Comprehensive Guide to Mutual Funds – Introduction | Types | Tax Implications

A Mutual Fund is a type of investment vehicle that pools together money from multiple investors to purchase a diversified portfolio of securities such as stocks, bonds, money market instruments, and other assets. Managed by professional fund managers, mutual funds aim to provide investors with broad exposure to different asset classes and reduce risk through diversification.

Table of Contents

1. Introduction
2. Mutual Funds
3. Cost and Expenses of Mutual Funds
4. Net Asset Value
5. Different Types of Mutual Funds Schemes
6. Latest Development Associated With Mutual Funds
7. Regular vs. Direct Mutual Fund: Which is Better?
8. Tax Implications on Mutual Funds
9. Key Points to Remember Before Investing in Mutual Fund

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1. Introduction

Investors invest their investible funds in the security market with the objective to maximise return for a given level of risk. There are varied securities available for individual investors to invest their money, equity shares offer significant returns however they are subject to high risk as a fixed amount of income is not a feature of equity shares. Therefore, to invest money in securities, one must thoroughly understand the operation, functioning and position of a company.

The tools and techniques required to analyse the companies are not within the ambit of common individual investors and sometimes the amount involved as an investment in these securities are so small that it is not viable. So, in such a scenario individual investors prefer to go for indirect investment rather than direct investment. They tend to route their money in the equity market via experts such as security analysts or portfolio managers They pool the money for collective investment in the diverse portfolio of assets such as equity and debt after thoroughly studying the market and the companies. The investment companies engaged in this process are called Mutual Funds.

2. Mutual Funds

A mutual fund is a financial intermediary that serves as a link between investors and the security market. It pools money from individual investors for collective investment in a portfolio of securities to generate a significant return. A mutual fund invests in a varied range of securities such as equities, bonds, government securities, and money market instruments.

The money collected in mutual funds schemes is managed and invested by professional fund managers in stocks and bonds per the mutual fund scheme’s investment objective. Investors are offered units in mutual funds and are called unitholders each unit represents the proportionate ownership of the unitholder in the mutual funds’ underlying portfolio. The income/gains generated in a mutual fund scheme are distributed proportionately among investors after deducting applicable expenses by calculating Net asset Value or NAV. For providing these services, mutual funds charge a small fee.

Mutual Funds are set up in the form of a Trust under the Indian Trust Act, 1882, in accordance with SEBI (Mutual Funds) Regulations,1996. As the mutual funds are managed by professional experts, they have better expertise and knowledge to screen the stocks and bonds from the universe of investments than the beginner initiating the buying and selling of stocks and bonds. The professional experts and investment consultants undertake investment analysis and then choose the portfolio of assets. Each Mutual fund is launched with an investment objective set by the Professional fund manager before introducing the fund in the market. Based on the scheme’s investment objective, the Portfolio fund manager selects the financial securities for the fund and sets the risk-return expectation.

Examples of Mutual Funds in India are ICICI Prudential Mutual Fund, SBI Mutual fund, Birla Sun Life Mutual Fund, etc.

3. Cost and Expenses of Mutual Funds

There are broadly two types of costs which are charged by the portfolio manager and borne by the investor dealing in mutual funds. These are:

• Entry Load and Exit Load
• Expense Ratio

3.1 Entry Load and Exit Load

The load can be defined as the difference between the price charged from investors at the time of buying or selling the mutual fund and the actual NAV of the units.

When expenses are charged from the investor when he buys the mutual fund,
i.e., at the time of purchase of units, it is termed as Entry load or front-end load.

For instance, the actual NAV is ` 20 per unit and the entry load on a scheme is 2%. So, the price charged from investors will be ` 20.40 [20 + 2% of 20]. It can be written as:

Entry Load = Purchase Price – NAV

Similarly, when expenses are charged from the investor at the time, he sells the mutual fund it is known as Exit load or back-end load.

For instance, the NAV of a mutual fund is ` 20 per unit and the exit load is 2%. So, the price realised by the investor will be ` 19.60 [20 – 2% of 20]. It can be stated as:

Exit Load = NAV – Repurchase Price

3.2 Expense Ratio

The Mutual Funds are permitted to charge operating expenses which includes registrar and transfer agent fee, audit fee, custodian fee, marketing and distribution fee, etc from mutual fund investors When these expenses are measured as a percentage of the fund’s daily net assets, it is called the Expense ratio.

