limit on the expense ratio a fund manager can charge for mutual fund management.

• Proper Regulation

  Securities and Exchange Board of India (SEBI), the regulating authority for capital markets, regulates mutual funds. Under SEBI Regulations, 1996. The entity lays down strict rules and guidelines to ensure transparency, risk mitigation, fair valuation, and investor protection.

• Tax Benefits

  
  ELSS investments up to ₹ 1.5 Lakh qualify for tax benefits under section 80C of the Income Tax Act, 1961. Investments in mutual funds prove to be tax-efficient when the an investor holds them for long terms.

How to Invest in Mutual Funds?

Broadly, investors can invest in mutual funds through three mediums: a mutual fund company’s website, a mutual fund distributor, or a brokerage firm. To invest through an asset management company’s website, the prospective investor should log on to the website and create an account. Then, they browse through the different fund houses to find attractive options. They have to sign up to each fund house to invest in them, which is a huge hassle that makes tracking and analysing the investment challenging. The second option is to invest in mutual funds through a distributor. However, this is an expensive option due to its lower returns and higher expense ratio.

Therefore, an online brokerage platform is the most efficient method of investing in mutual funds. Investors can simply sign up with the broking firm and start investing in their preferred schemes. Most importantly, the expense ratio is low, and charges are nominal per transaction. Tracking the portfolio also becomes a breeze at reliable platforms like Religare Broking. Investors can view all their new and old investments in one place, making tracking easier and helping investors make informed decisions.

These are the steps to invest in mutual funds through a broking platform:

• Signing up to the platform using OTP received on the registered mobile number

• Selecting the fund for investment

• Entering the investment amount

• Choosing between a lump sum or SIP investment plan

• Entering the name, mobile number, and PAN details of the investor

• Providing bank account details and selecting the payment mode

• Setting up a mandate in case of SIP

• Following the KYC process and signing digitally

• 
  Opening a Demat account after completing the verification process

• Start investing

Ways of Mutual Fund Investment

Prospective investors can approach mutual fund investments in several ways, including the following:

• Lumpsum Investment

  Mutual fund investors can invest significant amounts in one go. For instance, if a person gets a bonus of ₹ 1 Lakh and wants to invest the entire amount to get returns, they can invest ₹ 1 Lakh in a mutual fund of their choice in one go. Once invested, they can wait for the unit’s price to increase so they can sell it out and receive capital gain. The units purchased will depend on the NAV of that fund on the day of purchase. If the NAV is ₹ 1,000, they can buy 100 units of the fund with ₹ 1 Lakh.

• Mutual Fund Investment Through SIP

  Those who don’t want to invest in one go but save a small amount each month can commit to SIP for investment in installments. For instance, instead of making a one-time investment of ₹ 1 Lakh, they can make ten smaller investments of ₹ 10,000 per month for ten months. SIP is an excellent way to save money with small investments and inculcate the habit of saving. SIP plans encourage regular investments of fixed amounts monthly, quarterly, yearly, and so on.

Disadvantages of Mutual Funds

Just like most other types of investments, mutual funds also have a few disadvantages that one must be aware of. Below we have listed a few:

• Irregular Returns:

  Since mutual fund investments are linked with market positions, the returns they offer are not fixed or guaranteed. Although expert mutual fund managers monitor and manage them, they do not provide insulation against value depreciation.

• Loss of Control:

  Since fund managers manage mutual funds, investors have little control over their investments. The fund manager makes all major decisions regarding their investment. However, their expertise is usually better than the investor’s decision-making.

• Over-Diversification:

  Although diversification is an important advantage of investing in a mutual fund, over-diversification may increase the fund’s operating cost, demanding higher due diligence and diluting the benefit of diversification.

• Additional Costs:

  A mutual fund’s value fluctuates as per changing market conditions. Moreover, professional mutual fund management demands several additional fees and charges that do not incur when directly investing in stocks or securities. The investor must bear the mutual fund’s entry load and exit costs that increase the expense of mutual fund investment.

How Are Returns Calculated for Mutual Funds?

When investors buy stocks, they gain partial ownership of the company they invested in. Similarly, when they invest in mutual funds, they buy the mutual fund’s and its assets’ partial ownership. There are various ways of calculating returns for mutual funds. These include the following:

• Mutual fund returns depend on the income generated from interest and dividends on assets in the fund’s portfolio. Issuing companies pay these returns to shareholders in the form of distributions. Investors can choose to either redeem the returns earned or reinvest them back into the fund to generate more returns.

• If the fund manager sells securities when their prices increase, they earn a capital gain that they distribute to the investors.

• When calculating mutual fund returns, investors see total returns or their value changes over a particular period. These include interest, capital gains, and dividends that the fund generates or the change in its market value over a period.

The total mutual fund returns calculations are mostly for one-, five-, and ten-year periods. An online SIP calculator also calculates the exact mutual fund returns using variables like the investment amount, period, and return rate.

Terms Used in Mutual Funds

These are a few common terms one may come across when dealing with mutual funds: