Mutual Funds

Mutual funds diversify the portfolio across companies and sectors to reduce Risk because all stocks may not move simultaneously in the same direction and proportion. Mutual fund issues units to the investors following the quantum of money invested. Investors of mutual funds are known as Unit Holders. The investors share the profits or losses in proportion to their investments. Mutual Funds usually come out with many schemes with different investment objectives, which are launched from time to time.

LEARNING OUTCOMES

At the end of this course, you will be able to understand:-

• Mutual funds.
• Formation and Setup of mutual funds.
• Classification of Mutual funds.
• Various Mutual Fund Schemes.
• Net Asset Value (NAV).
• Compare Mutual Fund Schemes.
• Mutual Fund Benefits.

Mutual Funds based on Structure

Closed-End Funds

A closed-end fund has a fixed number of shares outstanding and operates for a fixed duration (generally ranging from 3 to 15 years). The fund is kept open for subscription only during a specified period. Closed-end funds may also be listed on the stock exchange, so they are traded just like other stocks on an exchange or over the counter. Usually, the redemption is also specified, meaning they terminate on selected dates during which the investors can redeem their units.

Open-End Funds

An open-end fund is available for subscription throughout the year and is not listed on the stock exchanges. The majority of mutual funds are open-end funds. Investors have the flexibility to buy or sell any part of their investment at any time at a price linked to the fund’s Net Asset Value.

Interval Funds

Interval funds are close-ended schemes with a peculiar feature: they open for redemption or a new subscription for a specified period at a fixed periodical interval. Before and after such specified interval scheme operates as close-ended funds while works as an open-ended fund during the specified time. Thus, these funds have a combination of features of open-ended and close-ended funds.

Mutual Funds based on Investment Objective

Growth Funds

The money is invested in growth funds with the prime objective of capital appreciation. Although growth funds are risky, they tend to offer high returns in the long run.

Income Funds

Money gets invested in fixed income instruments like government bonds and debentures under income funds. The objective of the income fund is stable income on investment with capital growth.

Liquid Funds

The money is invested in short-term financial instruments like treasury bills and deposit certificates to ease taking out money anytime. Liquid funds are considered low Risk with average returns and ideal for people looking for short-term investment.

Tax-Saving Funds or ELSS

ELSS or tax-saving mutual funds come under section 80C of the Income Tax Act 1961 and qualify for a deduction of up to INR 1.5 lakhs for a financial year. The majority of the investment gets invested in equity stocks. There is a lock-in period of 3 years in the ELSS investment.

Capital Protection Funds

The primary objective of these funds is to protect the money invested, and thus the funds get split between Equity and fixed income investments.

Fixed Maturity Funds

The investment is made in closed-ended debt funds with a fixed maturity date in fixed funds.

Pension Funds

Money invested in pension funds is for an extended period, keeping in mind the long-term objective of getting a regular pension to the investor when he retires. The pension funds get invested in Equity and debt instruments, where Equity helps the investment grow, and debt funds maintain a balance of Risk. The returns on the pension fund can be withdrawn as a lump sum, as a regular pension, or even a combination of both.

Mutual Funds based on Asset Class

Equity Funds

Equity funds are mutual funds that invest majorly in equity stocks of the company. Equity funds are considered risky, but they tend to give higher returns in the long term.

Debt Funds

Debt funds are mutual funds that usually invest in government securities, corporate bonds, etc. Debt funds are more stable and less volatile to market conditions.

Money Market Funds

A money market refers to the mutual funds that are highly liquid and where the money is invested in short-term investments like deposit certificates, treasury bills, etc. You can have your money invested in money market funds for a duration like a day.

Balanced or Hybrid Funds

Balance or hybrid funds are a mix of equity and debt funds. They tend to invest an equal amount in equity and debt funds to keep the risk level balanced in the investment.

Mutual Funds based on Speciality

Sector Funds

Sector funds are the funds that stick to one sector of the industry. For example, Real Estate mutual funds will only invest in companies in the real estate business or sector. The investment returns also depend on the performance of the particular sector.

Index Funds

The index fund is a type of investment made to match the working of a market index like BSE SENSEX, NIFTY FIFTY, etc. As a result, these funds provide broader exposure to the market, less operating cost, and low portfolio turnover.

