Investment Vehicles

Mutual Funds

Introduction

Mutual funds are the simplest way to invest in any asset class. It is called an investment vehicle and gateway to investment world. It is ideal for beginners especially. It is also a preferable tool for tax saving. In this chapter we will see what is mutual funds and various aspects and categories of mutual funds.

Mutual Funds

Mutual funds are pooled money from public to invest in various asset class. To understand this let us assume that Anubhav our hero, is an expert investment adviser. His friends wants to invest but they are new to investment and they need an adviser. So Anubhav collects the money from his friends and invests in various assets on behalf of his friends. For this he also collects a small fee.

One fine day, he feels he can practice this as his profession and obtains necessary approvals from regulators and starts to extend this service to others. He forms a company to carry on this business. Since, each person will have different objectives and time frames and risk appetite, he decides to have different schemes with different objectives to serve different investors. So, he forms different schemes with different objectives and he floats various funds. These different schemes he formed are mutual fund schemes and the company that he formed to carry on this business is called an “Asset Management Company”.

With the above illustration, we can understand that mutual fund houses are entities (asset management companies) that are engaged in managing the funds of the investors through their various schemes (mutual fund schemes) designed to serve different investors with differing objectives, time frame and risk appetite.

How does mutual funds work

Mutual funds collects money from investors and they will invest in equity, debt or in both as per the schemes' objectives under which they have collected the money. Mutual funds issue units to the investors for the money they invest. Suppose you invest Rs.10000 in a mutual fund scheme and the face value of the scheme is Rs.10, then you will be allotted 1000 units (10000/10) for the money you have invested.

A professional called “Fund Manager” will manage the funds collected. His responsibility is to invest the money according to the scheme's objectives to generate capital gains and or income to the investors. Before proceeding further let us list down the terminologies we have discussed till now and understand it in conjunction with our illustration.

Type of company floated by Anubhav to manage funds of investors = Asset Management Company (Mutual fund house)

The schemes Anubhav floats = Mutual fund schemes

Since Anubhav manages the investment of the collected money, he assumes the role of = Fund Manager

Now let us assume that Anubhav's friends Gaurav and Vaibhav invests Rs.2 lakhs each and five more people invests different amounts as per their wish. Let me put it in tabular form and see how much units are allotted to each of them assuming face value of Rs.10/-. Please note that when a mutual fund scheme is floated for the first time, the face value of the fund is generally fixed as Rs.10/-.

In the above image you can see that each investor is allotted units according to the money they have invested. Can you notice a new term “Total asset under management (AUM)”? This is nothing but total of the amount invested by all investors in that scheme. But why do they call it “Asset”? Because an equity mutual fund will invest the pooled money in various stocks instead of one stock. This is collectively known as an asset. It can also be called "portfolio".  The performance of the portfolio depends upon the price movement of different stocks in the portfolio. So, when there is an appreciation in the price of the different stocks in the portfolio, it leads to the appreciation of the value of the asset under management, thus increasing the net asset value (NAV). Net asset value is calculated by dividing the total value of the assets by the total outstanding units held by all investors together. When it is said net asset value, it means net of all expenses incurred in connection with managing the portfolio.

In the above picture, we can see that the value of the asset under management (AUM) has increased to Rs.7.08 lakhs from Rs.5.90 lakhs. The increase in AUM is reflected in the appreciation of net asset value (NAV) which is grown from Rs.10 to Rs.12 after one year.

The net asset value (NAV) will be calculated and published on daily basis as the change in price of the securities held under the schemes changes everyday.

Mutual funds distribute the profits and dividends earned by investing the money collected from investors, on pro rata basis according to their investment.

Mutual fund charges

A mutual fund incurs various expenditures while collecting and managing a scheme. The mutual fund collects the expenses from the investors by way of adjusting the expenditure while calculating the net asset value (NAV). While SEBI banned the entry load in the year 2009, funds charge an exit load while investors exit the scheme within one year of investment.

The funds incurs management expenditure, administrative and marketing expenditure. The management expenses includes fund manager fees and administrative expenses includes expenses such as office, staff expenses etc and marketing and distribution expenses incurred in connection with marketing of the mutual fund schemes. All these expenditure put together is used to calculate the important ratio called “Total Expenditure Ratio” (TER).