Phrased another way in simple terms, we may say that per unit cost incurred in running and managing the mutual fund. The NAV is disclosed on a daily basis after deducting these expenses. The expense ratio is revealed at an interval of six months.

4. Net Asset Value

The Net Asset Value is calculated to find the fund valuation and pricing. The Net asset value is defined as the net assets of the fund minus its liabilities divided by the number of outstanding shares.

NAV = Asset – Liabilities/Total number of outstanding shares

A Fund’s NAV is published daily on respective mutual funds’ websites and AMFI’s website. The value is influenced by four factors which are securities purchased and sold, the value of securities held, other assets and liabilities, and units sold.

4.1 Misconceptions about NAV

The majority of the time investors try to align NAV with the performance of the mutual fund which results in them making poor choices while selecting the appropriate funds and losing their hard-earned money. Below are some of the misbeliefs concerning NAV which should be avoided:

• Low NAV Mutual Funds are Cheaper: If an investor invests an equal amount of money in two funds having the same portfolio but different NAV, this does not mean that the one with a lower NAV is cheaper just because it gave more units.

Let’s understand it with an example. Aman invests `10,000 in fund 1 and fund 2 respectively. Fund 1 offers a NAV of ` 100 and fund 2 offers a NAV of `1,000 per unit. The number of units under fund 1 is 100 and under fund 2 is 10. Now let’s say, both the funds appreciated by 30% i.e., the NAV of fund 1 and fund 2 are `130 (100 + 30% of 100) and `1,300 (1,000 + 30% of 1,000) respectively. Thus, the total investment value after appreciation is `13,000 (130 * 100) for fund 1 and `13,000 (1,300 * 10) for fund 2. Thus, we can see that despite the investor receiving a larger number of funds under fund 1, the returns were exactly the same. Therefore, it is not wise to correspond low NAV to cheaper investment.

• Higher the NAV, the Better the Fund: The above example also proves that a higher NAV also does not correspond to a better fund. Two funds having the same portfolio will generate the same return irrespective of the NAV or the number of units acquired. Thus, it is advisable to analyse the NAV of funds in order to assess the direction of fund movement in the future.
• Book Profits as NAV Rises: Do not confuse share prices with the fund NAV. Both have different meanings and objectives. If you sell your fund units when the NAV is rising, you may be prematurely exiting a fund with great future Also, if you continue to hold a fund with a declining NAV you might get stuck with a stagnant investment. Thus, instead of looking at NAV to make an exit decision, one must look at the performance of the fund portfolio.

5. Different Types of Mutual Funds Schemes

Different types of mutual fund schemes address the investors’ needs, risk appetite, and return expectations. They can be categorised based on:

5.1 Based on Structure

The mutual fund can be classified as Open-Ended Funds and Close-Ended Funds.

• Open-Ended Funds: The units in open-ended mutual funds can be sold and repurchased continuously at NAV. There is no fixed maturity in open-ended funds. It can provide repurchases shortly after allotment and is not required to be listed on the stock market. Investors get the opportunity to enter or exit the scheme at their convenience during the fund’s Therefore, in the open-ended fund, the unit capital fluctuates as new entries and exits are allowed without any constraints. The defining attribute of the open-ended fund is liquidity.
• Close-Ended Funds: Close-ended funds have a pre-defined maturity period. Investors can invest in these schemes at the time of launch of this scheme and get out of this scheme at the time of maturity of the scheme. The close-ended funds are listed on the stock exchange as is the case of shares. However, these funds do not possess the liquidity feature as the trading volume in the fund is generally low.

5.2 Based on Asset Class

• Debt Funds: Debt funds are referred to as fixed-income funds comprising government securities and corporate bonds. These funds are considered to be less risky than equity funds and offer reasonable returns to investors It is a lucrative investment for an investor who desires a steady return and has a low-risk appetite.
• Equity Funds: Equity funds as opposed to debt funds invest money in equity shares. The key goal of the equity fund is capital appreciation. Equity funds have a significant level of risk and the return in these funds depends on stock market These funds are a suitable option for investors who invest with long-term objectives in mind such as buying a house. Examples of equity funds are index funds, sector funds, large-cap funds, mid-cap funds, and small-cap funds.
• Hybrid Funds: Hybrid funds are funds consisting of a combination of equity and debt. Hybrid funds can be further categorized into various subcategories depending on the asset allocation of how equity and debt are distributed.