Fund of Funds

Funds of funds are the types of mutual funds that invest in other mutual funds. The returns solely depend upon the performance of the target fund. These types of funds are also referred to as multi-manager funds.

Emerging Market Funds

In emerging market funds, the investment is made in developing countries growing economically at a reasonable rate. However, these funds are considered risky, as many other factors depend on the performance of the political and economic situations of the particular developing country.

International Funds

International funds invest their money in global companies in other parts of the world. International funds are also known as foreign funds. The money in international funds is not invested in the investor’s own country.

Global Funds

These are similar to international funds and invest their money in companies in all parts of the world. The only difference between international funds is that investments could also be made in the same country as mutual funds.

Real Estate Funds

As the name sounds, the real estate funds invest their money in the real estate business. The investment in a real estate project could be made at any project phase.

Commodity-Focused Stock Funds

The investment is made in companies working in the commodities market, such as mining companies or producers of commodities. Therefore, the performance of these funds is directly linked to the performance of those commodities in the market.

Market Neutral Funds

These funds do not invest directly in the market. Instead, they invest in securities and treasury bills to aim for steady and fixed growth.

Inverse / Leveraged Funds

These funds don’t operate as regular mutual funds. They profit when the market falls and incur losses when it does well. The risk factor in such funds is very high as they can make you huge losses or profits per market conditions.

Asset Allocation Funds

These funds allow the portfolio manager to adjust the allocated assets to achieve results. The investment amount gets divided into funds to invest in different instruments like bonds and Equity.

Mutual Funds based on Risk

Low-Risk Fund

These types of mutual funds invest in the debt market, where the Risk to the investment is shallow. The investments tend to be long-term, but the returns are also moderate due to their low risks. An example of a low-risk mutual fund is a debt fund, where investments are made in very safe government securities.

Medium Risk Fund

These investments carry medium Risk to the investor. Medium-risk mutual funds are ideal for those willing to take some risks to get good returns on their investment. The investment portfolio is a mixture of debt funds and equity funds.

High-Risk Fund

These investments are high for those willing to take a high risk on their investment with an expectation of high returns. High-risk investment invests a majority of the money (investment) in equity stocks of the company.

Features of Mutual Fund

Features of mutual funds are as under:

Diversification

They are a great tool to achieve diversification of investments. The investor can spread risks by investing in mutual funds, where the money is parked in different asset classes, liDebtquity, Debt, etc. Diversification is the ideal means to risk mitigation and allows the portfolio to perform better.

Professional Management

They are managed by professional fund managers, considered experts in their field. Fund managers value the value of the stock, the invested company product and its current & future market position, past performance of the stock, etc. They are also responsible for investing in stocks that sync with the fund’s strategy and investor goals. As a result, fund houses or Fund managers have access to resources that are above and beyond the reach of the individual or retail investor.

Flexibility

They offer flexibility through systematic withdrawal plans, dividend reinvestment, and investment plans. Given that these funds could be availed in small units, they are quite affordable for small MF investors. The fees associated with MFs are very low as well. In addition, these funds provide the option to redeem or withdraw money anytime.

Liquidity

They are more or less seen as liquid investments unless there is a pre-specified lock-in period. Then, investors are generally permitted to take their money out without hassles. For example, money market funds allow you to have your money invested for, as short a duration, as a day. However, do look out for the fees associated with selling the funds.

Affordability

They provide the option of investing through Systematic Investment Plans, where investors can park a sum as low as Rs 500/- every month. This makes it quite affordable, even for individuals of the low-income group.

Transparency

They are transparent about the various fees charged and the portfolio holdings. In addition, investors can view the underlying securities (bonds, stocks, cash, or a mix) that the portfolio holds. The mutual fund prospectus can easily be found on the company’s website.

Tax Benefits

They are considered to be more tax efficient than other types of financial instruments available in the market. ELSS, a specific class of funds, are exempt from taxation under section 80C of the Income Tax Act 1961 for a limit of INR 1.5 lakhs. The following are the advantages of ELSS:

• Substitute route to invest in the stock market.
• Only a 3-year lock-in period.
• A tax benefit of up to INR 1.5 lakhs.
• Best returns over a more extended period.

Choice of Investment

Another significant advantage is that they come in different types, suiting the needs of more comprehensive requirements of various kinds of investors. Depending upon your financial goals, you can choose to invest in the appropriate category of mutual funds available.