Importance of Expenditure Ratio

Expense ratio is an important ratio to be considered by the investors before investing in a scheme. It is expressed as a percentage on the total asset under management (AUM). The low ratio benefits the investor, because it means lesser deduction in the net asset value ((NAV). However SEBI has set limits on the expense ratio to be charged by the mutual fund schemes. It is capped on slab basis. Maximum of 2.5% is allowed on the first Rs.100 crore of average weekly total net assets and the lower is upto 1.75%. For example, if the fund's AUM is Rs.100 crore, then 2.5% expense ratio means Rs.2.5 crores.

But how does this affect you as an individual investor? The expense ratio indicates how much the fund charges to manage your portfolio. For example, if the returns from a mutual fund scheme is 10% and the expense ratio of that scheme is 2.5%, then the net returns you get will be only 7.5% . This is because the expenses are adjusted while calculating and publishing the net asset value (NAV) of the scheme.

Regulators

Securities and Exchange Board of India (SEBI) is the regulatory body for mutual funds in India. Mutual funds are governed by SEBI regulations 1996. SEBI also regulates the distributors of mutual fund schemes. To safeguard the interest of the investors and simplify the mutual fund investment, SEBI in the year 2018, re-categorized the mutual fund schemes.

Mutual fund categories

There are different categories of mutual fund schemes. Mutual fund schemes are broadly classified as “Open End”, “Closed End” and “Interval Funds” based on their structure.

Open end funds are the funds in which you can invest any time and exit any time. Open end funds provide liquidity to the investors.

Closed end funds are the one which has fixed AUM and investors can invest only at the time of its initial launch which will be open for a limited period. In closed end funds, investors can redeem their investment during the redemption period announced by the fund. However, since it is listed and traded in secondary markets, it provides an exit route for the investors who wish to exit before the redemption period.

Interval funds are the ones that will be open for subscription and redemption only for a limited period at particular intervals.

Whether the scheme is an open end or closed end, it can be further classified as equity, debt, hybrid or specialized funds based on its objectives.

Equity Funds

These funds invest majorly in stocks. Since, these funds have their investments made in equities, they carry high risk. And equity funds offer highest returns. Investors who seek growth and willing to take higher risk can opt for equity funds. Based on the objective of the funds, it can be further classified as under:

Large Cap Funds

Funds that invest in stocks that has large market capitalization. These funds should invest minimum of 80% of its funds in equities and equity related instruments.

Mid Cap Funds

Funds that invest in stocks that has medium market capitalization. These funds should invest minimum of 65% of its funds in mid cap equities and equity related instruments.

Small Cap Funds

Funds that invest in stocks that has small market capitalization. These funds should invest minimum of 65% of its funds in small cap equities and equity related instruments.

Large & Mid Cap Fund

These funds invest in both large and mid cap stocks where the growth opportunity is identified. It is stipulated that these funds should invest minimum of 35% each in large cap and mid cap equity stocks and equity related instruments.

Multi-Cap Funds

These are funds that invest in stocks of different market capitalization. These funds should have minimum exposure of 65% to equities and equity related instruments.

Thematic or sectoral Funds

These funds invest in specific sector such as pharmaceutical, FMCG etc. These funds are more riskier as they concentrate on a single sector. The returns from these funds are depended on the performance of that particular sector the fund invests. These funds should invest minimum of 80% of its funds in that particular sector.

Focussed Funds

These are open end equity funds that focuses only on maximum of 30 stocks. These funds should invest minimum of 65% of its funds in equities and equity related instruments.

Dividend Yield Funds

These funds invest in stocks that offer high dividend yield with steady business growth. These funds should invest minimum of 65% of its funds in equities and equity related instruments.

Value Oriented Funds

These are funds that identify and invest in stocks that offer value and good future growth prospects. These funds should invest minimum of 65% of its funds in equities and equity related instruments.

Contra Funds

These are funds that invest against the market trend. They invest in beaten down stocks hoping the stock price to rise in the long run. These funds should invest minimum of 65% of its funds in equities and equity related instruments.

Index funds

These funds invest in stocks that forms part of an Index such as Nifty 50 or Sensex. These funds offer growth in long term. These funds carries low risk as the portfolio is spread among stocks of different sector and with different market capitalization.

Tax Saving Fund (ELSS)

These funds invest in equities. These funds should invest minimum of 80% of its funds in equities and equity related instruments. This scheme offers tax benefit to investors u/s 80C of the Income Tax Act. This scheme has a lock-in period of 3 years. Among all tax saving instruments, this scheme is the one which has lowest lock-in period. Hence, investors prefer ELSS for the purpose of tax saving.