5.3 Based on the Investment Goal

• Growth Funds: The prime objective of a growth fund is to offer capital appreciation to investors in the long term. The major portion of the investment is made in equity shares. It is suitable for investors who invest with the long-term objective in mind as in the short term it may show a temporary loss but there is an expectation of a potential gain in the future. It is not recommended for those investors who are seeking steady income and investing for a short-term horizon.
• Income Funds: Income funds intend to provide a regular and stable income to investors These funds pool money and invest majorly in fixed-income securities such as government securities and corporate The capital gain in such securities is minimal. These funds are suitable for investors who have a low-risk appetite and aim to receive a steady return from the invested amount.
• Money Market Funds: The prime objective of this fund is to maintain invested principal amounts, and provide liquidity and certain The funds are invested in money market instruments such as treasury bills, commercial paper, certificates of deposit, etc. Investors can invest their surplus money for a short-term period and earn a reasonable return. However, the return on these funds may fluctuate in accordance with the interest rate that prevails in the market.
• Tax Saving Funds: Tax saving funds are ideal for investors who make investments with a perspective of tax rebate. The government offers tax rebates of a maximum permissible amount of `1,50,000 under section 80 C of the Income Tax Act. These tax rebates apply to certain funds, for instance, Equity linked saving scheme is an example of a tax saving fund. The ELSS fund has a lock-in period of 3 years that states money can be withdrawn from such a scheme only after the lock-in period matures.

5.4 Geographical Classification

• Domestic Funds: These are funds that pool money from a particular country only. Under these funds, only those financial securities can be included which are confined to the domestic financial market for buying and selling.
• Offshore Funds: The prime purpose of offshore funds is to induce an in-flux of foreign capital in the country of issuing company. The cross-border flow of funds in offshore funds results in an increase in foreign capital and foreign exchange reserves. It is permitted under these mutual funds to invest in securities of foreign companies and international investors to invest in the domestic capital The first offshore fund launched by Unit Trust of India in July 1986 in collaboration with US fund manager, Merrill Lynch was The India Fund. Now, many mutual funds in India launched offshore funds either independently or jointly with foreign investment management companies.

5.5 Other Funds

• Exchange Traded Funds: Exchange traded funds are a blend of open-ended mutual funds and listed individual stocks. They represent index funds listed on a stock exchange and are traded on a stock exchange like an individual stock. They are similar to mutual funds but can be traded throughout the day on a stock exchange. The shares of the ETF are not directly sold to investors, rather it is offered over the stock exchange. The open-ended portion of funds is sold to a few participants only who are called authorised participants and they get redeemed units in kind. The influential feature of these funds is that it charges lower expenses than index mutual funds; however, at the time of buying and selling ETF units an investor pays the brokerage fees. Nifty BeES (Nifty benchmark exchange traded scheme) based on S&P CNX Nifty is the first ETF in India launched in January 2002.
• Index Funds: An Index fund is a mutual fund that imitates a particular index, for instance, Sensex or Nifty 50. It invests in those securities which comprise a part of the index and keeps the proportion of the securities the same as that of the index.

6. Latest Development Associated With Mutual Funds

6.1 Systematic Investment Plan (SIP)

A systematic investment plan or SIP is considered a smart mode of investing money in mutual fund schemes. A certain amount of money is periodically invested under this strategy in equities and equity-oriented mutual fund schemes. It entails a consistently small amount of investment over a long period of time. An investor can invest a regular fixed sum of money rather than investing a lump sum amount. The investment under this plan can be made on a weekly, monthly or quarterly basis. This plan ensures a higher return on maturity through the power of compounding. SIP is considered a smart and easy way of investing money in mutual funds as it allows a predefined sum of money to be invested. One of the influential features of this plan is investors can choose to alter the amount of their investment anytime or can even stop the investment.