• Liquid Funds: If you want only to invest your money for the short term, you can invest in liquid funds.
• Short-Term Funds: If you don’t want to commit your investment for a period that is something like 1 to 3 years, then short-term funds will serve the purpose for you.
• ELSS Tax Saving Funds: For all your tax saving needs, the ELSS scheme in funds will be an ideal selection for you.
• Long-Term Funds: For investors who are willing to keep their money invested in the long term for them, equity funds are the best selection.

Mutual Fund Offer Document

The mutual fund gives an abridged offer document, which contains beneficial information, to a prospective investor. The application form for subscription to a scheme is an integral part of the offer document.

SEBI has prescribed some minimum disclosures to be made in the offer document. Therefore, an investor should read the offer document before investing in a scheme.

Due care must be given to portions relating to the following main features of the Scheme:

• Risk factors.
• Initial issue expenses.
• Recurring expenses to be charged in a scheme.
• Entry or exit loads.
• Sponsor’s track record.
• Educational qualification.
• Work experience of key personnel, including fund managers.
• Performance of other schemes launched by the mutual fund in the past.
• Pending litigation and penalties imposed, etc.

Net Asset Value

The Net Asset Value (NAV) of a ​mutual fund is the price at which units of a mutual fund are bought or sold. It is the market value of the fund after deducting its liabilValue. The value of all units of a mutual fund portfolio is calculated daily; from this, all expenses are subtracted. The result is divided by the total number of units; theValueltant value is NAV. NAV is also sometimes referred to as Net Book ValValue Book Value.

NAV indicates the market value of the units in a fund. So, it helps an investor track the performance of the mutual fund. An investor can calculate the actual increValuen value of their investment by determining the percentage increase in the mutual fund NAV. NAV, therefore, gives accurate information about the mutual fund’s performance.

NAV Calculation

Mutual fund assets usually fall under two categories – securities & cash. Securities, here, include both bonds and stocks. Therefore, the total asset value of a fund will consist of its stocks, cash, and bonds at market value. Dividends, interest accrued, and liquid assets are also included in total assets.

Also, liabilities like money owed to creditors and other expenses are included.

The formula for the NAV is :

Net Asset Value (NAV) = (Assets minus Debts) / Number of Outstanding units.

Here:

• Assets = Market value of mutual fund investments + Receivables + Accrued Income;
• Debts = Liabilities + Expenses (accrued)

The market value of the stocks & debentures is usually the closing price on the stock exchange where these are listed.

Important

Mutual funds depend on stock markets, and they declare the NAV after the closing hours of the stock exchange. All Mutual Funds​​ must publish their NAV daily as per SEBI guidelines. Also, NAV is obtained after subtracting the expenses based on a fund’s expense ratio.

Expense Ratio

Under SEBI (Mutual Funds) Regulations, 1996, Mutual Funds are permitted to incur/charge certain operating expenses for managing a mutual fund scheme – such as sales & marketing/advertising expenses, administrative expenses, transaction costs, investment management fees, registrar fees, custodian fees, audit fees, as a percentage of the fund’s daily net assets.

This is commonly referred to as the ‘Expense Ratio.’ In short, the Expense ratio is the cost of running and managing a mutual fund charged to the Scheme.

The expense ratio is calculated as a percentage of the Scheme’s average Net Asset Value (NAV)

The daily NAV of a mutual fund is disclosed after deducting the expenses. Thus, the Total Expense Ratio (TER) has a direct bearing on a scheme’s NAV – the lower the expense ratio of a scheme, the higher the NAV.

The operating fees (Expense Ratio) usually vary between 1% and 3% and are chargeable at an annual percentage for the effective management of mutual funds. It is also referred to as the management fee and the advisory fee charged by your agent/broker (if any).

For example: if you invest Rs.1,00,000 in a fund with an expense ratio of 1%, then you are paying the fund house Rs.1,000 to manage your money. It can be said that if a fund earns 10% and has a 1% TER, it means a 9% return for an investor. The mutual fund’s NAVs are reported after netting off the fees and expenses; hence, it is necessary to know how much the fund is deducting or charging as expenses.

Load vs. No-Load Fund

A Load Fund charges a percentage of NAV for entry or exit. Each time one buys or sells units in the fund, a charge will be payable. The mutual fund uses this charge for marketing and distribution expenses.