Debt Funds

These funds are income oriented and carries low risk. These funds invest in debt instruments such as company debentures & bonds, government bonds and other debt instruments. Debt funds are suited for investors who seek regular income with small growth in their investment. Debt funds are classified as under:

Dynamic Bond Funds

These funds invest in both longer and shorter maturity instruments. In line with the name of the fund, they keep changing their portfolio according to the change in interest rate.

Money Market Funds

These funds invest in government Treasury Bills (T-Bills) & commercial papers (Cps) offered by corporates. These funds are ultra-short term funds and are highly liquid. Investors looking for opportunity to park their surplus money for very short period or even for a day can invest in these funds. Since investment in these funds are for very less period the risk involved is very much less. Moreover, the risk is low as these funds invest in T-Bills though the returns are also low.

Long Duration or Income Funds

These funds invest in long term bonds and government securities and their objective is to provide capital protection and regular income to the investors. These funds are suitable for investors who look for medium to long term investment with regular income and capital protection.

Short Duration Funds

These funds invest in short term debt instruments, which has a maturity of 1 year to 3 years period. These funds also provide capital protection along with fixed income to the investors.

Gilt Fund

These funds invest in long term government securities. These funds should invest minimum of 80% of its funds in government securities. These funds offer regular income and capital protection to the investors.

Credit Opportunities Funds

These funds invest in lower-rated bonds that offers higher interest. These are more riskier funds as they invest in debt instruments that offer high interest irrespective of the ratings of the instruments.

Fixed Maturity Plans

These are closed-end funds and they have a lock in period. Investment can be done in these funds only during its initial offer. These funds invest in short to medium term debt instruments ranging from 1 to 3 years generally. Investors who seek decent returns with regular income can opt for these plans.

Hybrid Funds

These funds are also called balanced funds as they balance their investment among equity and debt instruments. These funds are further classified into :

Aggressive Funds

These funds invests 65-80% in equities and hence carries higher risk. Investors looking for growth and are willing to take higher risk can invest in these funds.

Conservative Funds

These funds invest 75-90% in debt instruments and are less risky. Investors looking for low risk investment can opt for these funds.

Balanced Funds

These funds invest up to 60% in equities and 40% in debt instruments offering the growth opportunity of equity as well as security.

Balanced Advantage Fund or Dynamic Asset Allocation Fund

These funds keep changing their investment portfolio according to the market condition. They switch between equity and debt.

Multi-Asset Allocation Funds

These funds invest in equity, debt and gold. It offers the advantage of investing in more asset class through single investment. It is a good option for the investors who would like to have diversified investment that includes safe haven gold.

Arbitrage Funds

These funds invest 65% in equities. They take advantage of the price difference between cash and derivative market.

Equity Savings Funds

These funds invest in equity, debt and they also take advantage of arbitrage opportunities. Minimum investment in equity should be 65% and in debt 10% of total funds.

Specialized Funds

The following types of funds are classified as specialized funds

  • International Fund
  • Global Funds
  • Fund of Funds

International Fund

These funds invest in stocks of countries other than the home country.

Global Funds

These funds invest in stocks of other countries as well as home country.

Fund of Funds

These funds invest in the other mutual fund schemes. Investors who want to have diversified mutual fund portfolio can opt to invest in this fund instead of investing in different funds for different objectives.

New Fund Offer

New fund offer is a process where a mutual fund house floats a new mutual fund scheme for the first time and opens it for subscription in primary market. The new fund offer will be open for a limited period wherein the fund units are offered at a face value of Rs.10/- each.

Investing in NFO provides diversification, if the new fund comes out with new thematic or sectoral fund that is not currently available in mutual fund industry.

The objectives of the fund will be clearly defined in the offer document. Investors should choose a fund that suits their objectives and goals and risk appetite. Moreover, investors should check the track record of the fund house and the fund manager before investing.

Taxation

Mutual fund investments are taxed according to the type of mutual fund scheme and according to the tenure of your investment. Short term capital gains arising out of investment in equity funds are taxed @15% and long term capital gains after one lakh rupees are taxed @ 10% without indexation. In case of debt mutual funds, short term capital gains are taxed as per the individuals income tax slab and long term capital gains is taxed @ 20% with indexation benefit.

In case of equity funds more than 12 months is termed as long term and in case of debt funds more than 36 months is termed as long term.