SIP is ideal for an investor who wants to realise the long-term potential of stocks and is prepared to make investments regularly. So, SIP is a technique intended to assist investors in building money over the long term with discipline. Further, it is one of the best choices of investment for beginners and individuals who are not yet well-versed in the dynamics of the financial market.

SIP is an investment strategy opted for by mass investors because it offers the following benefits:

• Cost Averaging: An investor invests a fixed amount regardless of the So, he gets fewer units when the NAV is higher and more units when the NAV is lower. This smooths out the ups and downs of the market, reducing investment risk in volatile markets and the average cost per unit. Let’s understand it with an example. Let’s say Piyush decided to invest in a SIP of ` 1,000 each month. In the presence of volatility, his investment will look like the below:

The average NAV cost comes down to a lesser amount of ` 96 i.e., 480/5. In case the whole investment would have been made in the beginning only i.e., January, then the per unit cost would have been ` 100.

• Power of Compounding: The power of compounding works as the eighth wonder of the Let us understand it by an illustrative example. Picture that you invested ` 500 monthly in SIP with an expected rate of return of 12%. Then at the end of 1 year, you will receive ` 404.7 as interest which will be invested again with the initial investment made summing up to ` 6,404.7. This amount will again receive interest and hence the process will continue consequently generating ` 41,243 at the end of 5 years, ` 1,16,170 at the end of 10 years and ` 2,52,288 at the end of 15 years Starting early and maintaining consistency is crucial ‘key mantra’ for maximising the effects of compounding.
• Disciplined Investing: Investing in mutual funds through SIP is an easy and disciplined way to accumulate wealth over a long period of time. A SIP investment can be made through small periodic payments instead of a lump sum.

6.2 Systematic Withdrawal Plan (SWP)

In contrast to a systematic investment plan, a systematic withdrawal plan permits investors to invest all at once and systematically withdraw at periodic intervals, while the remaining amount continues to be invested. An investor is permissible to withdraw monthly or quarterly depending on their needs and objective. The amount withdrawn by investors in SWP reduces the value of the investment by the market value of the units being withdrawn as per that day’s NAV value. SWP features a variety of tax benefits and convenient payout alternatives. Both taxes and the dividend distribution tax are not applicable under SWP. Additionally, SWP has no entry or exit loads.

Let us understand the working of systematic withdrawal plans with an example. Suppose Mr Aarav makes an investment of ` 1,00,000 by purchasing 1,000 units of a mutual fund scheme in the month of January 2022. He plans to withdraw ` 20,000 per month for the next three months that starts from February 2022 with a Systematic Withdrawal Plan.

From the above example, it is seen that by the end of April, Mr Aarav has withdrawn the amount of ` 60,000 in total via SWP and owns the investment of ` 44,310.

Some of the advantages of a systematic withdrawal plan are as follows:

• Regular Income: An SWP provides a regular income to investors. This plan becomes useful for those who are retired or need a consistent source of funds for living expenses.
• Flexibility: Under SWP, investors get the choice to choose the frequency and amount of their withdrawals to meet their needs and financial goals.
• Rupee Cost Averaging: SWPs offer the benefit of rupee cost averaging to the rupee cost averaging gives investors the average NAV of a mutual fund across the market (downmarket and upmarket) rather than the NAV at a single point in time.
• Tax Benefit: The amount withdrawn at regular intervals in SWP comprises income and capital. The tax will be levied on income but not on the capital For example, an individual invests ` 1,00,000 via SWP which grows at 8%. Let’s say he withdraws ` 10,000 at the end of each year. So, he is liable to pay tax on ` 800 which will be considered as his income while ` 9,200 is his capital which will not be taxable.

6.3 Mutual Fund Risk-O-Meter

One of the greatest advantage of mutual funds is that the investors are not required to manage their investment on their own, instead they have professionals doing it for them. The investors are just required to realize their risk appetite and based on that select the appropriate scheme. However, determining the risk associated with any scheme can be challenging for many investors due to lack of knowledge. Thus, SEBI came with the concept of Risk-O-Meter.