Suppose the NAV per unit is Rs 10. If the entry and exit load charged is 1%, then the investors who buy would be required to pay Rs 10.10, and those who offer their units for repurchase to the mutual fund will get only Rs 9.90 per unit.

Investors should consider the loads while investing, affecting their yields/returns. However, the investors should also consider the mutual fund’s performance track record and service standards. Efficient funds may give higher returns despite loads.

A no-load fund does not charge for entry or exit. The investors can enter the fund/scheme at NAV, and no additional charges are payable on purchasing or selling units.

Direct and Regular Funds

Mutual funds can be classified into two categories – Direct Fund and Regular Fund. The same fund manager would manage them both. However, there are specific differences between them.

Let’s understand them below:

Direct Mutual Funds

These funds do not involve charges as commission to the agent/broker, payable by fund investors. Also, these funds offer higher NAVs.

Regular Mutual Funds

These funds involve commissions payable to the broker/agent over the fund investment amount. This implies that these charges cut into the investor’s returns, thus, offering lower NAVs.

Mutual Funds Comparison

The following parameters may be considered to compare funds:

• Average Returns.
• Volatility.
• Corpus Size.
• Performance vis-à-vis Benchmarks/ Other Schemes.
• Load or No-load Fund.

Average Returns

An investor should look at the returns the fund gives over time. Care should be taken to see whether all dividends and bonuses have been accounted for. The higher and more consistent the returns are, the better the fund is.

Volatility

In addition to the returns, one should also look at the volatility of the returns the fund gives. Volatility is essentially the fluctuation of the returns about the mean return over time. A fund providing consistent returns is better than a fund whose returns fluctuate significantly.

Corpus Size

A large corpus is generally considered good because significant funds have lower costs, as expenses are spread over substantial assets. Still, at the same time, a large corpus has some inefficiency too. A large corpus may become unwieldy and, thus, challenging to manage.

Performance vis-à-vis Benchmark Schemes

An investor should not only look at the returns given by the Scheme they have invested in but also compare it with benchmarks like the BSE Sensex, S & P Nifty, T-bill index, etc., depending on the asset class they have invested in. Moreover, for an accurate picture, it is advised that the returns should also be compared with the returns given by the other funds in the same category.

Load or No-load Fund

A Load Fund charges a percentage of NAV for entry or exit. Each time one buys or sells units in the fund, a charge will be payable. The mutual fund uses this charge for marketing and distribution expenses.

Suppose the NAV per unit is Rs. 10. If the entry, as well as exit load charged, is 1%, then the investors who buy would be required to pay Rs 10.10, that is; [Rs 10 + (10 multiplied by 1%)], and those who offer their units for repurchase to the mutual fund will get only Rs 9.90 per unit [10 minus (10 multiplied by 1 %)]

Loads are essential and should be considered while making investments as these affect their yields/returns. The performance track record and service standards of the mutual funds are also crucial in arriving at any decision. Efficient funds may give higher returns despite loads.

A no-load fund does not charge for entry or exit. The investors can enter the fund/scheme at NAV, and no additional charges are payable on purchasing or selling units. In India, the entry load is not charged in a mutual fund scheme; however, exit loads are levied and may vary from Scheme to scheme.

Mutual Fund Investment Strategies

Different strategies to invest in a mutual fund scheme are:-

Systematic Investment Plan

A systematic Investment Plan (SIP) offered for every investment enables investors to easily invest in their chosen fund through weekly, monthly or pre-defined installments. The investor is allotted units on a pre-determined date specified in the offer document at the applicable NAV.

Systematic Withdrawal Plan

As opposed to the Systematic Investment Plan, the Systematic Withdrawal Plan allows the investor to withdraw pre-determined amounts/units from his fund at a pre-determined interval. The investor’s units will be redeemed at the applicable NAV on that day.

Switching

Switching to other funds is necessary when a fund is on a downward trend. It is called’ changing’ when you decide to move your entire investment or some part of it from one mutual fund scheme to another. In this case, you are transferring funds within the same fund house.

If you were to switch fund houses, it is known as ‘Switch-in, switch-outs, where you switch out your mutual funds from one fund house to another. In this case, you must redeem units from the fund source and purchase units in the fund target. This also involves exit loads and capital gain payments.