In case of ELSS scheme capital gains arising on redemption after lock in period of 3 years is considered to be long term capital gains and gains more than one lakh rupees is taxed @ 10% without indexation.

Benefits of Mutual Funds

Mutual funds has many advantages for investors. Though the cost of investing in mutual funds are slightly higher than direct stock investment, the expenditure we incur while investing in mutual funds are compensated by the benefits of mutual fund.

Diversification

First and foremost benefit is diversification. Mutual funds offers various schemes designed to suit particular objectives and time frame which makes it a good diversification tool. As many of the retail investors do not have either the expertise or time to analyze and make own decisions, mutual funds are ideal investment vehicle. Investors can diversify their investment in various schemes for their varied financial needs and time frame. For example an investor can divide his portfolio into equity, debt and gold and invest accordingly in respective schemes.

Professional Management

Mutual fund schemes are managed by professionals who have expertise in investment. When we invest in mutual funds, we get access to professional management of our portfolio though with small cost.

Low Investment

Mutual funds facilitates investment as low as Rs.100. It helps small investors to use mutual funds route to grow their wealth decently. The affordability that mutual funds offers has made it a preferred investment avenue for small investors.

Liquidity

Mutual funds investment offers higher liquidity. Investment in mutual funds can be done on any business day. However, with the introduction of mobile application, investors can invest and exit at any point of time from anywhere in the world.

Regular Income

By investing in dividend option of equity and debt mutual funds, investors can avail regular income by way of dividends.

Systematic Investment Plan

Mutual funds systematic investment plan (SIP) is the revolution in mutual funds industry. Investors can plan their investment amount and time according to their inflow of money. SIP is an option provided by mutual fund houses to invest in their schemes even in small amounts, with regular intervals.

An investor by opting for SIP can develop disciplined investment approach by scheduling his investment according to his income. Moreover, small investor can free themselves from the effects of volatility in stock market and it also helps in cost averaging.

Tradeplus' mobile application for mutual fund investment “Infini MF” provides options such as "Flexi SIP" under SIP. wherein investors can invest in mutual funds on any date instead of at regular intervals. Moreover, investors can track their mutual fund holdings and also redeem the units through the APP.

How to invest in mutual funds

There are two options in making investment in mutual funds. One is “Regular” and another “Direct”. If you go through a mutual fund adviser you will be investing under “regular” mode and if you take investment decision on your own and make investment on your own then you can select “direct” mode where you will be saving on the distributor cost.

Tradeplus offers online mutual fund investment facility where you can select your mode of investment. Investors can open trading account with tradeplus and with their login credentials access the online mutual fund portal and punch in their orders.

Alternatively, Tradeplus has world class mobile APP for mutual fund investment “Infini MF”. Through this APP investors can invest in direct mutual funds and save on the distributors cost. They can set SIP investment with an option “Flexi SIP” and track all their mutual fund investment in single APP anytime and from any where.

Key points to remember

  • Mutual funds are pooled money that invests in various asset classes.
  • Units are allotted to investors for the investment they make.
  • Net asset value (NAV) is the value of the total asset under management minus expenses.
  • Mutual funds incur operating expense, marketing and distribution expense and administrative expenses.
  • Investors should select a fund with low expense ratio for better returns.
  • Major categories of mutual funds are equity, debt, hybrid and specialized funds.
  • Investors with high risk appetite and looking for growth can invest in “equity funds”.
  • Investors with low risk appetite and looking for capital protection with regular income can invest in debt funds that invests in government securities and high graded corporate debt instruments such as “income funds”.
  • Investors who wish to have exposure to government securities can invest in “gilt funds”.
  • Investors who wish to invest in other countries stocks can opt for “international funds”.
  • Investors who want to have exposure to gold along with equity and debt can invest in “multi asset allocation fund”.

Round Up

Mutual fund is the ideal investment vehicle for both novice and experienced investors. It offers diversification and exposure to professional management at a minimal cost. Various schemes are floated by mutual fund houses to cater to the varied needs of the investors. Systematic investment plan (SIP) is a tool for small investors and it helps in developing a disciplined approach to investment.

 

Suggested Readings:

  1. SIP vs Recurring Deposit Read Here
  2. Is dividend plan of mutual funds sahi hai? Read Here
  3. All we need to know about index fund Read Here
  4. ETF Vs Index Fund Read Here
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