In 2013, SEBI came up with the concept of “Product Labeling” where the mutual fund houses are required to disclose the risk associated with the scheme with colour coordinated boxes which were blue for low risk, yellow for medium risk and brown for high risk. However, this colour coded classification was not doing its function properly. Later in 2015, SEBI changed the risk depiction from colour coordinated boxes to a pictorial meter called Risk-O-Meter which had 5 levels of risk as against 3 earlier. Moreover in 2020, another level of risk depiction have been included in the metric, resulting in total 6 levels at present. SEBI has mandated the mutual fund houses to provide the monthly risk level for each of its fund based on underlying portfolio. Note that here the risk level is assigned to the fund rather than scheme. For example, by nature liquid funds are of low risk category however, if the fund manager decides to absorb the credit risk to boost its returns, such action will make it high risky fund.

Below is the brief of various risk levels of risk-o-meter.

Source: https://scripbox.com/mf/mutual-fund-riskometer

6.4 Flexi-Cap Fund

In November 2020, SEBI introduces a new class of under equity mutual fund namely Flexi-Cap Mutual Fund. According to SEBI, it is an open ended dynamic equity scheme. It invests in stocks of companies of different market capitalization. At least 65% of the funds portfolio should comprise of equity and equity related instruments. SEBI has also allowed Mutual funds to change any of their existing equity scheme into flexi-cap scheme.

Flexi-cap scheme was introduced by SEBI after many investment houses disliking towards SEBIs regulatory change on rationalization of multi cap scheme. Before September 2020, multi cap mutual funds were allowed to invest in companies of varying market capitalization without any restriction. They just had to ensure that at least 65% of the portfolio comprised of equity and equity related instruments. This resulted in majority of the multi cap funds being dominated by large cap company’s stocks. In order to address such issue, SEBI in September 2020, revised the multi cap fund requirements. Now they are required to invest at least 25% respectively in large cap, medium cap and small cap company’s stocks resulting in minimum equity portion being raised to 75%. The aim behind the regulation what to make multi cap funds true to their label. Mutual fund houses argued that mandatory 25% investment in small cap funds under the new regulation make the multi cap funds a risky investment for investors. The fund managers are forced to invest minimum 25% in one market cap even though the economic conditions are against it. Thus, SEBI came up with Flexi-Cap Fund.

7. Regular vs. Direct Mutual Fund: Which is Better?

A regular mutual fund scheme is one that is sold through financial intermediaries, such as brokers or financial advisors Direct mutual fund scheme is sold directly by the mutual fund company to the investor, without the use of intermediaries.

Both regular and direct mutual fund schemes offer the same types of investments and aim to achieve the same investment objectives, but they may differ in terms of the fees and expenses charged to investors Direct mutual fund schemes may offer lower expense ratios than regular mutual fund schemes, as they do not incur the costs associated with using intermediaries to sell the funds. However, direct mutual fund schemes may also have higher minimum investment requirements and may not offer the same level of personalised advice and service as regular mutual fund schemes.

8. Tax Implications on Mutual Funds

Dividends and Capital gains are the income earned from the mutual fund investment. The Mutual Fund house deducts the Dividend distribution tax (DDT) of @10% on dividend income and capital gain is taxed in the hands of the investors.

The tax rate as per the financial year 2022-2023 is subject to enactment of the Finance Bill, 2022.

Note: Indexation means adjustment of the purchase price of an investment to reflect the effect of inflation.

9. Key Points to Remember Before Investing in Mutual Fund

The popularity of mutual funds as a most popular means of investment among retail investors is not new to the world. The significant growth in the asset under management of the mutual fund industry is proof of the same. A lot of investors tend to equate mutual funds with risk-free investment instruments. It is to be kept in mind they are not risk-free investments, rather they manage risk quite admirably through a combination of regular investing, professional expertise, superior stock selection and regular analysis and revision. Selection of the best mutual fund is a complex process. Below are the points to be kept in mind while selecting a mutual fund:

• The history of a mutual fund matters: As it is said “a known devil is better than an unknown angel” e., a mutual fund with a long and prosperous existence should be preferred over a new one because then it has the experience how to navigate through different market cycles.
• The experience of the fund manager is a key consideration. Fund managers are specialists in the area of the capital and financial They have the appropriate experience and skills to manage and maintain the funds of the investors and the ability to provide them with desired returns by efficiently navigating market shifts and corrections. Before investing in a mutual fund always without fail check the education and experience of the fund manager and their past performance.