Asset Class Investing

It invests in mutual funds based on its eight asset classes – equity funds, debt funds, money market funds, balanced funds, fund of funds, sector funds, index funds, and ELSS tax-saving funds.

Periodic Overview

Mutual funds are constantly vulnerable to market risks, which can be predictable and unexpected. While unforeseen risks cannot be averted, the predictable market risks can be avoided by keeping a close track of the funds’ performances in the portfolio and then selling or switching between funds.

Direct Plans

These funds are directly purchased by the fund house that owns it, generally through its official website or mobile app. Hence, they do not involve additional charges and expenses like brokerage fees.

Benefits of Mutual Funds

Some of the benefits of investing in Mutual Fund are:-

Easy to Understand

Mutual funds are simple to understand. They are an ideal option for investors who may not know much about investing. An AMC will pool investments from individuals and institutional investors with common investment objectives. A professional fund manager will manage the pooled money by investing in capital assets to generate maximum returns for the investors.

Easy to Buy

Online technology today makes buying, managing, and selling funds a hassle-free, convenient task for investors. You can just log in to the fund house website and purchase funds by following simple steps of instructions. Through online mode, you can also manage your investment by getting daily updates on your fund performance. Net Asset Value (NAV) gives you a simple understanding of your fund’s performance.

Different Categories

Asset management companies offer different kinds of mutual funds to meet investors’ diverse risk appetites. Some popular mutual funds in the market include equity funds, debt funds, income funds, money market funds, index funds, balanced funds, specialty funds, and fund of funds.

Low Expense

Mutual funds have money from many investors clubbed together in one fund. This way, the asset management cost gets divided amongst all the investors, and the investors feel no burden for the asset management cost. For example – If you buy something in bulk, you get a discount, and the price works out cheaper than a single product. The same applies to stocks – if you buy just one, the transaction fees work out more expensive than the stock if you buy multiple stocks in one shot. Help to make the transaction on a larger scale, ensuring the transaction charges don’t have much effect on the income.

Risk Diversification

A portfolio should diversify its assets in multiple shares and stocks across market caps and sectors to maintain a balance and avert unnecessary capital market risks. This will ensure that when a fund underperforms, other funds in the portfolio will not only keep your investments safe but also enable growth.

Mutual Fund Tax Benefits

The income received by an investor (other than income on sale/redemption) in respect of units of a mutual fund specified under section 10(23D) of the Income Tax Act is exempt under the Act.

Tax Impact on the distribution of dividends by a mutual fund scheme:

If a mutual fund scheme declares and distributes dividends to its shareholders, then a dividend distribution tax (DDT) is levied on such an amount. It is payable by the mutual fund and deducted from the amount paid to the mutual fund unit holder. On the other hand, the amount received by a unit holder is exempt from tax.

Taxability of income on Sale/ Redemption of units

The taxability of the income on sale/redemption of units and the rates at which such income is taxed are discussed in the given two conditions.

Mutual Fund Units are held as Investments.

• If the units are held as investments, the applicable tax rates will depend on whether the gain on the sale of units is classified as a short-term or long-term capital gain. As per section 2(42A) of the Act, units of the Scheme held as capital assets for more than 12 months immediately preceding the date of transfer will be treated as long-term capital assets for the computation of capital gains.
• In all other cases, they would be treated as short-term capital assets.

Short-Term and Long-Term Gains

The tax rates applicable on short-term or long-term capital gains arising on the transfer of units of a scheme, being an equity-oriented fund, are stated in the following table:

In addition to the above tax rates on LTCG and STCG, surcharge and cess may also be levied. Currently, the surcharge is 10%, and the cess is 4%. On capital gains, only a surcharge is levied. Dividend distribution tax (DDT) levied both surcharge and cess.

In the case of non-resident investors, the above rates would be subject to applicable treaty relief.

Mutual fund tax benefits under Section 80C

Investments in Equity Linked Savings Schemes or ELSS mutual funds qualify for deduction from taxable income under Section 80C of the Income Tax Act 1961. The maximum investment amount eligible for tax deduction under Section 80C is Rs 1.5 lakhs. However, it is essential to note that in an ELSS, there is a lock in three years; an after-investment amount couldn’t be withdrawn before three years.