A mutual fund is an investment vehicle which collects money from various investors and invests it in equities and debt instruments. It is managed by a professional fund manager. It allows investors to benefit from professional fund management and a diversified portfolio of stocks and/or bonds for a small amount (as low as Rs 100).
Here is an example of how a mutual fund works. Mr. X wants to invest SBI Bluechip Fund. the SBI Bluechip Fund will invest Mr. X’s investment and the money it pooled in from other investors into a group of different financial assets. At present, the top 5 holdings of SBI Bluechip Fund are the shares of HDFC Bank, L&T, ITC, Mahindra & Mahindra and Nestle India.
Types of Mutual Funds?
Mutual funds can be classified into 4 categories on the basis of the type of investments made by them.
- Equity Funds – Invest in the shares of different companies. You can read more about equity funds here.
- Debt Funds – Invest in debt, bonds, money-market instruments etc. You can read more about debt funds here.
- Hybrid Funds – Invest in a mix of equity and debt.
- Fund-of-Funds – Which invest in other mutual funds
Mutual funds can also be classified as open-ended, close-ended and interval funds based on when you can invest in them.
While you can make an investment in an open-ended mutual fund at any point of time, close-ended mutual funds are open for investment only for a specific period of time. Interval mutual funds are a type of close-ended fund which re-open for outflows and/or inflows for a limited period of time during the tenure of the scheme.
How to Select a Mutual Fund Scheme?
There are a host of parameters which you need to consider before making an investment in a mutual fund scheme, such as your investment objective, risk tolerance, mutual fund’s performance, assets under management (AUM), etc. Tap here to read more about it.
Ways of Investing in a Mutual Fund
There are two ways in which you can invest in a mutual fund. You can invest either through an investment broker/agent/distributor or directly. While the former are termed as regular mutual fund plans, the latter are called direct mutual fund plans.
Direct v/s Regular Mutual Funds
Direct and Regular plans are just the two options of the same mutual fund scheme, run by the same fund manager who invests in the same stocks and bonds. The only difference between the two is that in case of a regular plan your AMC or mutual fund house pays a commission to your broker as distribution expense, whereas in case of a direct plan, no such commission is paid. Instead, in case of direct plans the commission is added to your investment balance, thereby reducing the expense ratio of your mutual fund scheme and increasing your return over the long-term. You can read more about direct and regular mutual funds here.
Lump Sum or SIP: Which is a Better Mode of Mutual Fund Investment?
There are two ways in which can invest your money in a mutual fund scheme. You can either invest a lump sum amount in one go or can choose to pay at equal intervals via a systematic investment plan (SIP). A lump-sum will maximise your returns, if the market moves steadily upwards from your investment date. An SIP will average out your purchase price and reduce your risk of catching a market peak. It is thus better if the market moves downwards from your investment date or is choppy. An SIP also works better for risk-averse investors since it reduces the stress that comes from market volatility.
Growth or Dividend: Better Mutual Fund Option?
A mutual fund scheme comes with two options for wealth generation- growth and dividend. Under the growth option, the mutual fund investor does not receive any dividends on the invested amount and instead allows the asset management company to reinvest that amount in the fund. Under the dividend option, the investor chooses to receive dividends on his mutual fund investment. There are two more dividend options – dividend reinvestment and dividend sweep. Dividend reinvestment allows dividends to be declared by the fund, but they are used to buy more units in the fund instead of being paid to the investor. This increases the fund units held by the investor rather than the value of each unit. Dividend sweep uses the dividend declared by one fund to purchase units of another mutual fund.
How Do Mutual Funds Work?
When you invest your money in a mutual fund, the fund generates wealth for you in two ways.
- Dividend payments: You get your returns in the form of dividends declared by the fund. This is less tax efficient than capital gains, as we explain here.
- Capital gain:You get your return in the form of capital gain when you sell or redeem your mutual fund units. This happens if the Net Asset Value (NAV) of the mutual fund at the time of redemption is higher than the NAV at the time of purchase.
How Are Mutual Fund Investments Taxed?
Dividends and capital gains earned on mutual funds are taxed differently. The mutual fund deducts Dividend Distribution Tax (DDT) from the dividend paid to you at 10%. Capital gains tax is levied on your mutual fund capital gains by the Income Tax Department. The capital gain tax rate depends on the nature of mutual fund in which you invested and the time period for which you held that investment. The short term capital gains tax on equity funds is 15% and the long term capital gains tax on equity funds is 10%. You also get a annual tax exemption of Rs 1 lakh. You can find out more about this here.
AMC: Asset Management Company (AMC) is the company that manages a mutual fund.
Entry Load: Fee charged on joining a mutual fund scheme. This was abolished by SEBI on 18th June, 2009.
Exit Load: Fee charged on leaving a mutual fund scheme. This is typically levied up to a period of 1 year from the purchase of the scheme and can sometimes extend up to 3 years. The fee is usually 0.5% – 3% of your investment.
Expense Ratio: Fee charged by an AMC for the administration, management, promotion and distribution of a mutual fund. All expenses incurred in the running of the fund are included in this figure. This figure is capped at 2.25% of the total fund assets by SEBI.
Portfolio: A basket of all the holdings of a mutual fund. In case of an equity mutual fund this comprises of stocks of different companies. In case of a debt mutual fund scheme the portfolio consists of different debt instruments. The portfolio of a hybrid mutual fund contains a mixture of shares and debt instruments.
Riskometer: Quality rating of a mutual fund on the basis of the risk associated with it. It has 5 categories – low, moderately low, moderate, moderately high, and high. Every mutual fund is set to a particular risk category in the riskometer. It is mentioned in the SID (Scheme Information Document) of the fund. You can read more about riskometer here.
Yield to Maturity: Rate of return anticipated on the portfolio of a debt mutual fund if held until maturity.
SEBI: All the AMCs are regulated by the Securities and Exchange Board of India (SEBI). However, in case, the AMC is promoted by a bank, it is regulated by the Reserve Bank of India (RBI). Also, every mutual fund has its own board of directors which represents the interest of investors.
AMFI: Association of Mutual Funds in India. This body which protects and promotes the interests of mutual funds and investors.